P.S.: This is a big deal for all you index fund buyers too.

The Wall Street Journal ran a story earlier this week which made the case that price-to-earnings ratios don’t matter as much anymore. It’s a seductive argument. We’re in an age where a huge number of trades are made by quants, many of whom care more about stock market momentum than “boring” and traditional measures of value.

But ultimately, it seems hard to believe that the P/E ratio would become totally irrelevant in the way the authors and analysts in the story argue.

First, a quick definition. The P/E ratio is simply a stock’s price divided by its earnings. Depending on your preference, you can use a company’s last 12 months of earnings, its future 12 months of estimated earnings, the average of past years of earnings, and on and on.

I find it easiest to think of it in terms of yield. Just as your money market account yields a certain percentage every year (probably around 1% right now), a company regularly earns a certain amount of money for every dollar you have invested. Of course, company earnings are far less certain than that of a bank account, and that’s why investors require earnings yields—which is the inverse of the P/E—to be much higher than yields on safe investments like Treasury bonds and FDIC-insured accounts.

If you crack open a book on “how to invest”, the P/E is likely to be the explained in the first or second chapter.

Before we move on, if you just tend to dollar-cost average into index funds, like most personal finance blogs (including this one) suggest, you might wonder why this discussion even matters. The thing is, the central premise of buy-and-hold investing is that stock prices always move up over long periods of time. This should happen because earnings should rise over time, as the American economy continues to advance.

However, in a world where a P/E ratio doesn’t matter, by extension, earnings don’t matter either. Traders continually try to outguess each other rather than find good companies at cheap prices. You could say that more direct measures of value, like dividend yields, might become more important, but really the two are pretty similar—with the dividend yield, you just get to keep the earnings yourself.

Sure, P/Es are going down.

The article also spent a good deal of time on why P/E ratios might drop. That’s something I do think investors should worry about in the short term.

The market’s average P/E for the last couple hundred years had been about 15. However, over shorter periods, it has spent time at much higher and lower levels. At the end of the internet boom, it actually spent time in the 40s! During times of economic stress, like the 1980s and 1930s, it has gone into the single digits.

A few things influence their direction. The most simple is interest rates. Investors demand to be compensated for the risk stocks represent. So when risk-free Treasury bond rates go up, P/Es normally drop. Right now, Treasury bond rates are at historic lows. They have only one way to go—up.

But beyond that, investors can drive P/E ratios down when they perceive stocks to be more risky or feel their growth prospects are weaker. Those are both realities that most economists think we’ll be facing for a while.

No one factor should guide your decision to buy or sell.

If P/Es drop, even as the economy and earnings continue to recover, stock prices will stay the same or even drop. Such a period recent happened in the 1960s and 1970s.

Of course it turned out that when they hit those single-digit post Depression lows, it was an excellent time to buy stocks. It just took a decade or so for that to become clear.

And that might be the best takeaway for someone wondering why they should even care that these ratios might stay low for awhile. We’re used to our stock investments generally rising from year to year. Yes, the last ten years were a “lost decade”, but we didn’t really have to feel that until the market halved in 2008 and 2009.

This time around the market’s movements might be much more frustrating. It won’t go up. It won’t go down. It will just bounce around for years.

That means that even more so than during the last ten, you’re going to need patience. Owning stocks will pay off over the long run. The long run just be a long time coming.

In the end, the P/E must matter.

When you actively trade stocks, one of the easiest things to forget is that you’re buying and selling companies, not just meaningless pieces of paper.

In the short term, those pieces of companies can vary in value by huge amounts. One day Apple will have a P/E of 15, the next it will be 50.

That becomes especially easy with companies that aren’t yet paying a dividend. When a company reinvests all of its earnings, the only way you make money is if the stock price goes up.

If you look at investors like Warren Buffett, however, who truly are in it for the longterm, a company’s earnings will always matter. Because in the longterm, any mature company should end up paying a dividend to its investors.

That’s what makes the stock market different from a Ponzi scheme, and why the P/E will always matter.

And watch that basket.

As I don’t have a copy of Pudd’nhead Wilson, I don’t know the context. But Mark Twain once wrote that you should put all your eggs in one basket…and WATCH THAT BASKET.

You’re encouraged to diversify when you invest. A lot of employees sink more than half their 401(k) money into company stock—and then Enron show’s everyone why that was a bad idea. Even seemingly solid companies—banks, for example—can disappear overnight, but it’s much less likely that an entire index or basket of stocks will dramatically lose value.

Still, “watching the basket” is tempting. For one, it’s less to keep track of. If GE is one of five stocks you invest in, you’re going to know more about GE than you might about your own company. On the other hand, if GE is one of 20 stocks you own, you probably won’t know a heck of a lot about any of them.

But putting aside the benefits of focusing your knowledge, there are definite times when it doesn’t make sense to diversify, even if you planned to achieve it by buying one or two index funds. Here are a few of them.

The investment carries no risk.

The last few times I’ve touched on currencies and foreign bonds, I’ve had a few comments and e-mails asking about buying foreign government bonds. Even if the U.S. government up and disappeared, the argument goes, the government of, say, Australia would still be around to give your bond principal back.

It seems like this kind of argument comes from a general mistrust in the stability of the American government, which is pretty popular these days. Even China, one of the biggest foreign holders of Treasury bonds (with Japan), says it’s worried that the U.S. can’t sustain its debt levels.

But just because an investment isn’t as safe as it once was, doesn’t mean you should diversify away from it. Diversification only makes sense if adding the asset reduces your risk.

What can you add to Treasury bonds, FDIC-insured money market accounts, or CDs that would make your portfolio, as a whole, more safe? I can’t think of anything, and the solutions people have proposed carry their own, greater risks.

There’s nothing to show, for example, that holding foreign bonds of countries other than the U.S. would save you if the U.S. defaulted on its debt. In fact, the bonds of Australia, countries in the European Union, and Asia would probably be in big trouble as their own holdings of U.S. debt became worthless. What’s more, foreign bonds carry their own risks. Currency fluctuations happen constantly and could bring the bond’s value down at any time.

