Odds and ends

I wanted to use this space to tie-up a few odds and ends. I promise* the ideas here (although wide-ranging) will be valuable and I’m very hopeful that they will improve your ability to get more value in life - when you shop, invest, and sell goods. In the last section, I share a new visual to show underlying performance factors of my value fund.

Lessons of residual value & deprecation trends

First, I want to discuss residuals and residual value.

  • The Oxford Dictionary defines a residual as “remaining after the greater part or quantity has gone,” and;

  • Investopedia defines residual value as “the estimated value of a fixed asset at the end of its useful life.”

The term “residual” is a niche term not commonly used, please don’t get hung up on it (depreciation is likely a more commonly used term to describe a similar concept). The point I want to make is that how you think about the value of an asset at the end of its usefulness can totally change the cost and value. It can make expensive assets more affordable than cheap assets. If you have heard of residual values before, the term was likely used in relation to cars or trucks. I’ll start with a simple example in that space before I move to other asset categories. I believe Chevrolet Trucks advertised that they had the highest residual value heavily in the nineties. Yet today, it appears that the truck that holds its value the best over time is the Toyota Tacoma. Regardless, I’m guessing you have seen a graph similar to the ones below as you researched the pros and cons of buying a new or used car.

The actual numbers here aren’t super important, the trend is… I’ll walk through a really simple example using the graph above to illustrate a point. If you need a car for a year, how old of a car should you buy? Obviously, this depends on a number of complex factors, but if it’s just a decision based on the value lost - the car loses $1,607 of value from year 4 to year 5 ($10,719 - $9,112) vs. $6,250 from year 0 to year 1 ($25,000 - $18,750). As I mentioned, this concept seems fairly elementary (and well understood), I think the real power comes from applying it to areas where people forget about the residual value. Many people have made businesses to fill this void, why do you think people are offering to haul away your used appliances for free? They are gambling that the appliance you have decided has a residual value of zero (to you) has a residual value of greater than zero to someone else. Think about the deprecation curves above, as well, different products and different brands depreciate at different rates (think about a Toyota Tacoma vs. a Kia, Patagonia vs. Old Navy, or Nike vs. Unbranded Shoes). It is really valuable in life (and in investing) to understand how you can play the depreciation curve to your benefit (adjust the slope or understand how time influences the residual value). Time plays an important role here. The decision making process will be entirely different if you plan to use (or invest in) an asset for two years vs. ten years. Regardless, I hope you find the following examples thought-provoking:

  1. You need a winter coat. You might buy a $500 coat. You might buy a $100 coat… have you considered buying a $500 coat that is 12 months old for $200, wearing it for two years and reselling it for $160? The third option isn’t for everyone (it likely isn’t for most people) but does provide the lowest cost per day to use the coat. You also get to use the much more expensive coat (which we assume is warmer, more comfortable, etc.). The third option seems like a huge benefit to me, because you are using your understanding of residual values and the depreciation curve to get the most premium product at the most affordable price.

    ***I understand I’m making some assumptions here… maybe you could sell the $100 coat for $60 two years later (I doubt it). Maybe you could get a friend to give you a coat for free. Maybe you wear the $100 coat for 30 years - that’s sweet. Maybe you don’t have $200 to spend on a coat. My point is to think about when option 3 might be ideal for you, so don’t get too hung up on the details.***

  2. You need a car. You might buy a new car. You might buy a used car. What if you bought a used car that is scarce… like a late 60’s Mustang or an early 2000’s EuroVan. That choice might turn the depreciation curve into an appreciation curve. This is another example of approaching this challenge differently to get more value from the situation. The investing possibilities are numerous, anytime you acquire an asset you might be able to use the expected residual value to change the question in your favor.

  3. You are buying a stock. You might buy the stock of a brand you like without understanding the financials (but please don’t). You might buy on a tip from a friend (but please don’t). What if buy because the stock was selling for $9 per share but it had $7 per share worth of assets (from cash to real estate to inventory, etc.). Maybe that turns the potential investment into something with very limited downside risk and huge upside potential.

