Earn What You Spend

Institutions of learning are going to be dramatically changed in the coming years.

Rolfe Winkler is an astute blogger, and he (along with many others) sees a parallel in the markets for housing and higher education.  We have students (homeowners) purchasing an education (housing) at ever increasing prices using vast amounts of leverage.  That didn’t end well with housing.  What will happen in education?

A college degree can be valued by the incremental earning power that it can provide over a working lifetime.

In other words, how much more will you make if you go to college than if you don’t? Are those extra earnings enough to pay back your loans with interest, along with the opportunity cost of forgoing full-time wages while you’re a student?

A common misconception is that a college degree is worth a million dollars over the average working lifetime. But a paper published late last year by the National Association of State Universities and Land Grant Colleges pegs the value at close to a tenth of that, $121,539.

This is a very rough figure. There are big differences depending on the type of school, the time it takes a student to finish their degree and  other factors. In any case, the present value of going to college is positive, but not nearly as high as most think.

I do think there is a substantial intrinsic value in a college degree that makes the degree worth the investment.  There are huge value propositions to a person and society at large in having an educated citizenry, so we should not decide to attain a college degree based solely upon decisions about future earnings power.  (As an aside, philosophers like Rousseau and Alexis de Tocqueville recognized this fact early on). But can one justify going into ever-increasing degrees of debt for such an education, especially as alternatives become available?  This is why some people (myself included) looked for a high quality education combined with great investment value in our undergraduate alma mater.

This is of course equally applicable to graduate degrees, as evidenced most clearly in this NYTimes article about the dim prospects for law students at the top law schools:

When Julia, a second-year student at the University of Pennsylvania, decided to enter law school a year ago, she expected to find a lucrative law firm job in three years — if not collecting the $160,000-a-year associate salaries at one of the uppermost partnerships. By the time she obtains her J.D., she says, she will have around $200,000 in debt.“Had I seen where the market was going, I would’ve gone to a lower-ranked but less expensive public school,” she said. “I’m questioning whether law school was the right choice at all.”

Did the student in the example above go to law school for some intrinsic love of the subject?  It doesn’t appear to be so.  Rather, it looks like she was placing a bet that by using a large amount of leverage she could land an exceptionally high paying job.  This is the same type of conflation that is bringing so many homeowners to their knees: they began to think of their homes as investments vehicles rather than homes.

Craig Newmark does a round up of a number of excellent posts on this very subject, and links to a Seth Godin post I had seen a while back that I feel captures the coming storm perfectly:

Abundant education is easy to access and offers motivated individuals a chance to learn.

Scarcity comes from things like accreditation, admissions policies or small classrooms.

So we are seeing a divergence in learning and accreditation.  Accreditation in this case is some external benchmark of what you have learned.  Does an MBA know more about business than a non-MBA?  Not necessarily.  But for a hiring manager, the MBA simply acts as a filter.  Is this filter worth hundreds of thousands of dollars of debt?  If the rising tide of wages for MBA graduates were to continue, then yes, absolutely.  But when we see those same waters recede, as they are now, the whole system is brought into question.

The questions moving forward, as I see them, are a) how can we continue to bring down the price of learning so that it is accessible to every motivated student, regardless of age, income, or geographic location, and b) how can we create some type of accreditation to supplement this learning that isn’t dependent upon such large amounts of debt?

[Update: I haven't read it yet in it's entirety, but this article seems like a good expose on the same subject, via @jasontuttle]

[Update II: And another great article]

Update III: Neeru Paharia, one of the Founders of P2PU in the NYTimes:

She likes to talk about signals, a concept borrowed from economics. “Having a degree is a signal,” she says. “It’s a signal to employers that you’ve passed a certain bar.” Here’s the radical part: Ms. Paharia doesn’t think degrees are necessary. P2PU is working to come up with alternative signals that indicate to potential employers that an individual is a good thinker and has the skills he or she claims to have — maybe a written report or an online portfolio.

Once you think about any topic for long enough, you begin to develop a personal philosophy about how it works.  This could be your perspective of how to best throw a baseball, how to make the perfect souffle, or how to best tackle a sudoku puzzle.

I happen to think about investing, finance and business an inordinate amount, so I have the beginnings of a philosophy in this realm.  The great thing about any paradigm is that it is subject to change, refutation and revision: the rules I developed below are intentionally broad-stroked for this exact reason.

What follows are my five general imperatives of investing.  They are applicable primarily on a personal finance level; I imagine the technically inclined will be disappointed in the lack of specifics.

First, do no harm. This certainly seems an obvious piece of advice, but it is remarkable that many people conflate investing with gambling.  If you manage to save a certain amount of money, one of your primary goals should be to preserve the principle.  You wouldn’t purchase lottery tickets under the guise of investing: you similarly shouldn’t invest in things you don’t clearly understand because it is what you feel investors should do.