FDIC-insured products, like checking accounts, CDs, and money market accounts, fall into the same category, assuming you’re beneath the $250,000 FDIC limit for any one bank. Sure, the FDIC is underfunded. But that’s irrelevant. If the FDIC runs out of money, it’s going to be backed by the Treasury and Congress with every dime the U.S. government can mint.

Put simply, if you’re holding Treasury bonds to maturity or have money in FDIC-insured accounts, diversification gets you nothing. Just pick the account with the best combination of convenience and interest rates, and you’re done.

You need your money at a specific time.

If you’re like most investors, including me, you keep most, if not all, of the bond portion of your portfolio in bond mutual funds. That makes sense for those of us who are young to middle-aged. We’re saving for some obscure and far-off goal of retirement and don’t have an urgent need to get the money back.

But talk to someone a bit older, and you might find that they have most of their money in a bond ladder. of just ten or so bonds.

At first blush, you might think that’s really dumb. Instead of holding the vast universe of bonds included in something like the Vanguard Total Bond Market Index fund, they’re putting hundreds of thousands of dollars in the hands of just ten or so companies. Even though those companies might be seemingly strong, like GE or Anacott Steel, we all know that companies like GM and Ford once looked totally safe too, and look where that got us.

But the calculus of someone saving for a goal that’s soon to arrive is a bit different. You see, if you know you need a certain amount of money in exactly ten years, then a ten-year bond is a great way to get you there. A bond fund holds hundreds of bonds with different maturity dates. So its value is going to rise and fall with interest rates. You basically will never know with any certainty how much it’s going to be worth at any point in time.

On the other hand, an individual bond has an exact maturity date, and if you hold it until it matures, you don’t have to give a damn if interest rates double or halve while you hold it. As long as the company is still solvent, you’re going to get your money.

There are a couple caveats of course—the big one being that the company has to still be solvent. Companies can go through a lot over the course of a 10-year bond. Individual corporate bonds also only make sense for people with a lot of money to invest. Otherwise, you can end up paying a huge premium to what the bond would normally sell for.

But laddering Treasury bonds, and sometimes even municipal bonds, isn’t out of the reach for individual investors. For young people, it could make sense if you’re saving for a kid’s college expenses or a home downpayment. If you only have a little money to invest, you might forego the complexities of the bond market and just ladder CDs.

In the end, bond funds are great for diversifying you away from the risk a company will default, but do nothing to save you from interest rates rising (which make bond prices drop). And rising interest rates are a real, imminent threat to bonds right now.

Sometimes, you can’t diversify.

Ok, this doesn’t fit the topic as well, but let’s face it, sometimes you can’t diversify even though you want to. The classic example is your home. If you own an apartment in Manhattan, where the median home price is $900,000, you’ve probably got most of your wealth tied in one, 600-square-foot piece of real estate. The building or neighborhood could become unpopular. Wall Streeters could lose their jobs in droves again, tanking the local market. That’s not exactly what you call diversification.

Or the second, less classic, example: yourself. A 30-year old probably has more than $1 million-worth of earning power left in him, far eclipsing the $100,000 or so he or she’s saved already. But aside from taking on a second job, I can’t think of many ways he can protect himself from his industry failing or a debilitating injury with diversification. (He can protect himself with education or disability insurance.)

So diversify away, but only where it makes sense. And in the areas where you can’t—namely your home and your career—for the love of God, watch that basket.

Why it’s so hard to make money from the unpredictable

Today, the Wall Street Journal carried a story about how mom and pop investors can profit from “black swans”—those seemingly impossible events that, when they arrive, completely disrupt the investment landscape.

The term was made popular by Nassim Nicholas Taleb in The Black Swan a few years ago. Then, the financial crisis happened, and now, Taleb is one of those rare authors who would actually prefer to do fewer interviews and book promos than he does now.

Black swans are supposed to be inherently unpredictable. They’re the “unknown unknowns” of the investment world—extremely rare events that most consider impossible if not inconceivable. We all worry about tax reform, and then, boom, a few planes hit major American landmarks. (Which happened.) We all worry about Iran getting nuclear weapons, and then, boom, a nuclear power plant goes Chernobyl in Pennsylvania. (Seems improbable, but that’s the point.)

Once a black swan event happens, all of that other little stuff you normally care about as an investor—whether it be valuations, interest rates, or profit margins—ceases to matter, or at least matters much less. And as we discovered during the financial crisis, hitting a high-impact, improbable event results in almost all traditional asset classes losing value.

But in 2008, a hedge fund managed by one of Taleb’s collaborators didn’t lose money—in fact, it more than doubled. Today, mutual fund companies are opening their own funds, for investors who can’t afford a hedge fund, dedicated to protecting against or profiting from black swans. That’s not surprising. Mutual fund companies always come up with products after they would have been most useful. But now that these guys are around, do they ever make sense to invest in?

Predicting a black swan.

“Predicting” a black swan is an oxymoron. So how can investment strategies be tailored to do it? In his book, Taleb advocates putting the overwhelming majority of your assets in something extremely safe, such as Treasury bonds, and then taking a flier with the last 10%.

For example, after putting 90% of my portfolio into Treasuries, I might put the last 10% in a few biotech stocks. If one of them finds a cure to cancer—thereby hitting a positive black swan—I get rich, even though I had relatively little money invested in it. If they don’t, the worst I can lose is 10% of my portfolio.

More complicated strategies, used by some of the hedge funds that espouse Taleb’s strategies, involve buying out of the money put options.

Without getting into the strategy itself, basically the funds only make money if there are extreme market losses on whatever asset they buy the option on. Because the market thinks those events are unlikely, the options are very cheap. But over time, if the event never happens, a fund can slowly bleed to death as it waits in vain for luck to strike.

Practically, for a mutual fund like the Pimco Global Multi-Asset fund, which the WSJ article cites as a black swan fund, you get a fund that charges a 1.41% expense ratio with a strategy that you’re not going to really understand. The managers say that their hedging strategies will limit your downside risk in any one year to 15%, but isn’t the whole point of a black swan event that you don’t know in what magnitude and in what way the swan will strike?