  4. You are buying exercise equipment or music equipment. You might buy new equipment… but you should probably buy used equipment. Exercise equipment and musical instruments are items that are frequently purchased new and lightly used. They are both great examples of items where the depreciation curve is (often) very steep in the first few months of use. I think you might be surprised by the number of bands that play with used equipment (random fact: the Beastie Boys bought the majority of their equipment for the Check Your Head tour from a small, weekly newspaper in L.A. called The Recycler).

A quick disclaimer: this isn’t easy. You have to know and understand the asset well, if you don’t (and in some cases, even if you do) you can lose money be misestimating the residual value. I hope you found this to be a worthy thought experiment though. I think residual value (depreciation curves) help explain a significant amount of day-to-day economics, like why renters that drive new, expensive cars are renters and not yet homeowners… so much of the monthly income is being eaten about the depreciation curve. I’ll close a graph of Jordan shoe prices over time to (hopefully demonstrate) how this concept can be used almost anywhere.

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Resell trends of Jordans

Residual value is applicable everywhere

Understanding components of performance

In my experience, understanding the key drivers of the performance of a mutual fund or ETF can be very difficult. If you hold an S&P 500 ETF that is weighted by market capitalization (this is typical) you are holding ownership rights to approximately 500 different companies, but you only see one performance figure for your fund. About 22% of the assets are concentrated in the ten largest companies (AAPL, MSFT, etc.). This makes it hard to determine the impact of any specific stock on your total return. There are some good tools out there to dig into this, which I plan to write about in future newsletters… For now, I want to share a visual I’ve created to help tell the story. Below is a breakdown of the performance of my value fund. The light lines show the individual performance of each stock held in the fund and the dark line shows the combined performance of the fund. Several factors make this visual possible (and hopefully valuable) - the fund is small (<10 holdings) and the holdings are equally weighted (a market-cap-weighted fund would tilt the overall results towards the performance of the largest companies). Let me know what you think of the graphic below because I hope to expand on this analysis in the future.

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*good luck with this promise… I should say “I hope”

I'm "Investing Bored"

After almost 15 years or being fascinated by all things related to investing, I’m bored (which I imagine is how most people feel when they are forced to think about investing). There seems to be more quality content available today then ever before (brilliant authors, insights from fintwit, and so many high quality podcasts), yet I’m bored. Maybe being bored is a sign of growth, maybe it’s not, I honestly don’t know. Maybe the “waiting” for your returns to appear is the boring part, as Morgan Housel puts it:

After all, I’ve invested 15 years reading and developing strategies that are right for me. I have strong (yet not set in stone) investing and personal finance beliefs, like:

  • Ben Graham’s teaching and investing style is more meaningful than Warren Buffett’s teachings and investing style (can’t wait for the criticism in this one)

  • Money can be spent wisely to increase happiness, but money isn’t the key to happiness

  • Luck plays a significant role in most things, including investing

  • Reading about human behavior is at least as important to investing success as reading about investing

  • Automate savings (pay yourself first)

  • Save more than you spend

  • Investing success has very little to do with intelligence

  • “Safe investments” are often riskier than “risky investments” over long time periods (look at purchasing power of t-bills vs. equities over a 40 year period)

  • Understanding mean revision is powerful

  • Jack Bogle is an investing hero who did an incredible amount of good for America’s “average” retiree

  • You should diversify your investments

  • Leverage is bad

  • Debt is (usually) bad

  • Simple investing strategies are usually better than complex ones

  • Buying undervalued assets and having patience will produce good results long-term

  • Minimize fees

  • Focus of returns after taxes

  • A quantitive approach can minimize behavior errors

Many agree that boredom is critical to the creative process. Is my next key insight just around the corner? I don’t know. Do the great investors of our time get bored? I imagine so.

