Saturday, July 31, 2004

Buy your diapers from Amazon 


How does Amazon make money??! It's cheaper to buy diapers from Amazon than from Costco. Huggies packages are $7.49, no taxes, no shipping (if you buy over $25). So, for size 2 diapers which are 48 diapers per package, it is $0.156 per diaper ($7.49/48). A Costco box of 192 is also $0.156 per diaper ($29.99/192). It works out to be the same cost per diaper before tax, but remember: Amazon does NOT charge you tax!! Therefore, at Costco, you pay $2.47 ($29.99*8.25%) more per box. For a box of 192 size 2 diapers, that works out to be an extra $0.013 per diaper. Yes, one cent per diaper may sound trivial but if you are changing ~10 diapers per day, it all starts to add up. We used about 4-5 boxes for Isabella's first 3 months (these are size 1s which are 228 diapers per box; yikes - that means we changed over 1,000 diapers during that time) so we could have saved $12.50 if we only bought from Amazon! See this guy's diaper cost comparison if you need a more detailed analysis of the economics.

And, you have more room in your car when you go on Costco runs when you don't have to put that big box of diapers in there!

Friday, July 30, 2004

Trust or UTMA 

When trying to figure out how to transfer money to your child, you might be debating between setting up a trust or a UGMA & UTMA Custodial Accounts for Minors. If it is a large amount of money, you might prefer to set up a trust instead. This Fairmark site has some good information about the pros and cons of these types of custodial accounts.

Thursday, July 29, 2004

Where to park your money 

An ING Direct savings account will give you a much better rate at 2.2%, and it should be FDIC insured: Their rate is much better than most short term CD's and bonds.

Other options are to consider U.S. T-bills and other U.S. Treasury Notes b/c they're backed by the feds, they're tax free federally, and if you need to sell them early, you can (unlike a CD which usually has a penalty for early withdrawal).

If you can park your money for a set duration, risk-free CDs are great too. Check out

For longer term, it might be worthwhile to look at I-bonds and also state and muni bonds b/c of the extra tax benefits. (Munis can be triple tax free.)

Every Sunday, the New York Times Business section publishes the highest-yielding money market and CDs with reasonable credit ratings. also has charts like this. Last week, a bank called Charter One Bank, Ohio had a 2.5% jumbo money market account, and the highest 6-month jumbo CD was 2.41%.

Vanguard short term bond funds. Here's a summary. Note the 1 year spread and 3 year SD numbers: those are efforts to quantify risk.

Avg years Yield Tax-equiv AMT 1yr spread 3yr SD
(CA taxable)
VWSTX 1.1 1.54% 2.37% 13.3% 1.22% 0.97
VMLTX 2.2 2.25% 3.46% 11.6% 3.14% 2.47
VWITX 4.7 3.19% 4.91% 10.3% 6.40% 4.48

(CA tax exempt)
VCTXX n/a 1.14% 2.05% 13.0% n/a n/a
VCAIX 4.3 3.15% 5.66% 15.4% 6.54% 4.54
CA 50/50 2.15% 3.85% 14.2%

VWSTX: Vanguard Short-Term Tax-Exempt Fund Investor Shares 0041
VMLTX: Vanguard Limited-Term Tax-Exempt Fund Investor Shares 0031
VWITX: Vanguard Intermediate-Term Tax-Exempt Fund Investor Shares 0042
VCTXX: Vanguard California Tax-Exempt Money Market Fund 0062
VCAIX: Vanguard California Intermediate-Term Tax-Exempt Fund Investor 0100 CA 50/50: a straight average of the two CA options.

Taxable equivalent yields come from Vanguard's calculator. They assume top tax brackets (35% / 9.3%) and don't account for AMT. There's an AMT gotcha in those funds; you pay AMT on some portion of the otherwise tax-exempt proceeds. These bond funds' exposure is capped at 20%. Some data on the 2003 AMT exposure is summarized here, came from:

Other sources: Vanguard's own site, Yahoo Finance.

Monday, July 19, 2004

Asset allocation 

If you invest your money in index funds, it all boils down to asset allocation. Here is some research I did on firms that help investors with asset allocation.

Most major firms all seem to do Monte Carlo simulations of portfolios. Some do the optimization using statistics for asset classes, and then they instantiate that solution using "best-of-category" investments for each asset class. That seems like a good thing until you realize that the simulation assumed a random security for the asset class. There is no reason to assume that the final portfolio is still on the efficient frontier, and they don't re-run the simulation using statistics for the instantiated portfolio. Even if they were to choose a random example for each asset class, they should re-run the simulations and possibly re-sample depending on the outcome of the simulations.