Lessons from the last black swan.

Which brings us to the event that rocketed thinkers like Taleb to prominence—the collapse of Lehman Bros. and the financial crisis. Between Lehman’s collapse and the March 9, 2009 market trough, the S&P 500 lost 46%. That’s pretty bad and really devastating to someone who needed that money soon and had most of their money in equities.

But your average retiree didn’t (or at least shouldn’t) have most of his money in stocks. Using the oft-used rule of thumb to put your age in bonds, a 65-year old would only have 35% of his money in stocks. Which means, his portfolio right now might be down 15% to 20% from that peak. Not good, but not devastating either.

Sure, another crisis is still possible, but it seems that crises of the most recent variety, which wipe out a large, but manageable, amount of wealth, are best dealt with after the fact rather than beforehand. If you happen to be the unlikely victim of a huge, unpredictable event, it’s much easier to reduce your spending, delay retirement, or take a part-time job than it is to try to run an investment strategy that will eliminate the bad event’s effect.

Take Peter Schiff, for example. His prediction of the 2008 financial crisis was dead on, but his clients lost 40% to 70% of their money.

Why? Schiff was right about the crisis, but wrong about its effect. He thought the dollar would lose its value and foreign stocks would stomp stocks here. Instead, the dollar soared, as investors poured into what they thought was the last safe investment out there, and his clients lost a ton of money. Of course, we’re not out of the woods yet, but Schiff’s mistake shows how hard it is to get bets on unlikely events correct.

So in my view, black swans are just something we have to live with. It would be nice to “beat them” by anticipating and profiting from them, but that’s probably impossible. It would also be nice to limit the downside risk of a black swan event, but there are so many ways in which such an event could affect you that limiting your downside is also probably impossible.

You can invest wholly in Treasury bonds, but what if the “black swan” is the dissolution of the American government? You could invest in gold. But what if the black swan is the discovery of a way to turn lead into gold?

As long as black swans—and their effects—can’t be anticipated, the best strategy is to remain flexible and quick to adapt when it occurs, not to try to predict the unpredictable.

We’ve feared losses for 40 million years.

How hard is it to learn to be a good investor? I’ve written a lot about the behavioral quirks that cause us to make major mistakes when we put our money in stocks and bonds, even though we know that we’d do a lot better to make different decisions. Losses hurt more than gains feel good. Walking inside your boss’s office for a review actually triggers an adrenal response—you’re ready to sock your boss in the face or fly out the door as he tells you how well you’re filling out Excel spreadsheets.

Of course, none of these emotional and hormonal responses actually help you do anything. You know that having cold, sweaty hands isn’t going to help you explain your position to your boss effectively, in the same way you know that getting a free ice cream cone should make you just as happy as dropping one on the floor makes you sad. So why do we do it?

Monkeys fear losses too.

One of the unique traits of the human species is our use of money. If you’re a cattle rancher, you don’t have to drive 100 heads of steer to your Realtor’s office to buy a house. We’ve created a fungible, easily divisible medium of exchange that makes it much more convenient.

That old invention makes it that much harder to run economic or scientific tests to understand why we treat money the way we do. Animal testing—putting aside ethical issues—is much easier with medicines. The guinea pig was cured or it wasn’t. And after studying side effects for a while, we can move on to human testing.

But what if you could teach a monkey to value and use money? Then you could run all sorts of experiments to see how deep our ridiculously unprofitable predilections run.

M. Keith Chen, a behavioral economist at the Yale School of Management, has done just this. His community of Capuchin monkeys has learned to value coins. They can exchange coins for orange peels or apple slices. Chen can change the prices of the prizes every so often to see how the monkeys react.

In 2006, Chen ran experiments to see just how mad a monkey gets when prices go up versus how happy he gets when they drop. To do this, he faced the monkeys with two trainers, with different colored clothing. The first trainer would show a monkey two apple slices, but when the monkey traded in his token, he would either pay the monkey the promised two slices or just one—averaging out to 1.5 slices per payment.

The second trainer would show a monkey one slice. But when the monkey paid a token, he would either give the monkey the one, promised slice or would unexpectedly deliver two slices—again averaging out to 1.5 slices.

Rationally, the choice between the two trainers should have been a wash. But the monkeys preferred the trainer who gave them unexpected gains two-and-a-half times more than the one that gave them unexpected losses.

So, think you can get over loss aversion? Our ancestors might have felt this way for 40 million years. Good luck!

Monkeys also treat risk the same way we do.

Another fun monkey experiment: The capuchins were presented with two sets of trainers. In the first set, both trainers promised the monkeys one piece of food (by showing it to them).

But in fact, the first trainer always paid out two pieces, and the second trainer would pay out one piece half the time and three pieces half the time. Again, statistically, the trainers were a wash, but the monkeys preferred the one with the guaranteed, two-piece payment more than the risky guy.

In the second set, monkeys were always promised three pieces of food. But the first trainer would consistently pay out two pieces and the second trainer either paid out one piece or three pieces. In other words, the monkeys could take a guaranteed, one-piece loss or roll the dice (and risk losing two pieces). This time, the monkeys preferred to take the risk.

What do those experiments show? That when we have a choice between guaranteed gains or taking a risk for an even larger gain, we’d prefer the bird in the hand. But when we might take a guaranteed loss or can take a risk to possibly lose nothing, we’re willing to take the risk.

Monkeys overvalue what they own.

Why is it so hard to get a trade going in Monopoly? I noticed this especially when I was younger. After the board was bought up, the players would start to offer trades. Thing is, the offers would always be ridiculously lopsided. “I’ll trade you Boardwalk for North Carolina, Atlantic, Ventnor, and St. Charles.” And the response: “No way, I’ll give you Atlantic and $100 for Boardwalk.” And so on.

Economists calls this the “endowment effect.” We value things more if we own them. In one famous experiment, humans were asked to buy and sell coffee mugs. In each and every case, they wanted more for the mug than they, themselves, would be willing to pay for it.