Regardless, despite my boredom I found the following of interest in the last few months (which probably means they are of interest to you).

Choosing What to Focus On

I read The Wealthy Barber (which I recommend) recently and it changed (or reinforced) my thinking in a few key areas:

  1. For most people, investing success is dependent on strong personal finance habits

    The potentially more valuable point here is a broader one - choosing what you focus on is critically important. You won’t receive your desired outcome if you don’t understand the true drivers (inputs) of your desired outcome. If investing success is your desired outcome, but you don’t get the personal finance piece right (you have a negative savings rate) or you don’t control your emotions (you buy speculative “hot stocks”) you won’t achieve investing success.

  2. You should be able to save more than $300k by implementing the tips in the book (with common sense investing)

    Mr. Chilton recommends setting aside 10% of your salary for savings. Once you have set aside a decent amount (possibly enough to cover 3 to 6 months of expenses) in a standard savings account as an emergency fund, he recommends investing your 10% in low-cost equities (Wealthfront or Betterment are great options). This insight has the potential to be a game changer for your average family. When you run the numbers you see that a mid-career, middle-income family could expect their savings account to be worth well over $300k by the time they retire (in addition to their retirement accounts).

  3. A dollar saved is two dollars earned

We have all heard “a penny saved is a penny earned” but that turns out to be incorrect. If you grab your most recent itemized paycheck you should be able to quickly prove this point. For each $100 you are paid, how much goes to Federal Taxes, State Taxes, Medicare, Retirement, Health Insurance Premiums, etc. It’s likely that somewhere between $30 and $50 of each $100 you make disappears with taxes and other deductions. So, each time you decide to spend a dollar think about how much you have to “earn” to pay for that expenditure… it’s close to two dollars. Understanding this helps to reframe the true cost of purchases.

I want to briefly focus on the first point because it can be applied broadly. In order to determine success, one has to define a successful outcome. We frequently talk about investing here, so let’s start by considering investing success as our ideal outcome. If investing success is your goal what is the first thing you should focus on to achieve your goal? It’s certainly not asset allocation and it’s probably not even taxes or fees (this assumes you aren’t already independently wealthy). In order to achieve investing success, you are going to have to create money to invest… which is dependent on your personal finance habits. To farther illustrate this point, I’ve leveraged the USDA original food pyramid (which was used from 1992 - 2005). I remember this vividly from my childhood; it seemed to strongly imply that “bread, cereal, rice, and pasta” were good and the foundation of a healthy diet. While fats and oils were bad (there is significant controversy about how these recommendations were made by the USDA and what role the wealthy companies in the food industry played in crafting these recommendations). For our purposes, let’s disregard if the food pyramid is right and focus on the story it tells. If we tried to make a “food pyramid” for investing success it might look like the second image below.

The USDA's original food pyramid, from 1992 to 2005.

The USDA's original food pyramid, from 1992 to 2005.

Simple “investing pyramid”

Simple “investing pyramid”

I hope our “investing pyramid” illustrates the appropriate story. Your natural tendency is first to seek advice on your asset allocation strategies, but when you do that you are focusing on the wrong thing. Before you worry about asset allocations, set your foundation with strong personal finance strategies that enable you to invest more money, minimize your taxes and fees, etc.

When we apply this idea broadly, to areas where our focus may be misguided, I think of the following:

We often focus on: Investing (especially Asset Allocation & “Hot Stocks”), but we should focus on Personal Finance and Savings

We often focus on Money, but we should focus on Happiness, Well-being

We often focus on Tasks, but we should focus on Relationships

We often focus on Caffeine, but we should focus on Sleep

We often focus on Ourselves, but we should focus on Family and Friends

We often focus on Possessions, but we should focus on Experiences

We often focus on Our wants, but we should focus on Our neighbor’s needs that aren’t being met (by volunteering or giving back)

Regardless, you should read The Wealthy Barber, it’s enjoyable and it will reduce your stress levels.

Performance Update