Some of the firms seem to have a "strategic" asset allocation and a "tactical" asset allocation. The tactical is more short-term and incorporates qualitative economic insight (for example: Japan continues to show signs of improvement, namely rising confidence ... therefore 'overweight' this sector). They then perturb the strategic asset allocation for each category based on these qualitative 'overweight/underweight' assessments.

They often present three alternative portfolios: conservative, moderate, and aggressive (I think this is typically a bound on the acceptable variance).

Sunday, July 18, 2004

Mortgage or tax writeoff? 

(I'm still working on this blog, based on aggregation of many people's advice.)

If you have some extra cash, should you use it to pay down your mortgage or keep it for the tax deduction?

If your mortgage is $36K per year, then 42% of $36K is what you're saving. 58% of that is going to Uncle Sam. But you should forget the tax aspects. What is the opportunity cost of having the money, i.e. how else would you be using the money? If your are taxed at the 42nd percentile, having a mortgage would save you 42 cents on the dollar. You can take this money and invest it and hopefully get a higher return. Your investment should make more money than what you are effectively earning from the mortgage to make it worth it. So supposing you have a 5% mortgage, your investment should make 5% x (.58) = 2.9%.

Another example, suppose you have a 6% mortgage which after taxes is effectively 4%. Paying off the mortgage looks like a 4% investment. Compare this to the 3% you get in an index fund after taxes, and it starts to look pretty good. You are making the money the same way the bank is. Moreover, you don't have any worries about whether stocks are going up or down. Your investment is paying you whatever you would have paid to the bank each month as a mortgage payment.

Assuming 3% return on an index fund of 30 years is fairly conservative, but let's run the numbers:

Let's say you've got a mortgage of $500,000 and you also just so happen to have $500,000 in cash which magically appeared. Let's assume a mortgage rate of 6%. That means your monthly payment will be ~$3000/month of which $580,000 will be interest, which at the 33% tax rate will save you $191,400.

Now let's say that we invest the $500,000 in the Vanguard S&P 500 fund (just an example). Since 1976 the fund has return 8.03% after taxes (again 33% tax rate), so that would leave you with $5,073,000.

The alternative would be to pay off our mortgage and invest the $3000/month in the same fund for 30 years. That would give us a return of $4,471,078.

The other catch is you've lost the $191,400 in tax savings by paying off the mortgage early. Those savings as well could have been invested over the duration and would have produced additional return. In the end we are looking at a difference of around $1,000,000.

It's an interesting dilemma and if you have so much cash that you have enough to maximize your pre-tax contributions, setup IRAs, establish a nice diversified investment portfolio and pay off your mortgage, then well it's probably not a bad idea, but if you are struggling with paying off your house OR investing the money it might be worth some thought.

We're talking about the risk-averse person. This person looked at the flat period where the S&P growth for 10 years was close to zero (in the '70s? I forget). He looks at the Japanese flat period, and concludes that the Vanguard fund is not going to give him 8% after taxes. He's using Nelson's number of 3%, but really expects even less.

Furthermore, the reason he's in the 33% tax bracket is because he has to work all day to afford that $3000 mortgage payment. He'd rather write his novel, work on his web page, start a little software company with some friends, or maybe go fishing. If he pays off the mortgage, puts up solar panels, and thus prepays his expenses, he can move to a 10% or 15% tax bracket, without changing his standard of living for the worse (in fact, it improves because he enjoys fishing more than commuting). If you've retired early and thus fall into a low tax bracket, then interest deductions aren't that useful anymore.

Also, the "tax savings" of the mortgage deduction is not really there. That money went to the bank instead of to the government. You didn't get to keep any of it. By paying off the mortgage and moving to a lower tax bracket, you pay far less in taxes, and you don't have to work the extra 10 days a month for the government (33% tax bracket).

Burton Malkiel made the suggestion of buying a AAA rated municipal bond of the same duration as the mortgage. The AAA rating means the bond is insured, so the risk of default is almost zero. Longer term munis are fetching about 5% and this income is tax free, thus covering the after tax cost of the mortgage of many people. In other words, one can arbitrage the difference between one's home mortgage and a minu bond.