Sadly, it doesn’t look like evolution has gotten us over this one either. Chen gave one group of his monkeys one kind of good and the other group another kind.

The monkeys preferred each type of good equally. So you would expect the monkeys to end up trading about half of the food with each other. Instead, almost no trades were conducted at all. “Yeah, I like apple slices as much as I like orange peels. But this is my orange peel.”

So next time you find yourself thinking you can overcome the behavioral biases that cause us to handle money so irrationally, think back to the monkeys. We’ve been fighting this for 40 million years. Think you’re going to be the one to overcome it?

Not that any of them are all that great.

The hot air balloon above is inflating. Get it? Get it?! Sorry. I’m tired.

There are only so many ways our government can eliminate the deficit and eventually pay off its gigantic debt. The least painful—and the one federal officials were desperately hoping for when they enacted the stimulus—is to grow the economy. With the economy growing, they get more tax revenues without having to change any laws.

Two, less optimum solutions are to raise taxes or spend less. Both of those make voters angry. Spending cuts sound good until you realize it means your kid’s classroom goes from 25 students to 30 students. Raising taxes never plays well, even when you purport to target the highest-income households.

That leaves inflation. No politician has to vote for it. It’s hard for rivals to point to interest rates and say, “Congressman Smith did this!” Inflation is simply the easiest way to pay off the deficit without alienating your constituents. Yeah, it’s weak, but when push comes to shove, you’ve got to believe inflation is going to rise before Congress successfully balances the budget.

So where does that leave you? And what can you do to make sure a devaluing dollar doesn’t decimate your portfolio? And for that matter, how can you stop Pop from excessive alliteration?

The myth of stocks as inflation-fighter.

One of the most common arguments in favor of investing in stocks is that they keep your portfolio from being silently eaten away by inflation. For your retirement money to keep its earning power, the yarn goes, you need assets whose returns will outpace inflation. Stocks are one, good answer.

Except they aren’t. In fact, stocks tend to do terrible when inflation is high. Take a look at this chart from Martin Capital Advisors.

In times of rapid inflation (the gray boxes), the S&P 500 (the green line) tended to drop, sometimes by a huge amount.

The point is, while stocks will probably outpace inflation over the long-term, holding stocks as a short-term panacea to what you might think is a coming bout of major inflation doesn’t make sense. Indeed, it seems misleading that the two issues ever got combined. Yes, inflation is an enemy to your portfolio. Yes, stocks—even at a conservative 5% growth rate—outpace the average inflation rate of about 3% over the longterm. But the two aren’t built to counteract each other.

What about commodities?

It would seem that commodities—such as oil, natural gas, and, I don’t know, timber—would be better inflation hedges. After all, if prices go up, the prices on the raw goods we need to make things should go up, too. The problem, of course, is that a ton of things, in addition to inflation expectations, influence commodities prices. Let’s take oil for example. This chart is from Inflation Data:

You’ll notice that the 1979 high for oil (in 2010 dollars) wasn’t topped again until 2008. Of course, inflation didn’t go down over that long time period. Quite the contrary. There were just a few hurricanes and a couple major oil crises that jostled the price of oil around, even as inflation made its inevitable climb upward.

Other commodities face similar circumstances. But even if they didn’t, keep in mind: Commodities reflect inflation expectations. So if you’re thinking about buying some oil ETFs right now in expectation of high inflation, you’re already late to the game. Even if inflation does rise rapidly, if it doesn’t keep up with the lofty inflation expectations the market has set for it, commodity prices could still drop.

And I’m tempted to skip gold, but what the hell…

Not that some reasonable people aren’t making arguments for gold investments. It’s just I feel like it’s unfair to keep beating up on this one. One last chart, also from Inflation Data:

Similar to the oil chart, you’ll see that even though the price of gold, currently at about $1,200 an ounce, has surged this year, it’s still nowhere close to the $2,251 peak it reached in 1980 in today’s dollars.

If anything, gold is a crisis hedge. If the U.S. government collapsed and the world collectively decided to revert to a medieval trading system in which precious metals of limited industrial use became the currency du jour, then gold might be a good investment. When I write about this, a common counterattack is to say that the dollar itself only has value by fiat (i.e., because the U.S. government says it does).

They’re absolutely correct, but that’s the whole point. The dollar has the fiat, both from the government and (implicitly) from investors who flock to it in the face of danger. Gold has an implicit fiat from a limited number of investors and practically no governments. And…oh forget it. If you’re going to buy gold, at least don’t listen to Glenn Beck and buy coins through Goldline.

TIPS: An imperfect option, but the closest to perfect you’ll get.

Treasury Inflation-Protected Securities are Treasury bonds created by the U.S. government whose principal also adjusts with the Consumer Price Index. As many people point out, CPI is an imperfect measure of inflation. Even putting aside the specious, government-lies-about-everything arguments for a moment, there is no possible way that what you spend money on will track CPI exactly. If you, for example, have to spend a lot of money on healthcare, whose cost is rising several times faster than CPI, your personal inflation rate will be higher.

However, TIPS, and their less-mentioned cousins, I Savings Bonds, will at least track inflation loosely, without the wild, speculative swings that stocks, commodities, and gold fall subject to.

Right now, a 10-year TIPS bond yields 1.09% after that periodic inflation adjustment. Given that regular Treasury bonds of that length yield less than 3% right now, that implies investors think inflation over the next decade will actually be extremely low.

And best of all, TIPS can easily be bought straight from the U.S. government. One word of warning though, if you buy them this way, make sure you hold them until they mature. Selling individual bonds is expensive, and bond prices will move around as interest rates move. If you think you’ll sell before the maturity date, try a TIPS mutual fund or ETF instead, though they won’t track inflation as exactly.

Anyway, I’m sure there are good arguments in favor of some of the traditional inflation “hedges” investors have used over the years, and throwing a few charts out there does not a Ph.D. dissertation make. How would you challenge some of the arguments I’ve laid out here?

So, when can we start calling it the “old normal”?

Stocks have gone nowhere in ten years. Not even dividends have made it better. Sure, you might have had a bit of a gain if you stuck your money in emerging markets at the right time or gold or any of the other asset classes that turned slightly positive. But on the whole, buy-and-hold investors had it pretty crummy.