Understand appropriate time frames. This was a lesson learned the hard way.  I’ve always invested in equities under the assumption that I am young and retirement is far away.  Those are both true, but I missed a key point: there are plenty of things to save for on a drastically shorter time frame.  I was in fact saving for a down payment for a house through equities, under the assumption that that time frame was far off.  When an incredible buying opportunity arose - a collapse in the real estate market - the money I had saved was tied up in the stock market, which has taken an even stronger beating.

There are numerous things worth saving for, each with their appropriate time frame and investment implications: emergency funds, education, retirement, children, etc.  Saving in and of itself is fine, but you should always ask, what am I saving for?

Liquidity when needed. As a corollary to the previous point, understanding the appropriate time frame for investing means recognizing the importance of liquidity when you need it.  In the example I gave above, I wasn’t  worried about losing money on stocks for retirement - I have plenty of time to make that up.  But I do worry about not being able to substantially participate in this down market in real estate: if I had been saving money for a down payment through more appropriate investments, I could have acted.  Investments - stocks, bonds, real estate, commodities, and so on - occasionally go on sale, which we generally call a crash in that particular market.  An intelligent investor has the liquidity to make such investments at just the right moment.

Liquidity can also apply to living just as well as investing.  A job loss, sickness or unforeseen emergency demands liquidity in your savings.  We are unfortunately witnessing just how fragile this is for most Americans.

Understand your tax situation.  Any one who has owned a business knows the burden of a high tax liability.  An intelligent investor knows the same: dividends and capital gains are taxed, usually at both the federal and state level.  Yet there exist investment vehicles for every tax situation, from retirement accounts (tax free/tax deferred) to municipal bonds.  One should know where you stand.

Lastly, understand active investing versus passive investing (at least how I define these terms, which may not be standard).  We’re all familiar with passive investing: stocks, bonds, savings accounts.  For the vast majority of us, there is little to nothing we can do to change the underlying value of these investments.  You can’t reprice the bond, ask the bank to give you a higher interest rate, or call up the management of the company whose stock you own and plead with them to do a better job.  Rather, you just invest and hope for the best.  Pay and pray, as it often said.  Active investing - at least as I define it - is investing in something whose underlying value you can affect.  If you own stock in a small private company, there are things you can do to increase the value of that stock.  If you own a rental unit, you are actively managing this investment: the decisions you make on how to run the rental business will alter the outcome of the underlying investment, in this case your down payment.  I see active investing as a bridge between entrepreneurship and passive investing.  When you invest in stocks on an exchange, you are investing in a business.  Active investing is also about investing in businesses - it just happens the scale is usually much smaller.  Putting up capital for a working farm and sharing the profits, rental properties, and online properties with revenue opportunities are just three examples of these types of investments.   These are powerful, and often overlooked, investment opportunities.

These five points comprise the foundation of my personal investing worldview.  Each, of course, can be broken into specifics, but a broad overview, I think, is interesting and helpful in determining what an investor should be thinking about.  The simple process of outlining my perspective was immensely instructive, and something I certainly recommend.

There were too many good articles to post only to Twitter.

The WSJ examines why renting is the new American dream.  I agree.  Homeownership, while certainly a nice thing, is not necessarily better than renting, and there is not a strong case for promoting one method of consuming shelter over the other.  Especially after having seen the disastrous effects of too many mortgages we simply cannot afford.

This article in the Times outlines why I think the notion of rationing obscures an underlying reality: what a single payer system like National Health Service in Britain does is guarantee a basic form of coverage for everyone.  But if you don’t want to have your health care ‘rationed’ or be subject to wait times for medical services, you don’t have to: you can purchase supplemental private insurance or simply pay out of pocket.  One exchange with a health care provider went like this:

Told my husband needed a sophisticated blood test from a particular doctor, I telephoned her office, only to be told there was a four-month wait.

“But I’m a private patient,” I said.

“Then we can see you tomorrow,” the secretary said.

So while this system would “ration” health care for those who are only covered by such a system, if you want better coverage, you can simply pay for it.  It’s the same underlying principle as what we have in education: the government provides a basic level of service.  If it is not up to your standards, there are plenty of private schools that would gladly admit you.

Barack Obama then makes his case for health care reform, outlining four key reforms the bill would address.

And lastly, an article by the CEO of Hulu, who is an alumnus of my alma mater.  His reasoning was exactly what mine was when I was deciding on where to go to college: “When I applied to college, both education and investment value were important to me. I applied to the best public schools in the country and enrolled at the University of North Carolina at Chapel Hill.”

[Updated]

Three more articles on health care I’ve been reading, and are certainly worth one’s time:

Brad Delong’s Utopian fix for health care.

An excellent article in Atlantic Monthly, which contains a proposal that I’m very impressed with.

And lastly, Milton Friedman’s solution for health care.

As you may know if you read this blog, I live in Brooklyn, New York.  Although the subway is my primary means of transportation, I occasionally indulge in using a car service to get to the airport or during exceptionally rainy days.  This is not, as those who live in Brooklyn can attest, an extravagant luxury, but rather a necessity: Brooklyn doesn’t really have cabs.  So calling a car service on occasion is the equivalent of hailing a cab in midtown Manhattan.