Other notes on real estate:

One thing people often neglect about real estate is that the leverage can be much higher than with equities. If you put 10 percent down on a million dollar house and the market drops to where your house sells for 900k, you have nothing. On the other hand, the slightly more likely scenario is that the house sells for 1.1 million, and you have doubled your money.

Costs such as the 8% management fee paid to a management company for a rental property (to find renters, take phone calls about plumbing problems, handle repairs,
etc.) come out of the rental income before taxes. In the early days of owning the property, you have net losses (the rent is smaller than the mortgage payment) which can be used to offset income for tax purposes. This negative cash flow is subtracted from the $175k when you sell the property, reducing your taxes a second time.

If you like renting, all of this may not make sense economically. Rents are currently very low compared to the costs of a mortgage, and your speadsheet may show you coming out ahead with the index fund. And you may not wish to live in the same place forever, and thus you run the risk of selling the house when prices are low. Everyone will want to run their own numbers.

Any maintenance costs for a rental property can be written off against the rental income (or other income). You can also write off depreciation on the property each year. Of course when you sell it, any depreciation you've claimed reduces your basis in the property, increasing your capital gains.

For primary residences, costs cannot be written off, but major improvements do increase your basis in the house for capital gains purposes when you sell. Things like adding a deck, putting on a new roof, remodelling the kitchen all qualify for this, but normal maintenance like painting or replacing the carpets doesn't.

The main risk is being forced to sell at a bad time.
> If you have enough money in other investments to either
> live off of their proceeds, or pay off the mortgage, then you can
> isolate yourself from the risks of not being able to pay the mortgage.
> The high leverage occurs in the beginning. After a while, the
> Loan-To-Value decreases, along with both the advantages and
> disadvantages of leverage.
> Someone with a 6% mortgage is paying about 4% interest after taxes. By
> using a windfall to reduce the loan amount on their house, they are
> getting 4% on their money (by not paying interest). No matter what
> happens to the economy, that 4% is guaranteed, as it is money that
> would otherwise have to be paid, but now is forever retired.
> The risk-averse investor would first pay off all existing debt before
> investing in something more speculative, such as index funds. If you
> happen to own a house for all the non-economic reasons for doing so,
> paying off the mortgage reduces your risks substantially. You will
> never get less that 4% return on that money.
> People who are less risk-averse might try for higher than 4% after tax
> returns on their money, and accept the risks of getting less than 4%
> if the economy goes sour. People who are content to rent their homes
> can save money because renting a house is cheaper than paying a
> mortgage on that same house. But they should be investing the
> difference, in order to keep up economically with the homeowner, who
> not only has something of value in the end, but who has the advantage
> of up to 10 fold leverage.
> If the homeowner never intends to sell the house, then he might
> consider paying off the mortgage. This eliminates over half of the
> cost of the house over a 30 year period (by eliminating interest
> payments). This brings the cost of housing down to what the renter
> pays if they both live for 20 years or more. Longer than that, the
> homeowner with a paid-off mortgage wins.
> Even with a normal situation, the homeowner looks pretty good after 10
> years. Rents have risen to match his mortgage payments, so the renter
> is paying as much as the homeowner. His mortgage payments will not
> rise, but the renter's cost of housing will. The rent on my rental
> properties are above what I pay in mortgage payments, and I haven't
> owned them that long. (And in the meantime the depreciation has been
> lowering my taxes, but that does not apply to the homeowner, so it is
> not relevant here.)
> When looking at the economics of owning a house vs renting a house and
> owning shares in an index fund, you will need to factor in the rate
> that rents rise, the volatility of the stock market, and the chance
> that you will be forced to sell your
> home due to an inability to find a job in the bay area. Add to that
> the appreciation
> of the house's value over the long term, multiplied by the leverage of
> the low down
> payment, and things look pretty good for the homeowner. It is in the
short term
> where things are unpredictable. Never have short term money in the
> stock market, but that goes even more so for less liquid investments
> such as real estate.