And yet, we still get this from Dave Ramsey (hat tip to All Financial Matters for noting the clip). On slide 12 of an otherwise smart little video on not rushing out to buy a new car, Ramsey throws out this line (paraphrased): “But instead of spending that money, you’ve invested it in a mutual fund earning the average stock market return of 12%.” Bwahahaha.

A 12 percent stock market return is so 1998. We know now that 12% is wildly optimistic. Eight percent might even be optimistic. What’s more reasonable? Take this sobering assessment from Bill Gross in Money Magazine this month: “Instead of 10% returns for stocks, look for five or so. And instead of the past 20 years’ returns on bonds, which are actually better than stocks — close to double digits — it’s 4% going forward.” Oof.

Gross, and his colleagues at bond investment shop PIMCO, call this low growth period for investments and the U.S. economy the “new normal.” It’s hard to say PIMCO is “talking its book“, because it doesn’t see bonds as faring all that well either.

There seems to be a general consensus that PIMCO is more right than Ramsey is. But I don’t think the implications of changing stocks’ rate of return from 10% to 5% have sunk in. We acknowledge that stock returns will be poor, and yet all of our retirement advice—save 10% of your income…withdraw 4% in retirement—stays the same. So, for your viewing pleasure, here are a couple math problems.

How your savings rate changes.

Scenario: 45-year old making $90,000 per year. Plans to retire at 65. Holds a $200,000 portfolio.

In real life, this guy would slowly shift his money from stocks to bonds, but to keep it simple, let’s just assume he puts it all in stocks. Since we’re using an “average” rate of return, rather than the volatile real-life returns he’d really get, we’re being generous.

Old math: If he saves 10% of his income per year (pretty standard advice), his portfolio grows to $1.86 million. Using the flawed-but-ubiquitous 4% rule, in his first year of retirement, he could afford to withdraw $74,400. Combined with Social Security, that’s not a bad income.

New math: But what if his portfolio only returns 5% per year, as Gross predicts? If he held steadfastly to saving 10% per year, at age 65, he’d have $828,253. That would leave him with an income of just over $33,000 plus Social Security. That’s less than half of the old math scenario.

Unacceptable, right? So what does he have to save instead? Please don’t cry. That 45-year old, trying to achieve a $1.86 million portfolio with only a 5% return, would have to save forty-four percent of his salary per year. If he was willing to work until age 70 instead, he could save 28%. But still, that’s a huge difference. I used the simple calculator here for all the calculations.

How your withdrawal rate changes

Oh, and about that 4% withdrawal rate. I’ve written before about how writers and planners twisted the findings of a few Trinity University professors into a mantra that at least one of the professors doesn’t believe. But the 4% rule gets even more off base when you start to assume stocks grow more slowly than they have in the past.

Why? Well the Trinity guys used stock returns between 1926 and 1997 to inform their results. That’s a time period that saw the United States rise from upstart nation to global superpower. Do we really think the pattern of returns we saw then is going to repeat itself going forward? As financial columnist-turned-money manager Scott Burns notes, when you start to factor in the sad truths of modernity—like lower interest rates, lower dividends, and, yes, lower stock returns—the rules developed by probability studies that were done just a couple decades ago don’t seem to apply any more.

Shutting down in the face of uncertainty.

I don’t save 44% for retirement. Not close. I don’t save 28% for retirement. Still not close. In the face of numbers like that, it’s no wonder that we’d rather hear about magical 12% rates of return on stocks that no one believes anymore.

The good news is that if you’re young, you have time. And while you can’t control what your investments do, you have a couple other dials you can turn to give yourself a chance to retire. One, is the aforementioned savings rate, no doubt the most painful of the bunch.

Option number two: Retire later. You’re likely going to live to an age older than your parents anyway, and I’m sure you’ve had it in the back of your mind that it was never reasonable to work 40 years and then have a 40-year retirement anyway.

And option number three—the most fun option—is to earn more money. With a higher salary, you can save 28% but maintain the standard of living you had when you were earning less and saving 10%. Unless you have a defined benefit pension—and few private sector employees do anymore—this is the only truly guaranteed way to have a reasonable shot at early retirement.

Just a small prediction: You’re going to be hearing a lot about earning more from me and personal finance authors in the coming years. Because we’re finally starting to realize that investing well and being frugal just isn’t going to be enough anymore.

Little tweaks vs. titanic decisions

I enjoy personal finance blogs a lot. Admittedly, some of the time, what they cover can get a bit redundant. A lot redundant. Mind-numbingly redundant. But hey, the best personal finance advice is timeless. It’s the clever repackaging that makes or breaks someone new who steps into the field.

But of all the disorders that personal finance blogs suffer from, there’s one that’s the worst. And I’m sad to say, I suffer from it too. About 90% of what I’ve written about investing, real estate, the economy, and everything else doesn’t matter nearly as much as how much you earn. It’s not even close. The decision to add gold to a portfolio—which I derided in March—will ultimately only affect a small percentage of your wealth. Refinancing a mortgage when interest rates are only 5% instead of 8% will save you a few thousand dollars until you sell the home. And on, and on. Meanwhile, increasing your income by 10% will affect your savings by a huge amount for the rest of your career.

I haven’t found any research to back this up—which is unlike me—but I’m pretty sure that we focus so heavily on frugality and investing because it’s relatively easy to draw connections between what you do and what you gain. You don’t buy a flat-screen T.V., so you save $800. You move from a mutual fund with a 1% expense ratio to one with a 0.25% expense ratio, so you save $2,000 per year or whatever.

In the meantime, the steps you’d take to earn more money, like asking for a raise or promotion or taking the first steps to starting a side business, are either uncomfortable or don’t have a direct link to the end result. I know how to cut my expenses by 20%. Move to a cheaper place. Cut travel. Don’t eat out. Easy peasy, Japanesey (quoting the Shawshank Redemption).