New York Magazine had a great profile about one such car service a while ago.  Being a driver for a car service is not unlike purchasing a taxi medallion from the City.  Each driver is basically running an independent business: they pay the company a weekly fee to field calls and direct customers to them. So the money I pay a car service only indirectly goes to the company I call: it first goes directly to the driver, who then pays a fixed weekly fee “for the chance to compete for every job.”

My last two experiences using a car service have underscored how even those who are technically employed are struggling in this economy.  I have on two separate occasions called for a car, and had two cars respond to my call in less than a minute.  The drivers argued vociferously with one another that I was their customer before I was forced to choose one.  A few years ago it was common to wait ten times as long for any one driver to pick me up.

Disputes about who should get which call are somewhat natural: without the call from the dispatcher, there is no customer.  Since these drivers cannot pick up passengers off the street, they are simply out of luck when they don’t get enough calls. The dispatcher in the NYMag article clearly understood that he wields considerable power over these drivers’ economic fortunes:

“I’m the dispatcher,” he says. “I’m the one who gives out money, because the calls are money.” On any given night, he finds himself caught in the middle of a hundred hungry drivers, each determined to ensure that no other driver gets more work. Until recently, [they] received about 14,000 calls a week, but that was before the economy plunged, before livery cabs came to seem like a luxury. Now, with fewer calls coming in, the drivers are hungrier than ever.

If all their costs were variable (like gas), this might be bearable for the drivers.  But they aren’t.  Each driver is paying a high percentage of fixed costs: the weekly fee to the company to have calls fielded to them, the price of their car, and monthly insurance.   It is possible that each driver can not only not make money when there are  few calls, they can in fact lose money while working.  That is a particularly cruel twist of fate most of us do not face.

9.5% unemployment is certainly a bad number on its own.  But when you scratch below the surface - and take a look those who fall into that other 90.5%  - you realize just how deep this recession cuts.

A collapsed economy has many implications, one of which is a rather drastic uptick in the personal savings rate of most Americans.  This is entirely logical: unemployment is up, wages are down, virtually every asset we own has lost value, so Americans are spending less than they used to.  We are, collectively, at last living up to one of the basic maxim’s of personal finance: spend less than you earn.

The personal savings rate in May was 6.9%, the highest percentage we have seen since 1993.  This is a welcome and needed change for the long-term sustainability of the American consumer.  But in the short term, we can see the effects of the Paradox of Thrift at play here:

Although saving money helps individuals repair their finances and pay debts, a sharp rise in overall personal saving can actually deepen a recession and hurt the people who are saving more. As people save money, fewer dollars circulate through shopping malls, Main Street businesses, and large employers and subsequently back to workers through their paychecks. This thrift pulls the economy lower.

Economists say the recent spike in personal saving is likely to fall back slightly as the effects of government stimulus fade, but they have said that Americans are becoming thriftier and are not likely to return to the free-spending patterns that fueled much of the growth of the last nine years.

With consumer spending making up a significant percentage of our GDP, our economy is still looking for a sector that can pick up steam and pull us out of the recession.  Yet consumers are shell-shocked from watching the economy deteriorate as quickly as it has, and it is unlikely we will forget this lesson anytime soon.

Despite the obvious downside of consumer spending no longer being able to pull the economy out of a downturn, most economists agree that a personal savings rate at or near our long-term average is undoubtedly beneficial. According to one economist:

My hope is that the uncertain economic times many Americans will be finding themselves in will be an opportunity to rethink their values regarding the use of money at a deeper level… They would embrace thrift not because we have to, but because we want to. And not just for a few months, but as a long-term proposition.

There are, after all, many things more important than money.

I recently bought TIPS - Treasury Inflation-Protected Securities - for the first time.  All the talk about looming hyperinflation was beginning to alarm me, and given a recent conversation with a friend who professionally manages money, it seemed justified.

Alan Blinder’s article in the NYTimes was all the more interesting: inflation, he contends, is the least of our worries.  Our primary worry is still deflation, not inflation: it is amazing how until recently virtually every economist was worried about a Great Depression-style deflationary cycle.  But with deficits as far as the eye can see, interest rates as low as they can possibly go, oil prices coming off their lows, it does seem like inflation could make a quick comeback.

Blinder informs us, though, that we can already see what the market is forecasting for inflation. And it isn’t that bad:

The market’s implied forecast of future inflation is indicated by the difference between the nominal interest rates on regular Treasury debt and the corresponding real interest rates on Treasury Inflation Protected Securities, or TIPS. These estimates change daily. But on Friday, the five-year expected inflation rate was about 1.6 percent and the 10-year expected rate was about 1.9 percent. Notice that the latter matches the Fed’s inflation target. I don’t think that’s a coincidence.

Perhaps my timing of a TIPS purchase was off.  But it still seems like a smart hedge.