> > I have heard variations of this argument many times. I think it's
> > incorrect.
> >
> > I believe there is something fundamental about markets that makes
> > the possibility of losing money necessary. I believe the
> > uncertainty is an essential property. I am especially paranoid
> > about the housing market because there is so much confidence,
> > because people have an irrational faith in the safety of real
> > estate, because financial planners urge people to treat it in a
> > different category from investments (as something that you live in
> > rather than invest in), and because of the high leverage that is
> > typically associated with a real estate investment.
> >
> >
> >
> > >Housing bubble is very hard to burst. The LA real estate market
> > >dropped a lot in the early 90's due to severe defense cut. The
> > >collapse of USSR was the primary reason. How often does it happen
> > >when a big country like USSR bellies up?
> > >
> > >When housing bubble indeed burst, it is more like hiccup than
> > >burst. The price "dropped 21% after 77% jump". If you buy your
> > >house 2 years before the burst, it still worth more than your
> > >purchase price even at the worst the burst. I do recall that many
> > >people treat the 89-96 housing dip as an "opportunity" to trade-up
> > >because the price gap between their current homes and their dream
> > >homes is somewhat smaller. If you have secure job, you should treat
> > >housing dip as your friend instead of enemy.
> > >
> > >Housing bubble is very resilient to burst. It survived 80% decline
> > >in NASDAQ and 9-11 terrorists attack. The real threat is prolonged
> > >recession and high interest rate at the same time -- which should
> > >not happen unless the government is seriously screwed up.
> > >Therefore, the burst of housing bubble is usually regional -- when
> > >regional recession is much deeper than the interest rate can drop
> > >nation-wide.
> > >
> > >Super-expensive housing may be more risky. However, the volume of
> > >super-expensive housing is so low that they have very little impact
> > >on the overall housing market.
> > >
> > >The fundamental question for primary residence is "can you afford
> > >it" instead of "is it expensive". You should not buy a house you
> > >cannot afford, regardless whether housing is deemed cheap or
> > >expensive.
> > >
> > >By the way, if the burst of housing bubble is the worst financial
> > >disaster for me, I am a very lucky man.
> > >
> > >
> > >
> > >>I tend to agree with Rob, I think if people are able to keep hold
> > >>of their house and make the mortgage payments, they're likely to
> > >>just hold on to a house than make a loss now.
> > >>
> > >>That's why I think the real estate bubble bursting is unlikely.
> > >>More likely is the bubble staying the same size for a prolonged
> > >>period of time.
> > >>
> > >>
> > >
> > >It might be good for people to remember the CA real estate bubble
> > >in the 80s...bubbles do burst, and often the reason is correlated
> > >with general economy badness. The mechanism that bursts the bubble
> > >is that people are forced to sell--for example, they lose their job
> > >and can't afford the mortgage anymore. In Los Angeles, home prices
> > >shed 21% between 1989 and 1996, with the typical house selling for
> > >$172,900. (The peak was $214,800 in 1989 following a five year,
> > >77-percent jump.) It took over 10 years for prices to get back to
> > >where they were. A 20% correction doesn't sound like much, but if
> > >you have a 80% mortgage it means you lost 100% of your downpayment.
> > >Yup, the Bay Area isn't LA in the 80s, but lots of warning signs
> > >are all over the place.
> > >
> > >To quote from a pretty good overview article
> > >(
> > >.asp):
> > >
> > >"You don't have to know exact P/Es, however, to spot signs of
> > >trouble, Leamer says. Any time there's a disconnect between prices
> > >and the underlying value of homes, as measured by their market
> > >rents, there's the potential for a bubble.
> > >
> > >If home prices are rising much faster than rents, as is true in Los
> > >Angeles, that's a strong indication a bubble is forming.
> > >
> > >If home prices are rising while average rents are falling -- which
> > >is the situation in San Francisco -- the bubble is pretty much
> > >unmistakable."
> > >
> > >Remember that bubbles look obvious only *after* they burst, not
> > >before.
> > >
> > >Now, this doesn't mean you shouldn't buy a house...but it does mean
> > >that there's a fair chance (some would say a near certainty) that
> > >the appreciation over the next 5 years is going to be zero or
> > >negative. The more expensive the home, the more likely this is to
> > >be true, IMO.

Each person can deduct two personal properties on their tax returns.

Saturday, July 17, 2004

Index funds 

* For basic, truly passive index funds -- look for lowest expense ratios & ability to track index accurately. Also look at ETFs for tax advantages for the buy-and-hold investor.

* For quantitative "alpha" funds -- look for performance & lowest expense ratios.

The counter-argument from the active managers is that Malkiel's argument for index funds only holds true for an investor with $500,000 and $5m to invest. In that category, the active managers have told me, index funds do, indeed, make the most sense.

If you have more than this, the active managers argue that new investment vehicles become available that are simply not open to the average investor. These, combined with lower fees, allegedly make an actively managed portfolio the smarter way to go.