And yet, how would I increase my income by 20%? Blank page. Vague idea of starting a personal economics blog that rises to must-read. Freelancing as a…? I’ve had a blank page for a while and am just getting off my ass to change that. I think it’s extremely important that you do it too.

Your job as an investment.

Imagine your investment portfolio. You’ve been reading personal finance stuff for a while. So you’re probably in a bunch of low-cost index funds that own literally hundreds of stocks. You would laugh at me and leave derisive comments if I said you should stick it all into one equity.

But that’s basically the approach most of us take to our jobs. We have one source of income. If the job disappears, the income disappears. Sometimes, you get lucky, and sink your skills into a company like Google or an SAS, which rarely has layoffs and compensates employees well. Other people don’t get lucky, and sink their skills into a BP, automaker, or, more recently, a cash-strapped public government. They’re finding out the drawbacks of undiversified income right now.

This idea of viewing yourself as a valuable investment isn’t new. Moshe Milevsky, a finance professor at York University in Canada, has been telling people to include themselves in their investment portfolios for a while and invest in other assets accordingly.

Think of it this way. Imagine being a mortgage broker in 2004. Pretty sweet gig, right? You get commissions based on every mortgage you arrange and get even bigger payments if it’s an expensive house or if you push the buyers into adjustable mortgages. Real estate is brisk, and you’re making more than $100,000 per year.

Fast forward to 2009, and you’re making nothing. Maybe $40,000, if your job included a base salary. Your firm has likely cut down on the number of brokers it employs. You might be out of a job.

Now imagine being a tenured economics professor in 2004. Nice job, nice hours, and making $70,000 to $100,000, depending on your tenure and what university you’re at. Now fast forward to 2009, and you’re making…the same. Maybe a little more if you got a cost of living adjustment. You still have a job, because that’s the deal. No peaks or valleys in income.

Milevsky would argue that the unstable but high potential broker income is “stock-like” while the professor income is bond-like. His book, Are You a Stock or a Bond?, is a fascinating look at the subject. The general summary: Young people should treat their future earnings potential as part of their portfolios. In a high risk profession? Balance that with more conservative investments. Are you a tenured professor? Take a risk on stocks.

So how do you protect and grow the most valuable piece of your wealth?

1. Diversify. — As mentioned above, the only way to truly diversify your earnings power is to have more than one source you can draw on for money. Sure, at its most advanced stage, this can take the form of a side business. But anything you can do to generate income, such as freelancing or transforming a fun hobby into a fun hobby for profit, helps to keep your income from going to zero.

Easier said than done, I know. Luckily, Ramit Sethi one of the best bloggers on the subject of earning more money, happens to be running a series on starting a freelancing business, right now.

2. Increase your earnings. — This is something I’m going to address at much greater length soon. But just keep this word of advice: Your success will increase in direct proportion to the number of uncomfortable conversations you’re willing to have.

We introverts (extroverts can skip to the next point) have a tendency to sit at our desks and hope our hard work will get noticed. That does happen every once in a while, but simple asking for a raise or a promotion after a success at work will bring the raises and promotions much more quickly. And even if asking doesn’t bring it immediately, it at least opens the conversation with your boss about what you can do to advance. That’s much better than stabbing in the dark.

3. Reduce your risk. — Although I know quite a few commission-based salespeople who didn’t follow this advice, that mortgage broker I referenced above could have smoothed out his income. Earnings made in one year don’t have to be spent in the same year. If you have a job in a volatile industry, keep on hand at least a year’s worth of living expenses in an emergency fund. On top of that, especially if you have dependents, consider getting disability insurance. Your work probably only gives you coverage for a few years. Meanwhile, a disability could cripple your most valuable financial asset for your entire life.

Anyway, something to think about.

Something to look forward to.

When I surveyed you all a couple months ago, one of the most common write-in requests was for ideas on how to make more money. This stumped me for a little bit—how could I teach earnings lessons in a way that wouldn’t repeat the great content already out there and fit in with my research-driven, psychological approach to other financial topics?

Well, after surveying the latest research on the subject, I think there’s a ton to contribute. And in the end, it’s not just stuff that will grow your income, it’s stuff that will help you achieve any goal you might have, financial or otherwise. I’m just starting to outline it, but I’m pretty sure it’s going to take the form of an e-book and comic book, with not only traditional comics but moving picture animations. My artists and I are already putting our heads together on how to best put this together.

Will it cost money? Not sure yet. “Make it free!” you say. “This ain’t a charity!” I shoot back. But hey, I’m going to make sure it’s great. More on this soon…

Thanks, as always, for stopping by.

Oscar Wilde died broke, why not you?

Ok, bad example. Wilde was an extremely gifted poet and playwright, but he had a lot of personal problems confounding him before his death. This post is about a question that’s a little more clear cut than that: Does being smart make you better with money?

Yeah, it’s wide-ranging, and you think you might know the answer off the top of your head. My automatic answer was, “Yes! Of course.” Smart people are better at math, which would make them see through to the consequences of their decisions more clearly, right?

I dug up an old Yahoo! Answers user who posited the same question. The winning answer had a bunch of mumbo jumbo about common sense versus book smarts and something called a “social IQ.” So the Web 1.0 unscientific survey of anonymous web users named “species456″, “Father Christmas”, and “Ratz” says intelligence and money aren’t correlated at all.

I was hoping to find the definitive economic analysis that would allow Pop to smack Ratz back to the, um, sewer, but (sigh), things are never that clear cut. So without further ado, let’s get to how smarts affect wealth.

Smart people take more risks but show more patience.

I recently tripped upon a paper published last year by several German economists who studied whether someone’s IQ plays a factor in how likely they are to take risks or show patience when presented with financial problems. It turns out that it does, even when you control for things like age, experience, and wealth.

First, the thousand or so participants were asked to take different modules of the Wechsler Adult Intelligence Scale test, one of the most popular tests to measure someone’s intelligence quotient (IQ). They also filled out a separate survey with demographic data: age, income, race, etc.

Next, the economists asked participants to participate in one of two paid experiments designed to measure risk aversion or impatience.

The risk aversion test took the form of a lottery. You could either take a guaranteed, safe payment or choose to participate in a lottery where you had a 50% chance of winning 300 Euros (you won nothing if you lost). The tester would “tempt” the subject with a safe payment of 0 Euros to start (I’d guess everyone would pick the lottery at that point), then with 10 Euros, then 20 Euros, and all the way up until someone could pick a safe payment of 190 Euros rather than take the risk. A completely rational person would take the bet until the safe offer hit 150 Euros (50% of 300).

For the patience test, economists told the subjects that they could either have 100 Euros now or a larger amount of Euros a year later. In a similar fashion to the risk aversion test, they tempted people with increasingly larger amounts until the subject said he’d take the delayed payment.

Anyway, to cut to the chase, here’s the graph of their results:

And in case you have trouble reading that (who wouldn’t?), the gray-enclosed line shows how risk-taking changes with increased intelligence and the white-enclosed line shows how impatience changes as people get smarter. It looks like smart people are both more willing to take risks and more willing to wait for a payout.

Smart people make more money, but aren’t necessarily more wealthy.

If I were to pick a favorite data set amongst all the data that the Bureau of Labor Statistics collects (and everyone does this, right?), it would, without a doubt, be the National Longitudinal Survey of Youth. The BLS has been following about 7,400 Americans who were born between 1957 and 1964 for nearly three decades (they started the surveys in 1979), asking them about their work histories, incomes, life events, and all that other fun stuff economists love to analyze. What makes it unique is its long-term look. They spoke to Joe Smith when he was 17, and caught up with him again each year until 1994. Now they only talk to Joe every couple years, but still, that’s a lot of data on one guy that you can harvest for all sorts of interesting experiments.

Well, a research scientist from Ohio State University named Jay Zagorsky decided to mine the data to see how well intelligence predicted how much money people ended up making and how wealthy they were.

Instead of an I.Q. test, the subjects took the Armed Forces Qualification Test, which the Department of Defense uses to judge the mental acuity of new recruits. Then, Zagorsky surveyed them on their incomes, total wealth and three measures of financial distress: if they had maxed-out credit cards, if they had missed a bill payment in the last five years, and if they’d ever declared bankruptcy.

Result numero uno: Smart people do make more money. In fact a one point increase in their IQ score (it’s still called IQ with this test, apparently), was associated with $202 to $616 more income per year. A normal IQ is around 100 whereas a really smart person has an IQ closer to 130—that’s a $6,000 to $18,500 per year difference in income on average.

But on the other two measures, the results were mixed. For one, smart people don’t report higher wealth than the less intelligent people. They apparently just save less of their larger incomes.

In those other measures of financial difficulty, the results were more strange. People of average intelligence were more likely to max out their credit cards than people of slightly better than average intelligence. But the most intelligent people were worse off than the better-than-average. Zagorsky concluded that it was best to have “slightly better than average intelligence.” I, for one, look forward to a follow-up study that explains the trend a little better.

It was slightly amusing to me that the OSU article on Zagorsky’s research ended with a quote noting that OSU professors don’t drive many Rolls Royces or Porsches. That was supposed to show anecdotally that smart people aren’t necessarily wealthy. I know about a thousand people who would argue that your wealth is inversely proportional to how many Porsches you buy. But that’s just me.

Just because you can doesn’t mean you should.

A decade ago, there were few options for investing in foreign bonds that didn’t cost a bundle. Even today, you’re going to have a lot of trouble investing in foreign bonds directly. But the options for investing through mutual funds and ETFs, either with active or passive managers, have truly proliferated, which might make you wonder whether it’s worth adding a fund and how much to stick in it.

It’s easy to see the attraction. Ten-year U.S. Treasury bonds only yield 3.05% right now. Put that in contrast to bonds from Australia, which yield 5.11%, or—steppin’ on down the development ladder—Brazil, which yield 12.28%. Holy cow. Brazil is still a developing and sometimes unstable country, but 12.28% is better than you’d get from a company like Ford, which has an issuance maturing in 2018 that yields 6.5%.

Yield aside, the real question is this: Should passive investors have them as a standard part of their allocations?

First obstacle: You might not have the option.

This is an unfortunate side effect of the most common vehicle we use for retirement savings—the 401k. Many (probably most) 401k plans don’t have a foreign bond fund as an option to invest in. This might be a good thing, given that a lot of investors, who don’t know what they’re doing, could do something silly like equally weight all the options available to them, thereby putting a huge amount in a foreign bond fund.

That said, in a traditional account or an IRA, you most certainly do have the option to invest in foreign bonds through ETFs or funds. Two of the more popular actively managed funds are PIMCO Foreign Bond and T. Rowe Price International Bond. Their expense ratios aren’t great, but they are under 1%.

And although your anti-active manager neurons are surely firing right now, remember that the argument for a market-capitalization weighted index fund for bonds is a bit weaker than for stocks. For stocks, investing in the biggest companies might make sense. But for bonds, it would essentially mean you’d invest the most in the countries with the most debt. Does that make sense to you?

Second obstacle: These don’t add stability to your portfolio.

It’s probably tempting to carve out 5% to 10% of your bond portfolio for foreign bonds in the same way that you might do it for foreign stocks. But remember why you have bonds in your portfolio in the first place: To lessen volatility as you grow older.

Most foreign bond funds don’t do that. Why? Unless they say otherwise, the funds aren’t currency hedged, meaning that their shifts in price come not only from changing yields, but from how, say, the New Zealand kiwi fares against the U.S. dollar. And currencies can be extremely volatile.

Take the PIMCO Foreign Bond fund mentioned above. According to CBS Moneywatch, it’s three times more volatile than the Vanguard Total Bond Market Index, which only invests in U.S. bonds.

You might think holding foreign currencies is a good thing. We all know that the federal government will eventually have to pay its debts somehow. Since politicians are loathe to raise taxes or cut spending and the economy is slow, the dollar will probably have to be devalued.

But that’s not a sure bet. Japan, for example, is the banner example of a country that’s in debt up to its eyeballs. Yet its currency has held steady for 10 years, and the country is actually experiencing deflation. What’s more, bonds are about stabilizing your portfolio, right? Not making a bet on currencies one way or the other. And ultimately, you’re going to be spending your retirement savings in U.S. dollars.

So who are they right for?

I won’t say “no one.” After all, some really smart bond investors, like Bill Gross, have recently come out in favor of foreign bonds from countries much less indebted than the U.S. But in the end, I think they’re probably unnecessary for most people.

Why? Well, the mission for your bonds is fundamentally different than that of people like Bill Gross. He wants to beat the market. You just want to add some stability to your portfolio. Since foreign bonds don’t fit that bill, they’re more akin to a replacement for alternative asset classes like real estate investment trusts or even for stocks. And since there are much more clear cut (not to mention cheaper) ways to get exposure to those assets, personally, I’d rather stick with what I know.

First, a quick announcement. I’ll be hosting the Carnival of Personal Finance next Monday! Many followers of this blog probably discovered me through the Carnival, and I’m really proud to be giving back a little bit by hosting this week. I have a newfound respect for the people who’ve put it together and will try my best to make this carnival excellent. To that end, I hope you can help too by blogging about it, tweeting it, facebooking it and doing whatever you can to promote it. I’ve never solicited such publicity before, but this time, it’s really about all the great posts the carnival will feature, rather than about Pop Ec. But on to our regularly scheduled programming…

What happens when making mistakes becomes a capital offense?

Longtime White House reporter and columnist Helen Thomas resigned earlier this week. In case you haven’t paid attention to the case, she told a website catering to the Jewish population that Jews should “get the hell out of Palestine.” I don’t really want to talk about the statement, whether or not it was bigoted, and whether she deserved to lose her job over it.

However, I was disturbed by the piling on of criticism from seemingly every pundit and retired politico who could get a reporter on the phone. Ari Fleischer, Bush’s first press secretary, e-mailed journalists who might have missed her comments to call for her firing. This is a guy who currently runs a sports marketing business. Clearly, Thomas had built up some enemies during her time in the White House press room.

Thomas apologized almost immediately, but it was too late.

So how is this relevant to investing, economics, and all that other stuff you read about here?

Thomas was wrong. And instead of acknowledging it, correcting it, and moving on, we forced her to retire.

Reuters blogger Felix Salmon had a great piece on this trend earlier this week. The long and the short of it was this: “It’s still unacceptable, in public discourse, to be wrong in one’s opinions. I find that sad.” He went on to describe an interview with atheism promoter Christopher Hitchens, who refused to directly admit that he has ever been wrong or could be wrong in any of his opinions.

Having to be right is a plague

I’m fairly sure that I’ve made at least one error in every blog post I’ve written since starting Pop Economics this January. Some of them are easy: I wrote about how mortgage rates would go up in March in one particularly bold (and wrong) post. Some errors are more slight: I change my mind on whether active or passive investment strategies are superior almost every other week. So at least half of those posts are wrong.

I know none of those errors are incendiary like Thomas’ comments, but imagine if at least some of you decided to take off for another blog after discovering that I had made a mistake or flip-flopped on a position. I’d have a serious problem on my hands. Indeed, it’d be tempting not to admit any errors at all.

Investors are overconfident.

I know I make mistakes. And that’s why I didn’t put all my money into ETFs that bet Treasury bond yields will go up, even though I was almost certain that would be the case in March. It’s why I write about value investing with passion, yet don’t commit more than 5% of my own portfolio on betting that the market is over or undervalued.

I’d say my most confident evaluations of any given stock’s true value have only a 55% chance or so of being right. And I bet Warren Buffett would say his most confident evaluations wouldn’t be that much higher. (Incidentally, I’ve probably just made a mistake even in that modest calculation of my chances.)

But your average investor has a worse overconfidence problem than I do. Economists have repeatedly demonstrated that we put way too much belief in our predictions and abilities. In a famous 1981 survey of Swedes, 91% said they were above-average drivers.

An article in MIT’s Sloan Management Review describes a survey conducted of professionals in various industries. Each were given a 10-question quiz on their own industries that asked them to give high and low estimates in response to certain questions, such as “How many patents were issued in the U.S. in 1992?” (The survey was conducted in the mid ’90s.) The right answer was 96,727. So a respondent could give any range that encompassed that figure and be correct.

They were told to give ranges that gave them about a 90% of getting the question right. But when the quizzes were evaluated, the professionals tended to miss more than 60% of the questions asked. Their overconfidence caused them to set ranges much too tight.

And they’re slow to change direction after being proven wrong.

Investors have extremely peculiar views on profits and losses. If you bought BP at $60 and watched it drop to $30, somehow you tell yourself that the loss doesn’t “count” unless you “lock it in” by selling. So maybe you hold on, hoping it will recover a bit.

Economist Tyler Cower writes that we tend to place a greater value on something because we own it. In other words, a share of BP at $30 per share seems more valuable when it’s registering in your ETrade account than when it’s just running through the ticker on CNBC. It reminds me of playing Monopoly games when I was younger. When you asked a kid under the age of 12 to part with even his most insignificant properties, say Oriental, he would ask for a ridiculous sum in return. And so no one would trade with anyone, and I’m pretty sure that game is still ongoing.

But a couple economists from Yale and Princeton have come up with another theory, which they’ve called “realization utility“. In short, they’ve determined that an investor derives more pleasure from actually selling a stock and reaping the profits than he does from simply seeing the stock price go up on his ETrade account (and vice versa for losses). The sale of the stock (and money in the account) serves as a validation that he or she made a right decision. And you could assume that the sale of a stock when it’s lost value would be a confirmation that he made a wrong decision. As long as he doesn’t sell, he doesn’t have to admit the problem.

It’s a dangerous wonderland to end up in — where not looking and not correcting seems superior to admitting a mistake. And while it’s definitely a culture that we’ve begun to build up in America — ok, maybe the Helen Thomas lead in was a bit of a stretch — I hope it’s not one that you’ll fall into when making important decisions with your money. Cause when it’s time to retire and sell that fund or stock for rent money, the landlord’s not going to much care that you held on to escape admitting a mistake.