The Efficient Market Hypothesis is among the most-debated topics in all of finance.  Do the prices of securities traded on  the major financial exchanges instantly reflect all known information about the prospects of that particular stock?  Or is the efficient market hypothesis bunk, as many believe?  The answer to this question is extraordinarily important, since modern portfolio theory and most modern financial advice is predicated on market efficiency.

My personal belief is that the market is mostly efficient most of the time, or at least efficient enough that attempting to beat the market isn’t worth the effort, and my retirement portfolio reflects that belief.  I will stop short of declaring the market is 100% efficient all of the time and it is impossible to beat the market by skill alone, but I will definitively say there is absolutely no substantiated evidence that the market is not efficient, Warren Buffett included.  In short, The existence of Warren Buffett is not evidence that the efficient market hypothesis is wrong.

If Not Investing Skill, Where Do Buffett’s Returns Come From?

First a disclaimer:  I am not claiming Buffett’s superior long-term returns aren’t the result of superior investing skill.  I am merely saying there is no evidence of said superior investing skills and even if there were, it in no way disproves the efficient market hypothesis.

Buffett’s superior long-term returns conceivably (and far more likely) originate from three primary sources other than skill.

1. Management Ability - When people say Buffett has generated 23% annual returns over a 40 year period, what they are really saying is that Berkshire Hathaway’s (BRK) book value has grown at a 23% annual rate over that period of time, which is not even close to the same as saying Buffett’s stock-picking prowess returned 23% per year.  Berkhshire Hathaway owns over 70 different companies outright, including such well-known brands as Geico, Dairy Queen, and Fruit Of The Loom.  His success generating out-sized returns from these brands is due more to his managerial and leadership ability than investing ability.  After all, he’s the CEO of all those companies and has a direct hand in running them.  Furthermore, Buffett often takes a seat on the board whenever he buys a large stake in another company, such as Coca-Cola (KO),  as an “outside” shareholder. He’s able to get a board seat because he is a well-respected and knowledgeable businessman, allowing him direct control over the strategic direction of the stocks he owns.  When you or I are unhappy with the performance of a stock we own, there’s little we can do about it besides sell.  Buffett, on the other hand, can directly influence management and sometimes force them to do his bidding (board members control executive pay, after all).  That’s hardly the same as the passive form of “investing” most people practice it.  Not even most highly-respected and influential mutual fund managers have that sort of pull.  Buffett truly is a special case.
2. Prestige - Buffett himself has admitted in his biography The Snowball: Warren Buffett and the Business of Life by Alice Schroeder that his larger-than-life reputation attracts many attractive investment opportunities he would otherwise be locked out of.  As Buffett puts it, companies in need of cash often come to Buffett directly and are more than willing to pay him above average returns due to two reasons.  First, Buffett’s deep pockets allow him to fund their needs immediately and don’t require them having to jump through any bureaucratic hurdles like they would with a bank or the public markets.  Second, being publicly aligned with Warren Buffett is often enough to entice vendors and customers to do business with them.  It’s also a clear signal to rivals saying “Beware!  Warren Buffett himself has deemed us worthy of his attention.  What chance do you think you have competing against us with Buffett on our side? Give up before it’s too late.“
3. Random Luck - The most common argument I hear is also the most ridiculous and unfounded one:  “It’s simply not possible for Buffett to have done as well as he did for as long as he has purely by luck.”  Nonsense, of course it’s possible.  Not only is it possible, it is 100% probable that somebody like Warren Buffett must exist and do so purely by chance.  Then, the  follow-up argument goes something like this:  “Well that still doesn’t explain why other investors with similar strategies have also outperformed the market over time, such as Bill Ruane, Bill Miller, etc…“  Nonsense.  It explains that phenomenon equally well.  To illustrate, try the following experiment.  Pretend you have a coin and record on a sheet of paper a series of random flips of the coin (don’t actually flip a coin, just write down what you think a random sequence of coin flips would look like).  All done?  Now flip a coin for real and record the sequence.  Do you notice any differences between the sequence you predicted and the actual sequence you recorded?  I bet you will.  I can’t give away what that difference will be here without ruining the exercise, but I will reveal it in the comments if anybody is interested.  Fully 80-90% of the time you will notice the same inconsistency between somebody’s predicted and actual sequence.  In fact, I would be willing to bet I could determine which was which the majority of the time.  The moral of the story is that people are horrible at estimating probabilities accurately.  Most people think it’s extremely unlikely that Buffett and many with similar investing styles would all outperform the market when in reality, it’s quite probable this will happen purely by chance.

What Does This Mean For The Efficient Market Hypothesis?

In the end, the existence of Warren Buffett neither proves nor disproves the validity of the efficient market hypothesis.  It simply has no bearing.  Sure, Buffett could be a superior investor, but there’s nothing in his record or the record of managers with similarly-impressive long-term records that suggests the results are anything other than luck.  To believe Buffett’s record disproves the efficient market hypothesis is to completely misunderstand the nature of probability and markets.  Do I believe Buffett is just lucky?  Not really.  I personally believe he’s a very skilled investor and that skill has played a large role in his success over the years.  But I can’t prove it, and neither can anybody else.

In the end, it really doesn’t matter if Buffett really can beat the market or not.  The bottom line is, you’re not Buffett.  Just because he can beat the market doesn’t mean you can.

Buy Warren Buffett’s biography The Snowball: Warren Buffett and the Business of Life by Alice Schroeder from Amazon today!

Index funds are by far my favorite investment vehicle.  They are passive, cheap, come in practically any asset class you could think of, and most importantly tend to outperform the competition over long periods of time.  Hopefully by now you’re convinced index funds are the way to go, but how exactly do you go about choosing one index fund over another?  After all, there are literally hundreds of different index funds out there, many of them tracking overlapping segments of the market.

Following are four useful metrics to use when comparing competing index funds.

Low Expenses

The single most important attribute to consider when choosing an index fund, and the primary source of their advantage over actively-managed mutual funds, is its expense ratio.  Everything else is secondary.  All else being equal, the index fund with the lowest expense ratio will always outperform other funds tracking the same index by the amount of its cost advantage.  Sadly, there are plenty of expensive index funds out there, so be sure to check before buying.  The quickest and easiest way to check a fund’s expense ratio and other basic characteristics is by signing up for a free Morningstar account and typing the fund’s name or ticker symbol into the search box.

The Index Being Tracked

An index funds will share the investment characteristics of whichever market segment it happens to be tracking.  That is, a small-cap international index fund will perform poorly whenever small-cap international stocks in general are performing poorly, regardless of how large-cap domestic stocks happen to be performing at the time.

There also exist indices constructed in such a way they cost investors money, such as the Russell 2000 index.  The structure of the Russell 2000, for example, encourages large institutional investors to buy and sell at known intervals to take advantage of arbitrage opportunities when securities being added or subtracted from the index, leading investors in Russell 2000 funds to owe larger tax obligations than they otherwise would.  David F. Swensen gives a detailed account of this particular phenomenon in his book Unconventional Success:  A Fundamental Approach To Personal Investment.

Portfolio Turnover

Portfolio turnover is a measure of how often a fund buys and sells securities.  A turnover of 25% means the fund “turns over” approximately 25% of its portfolio every year.  Put another way, it means the fund’s average holding period is about 4 years.  By the same token, a 10% turnover indicates the fund owns the average stock in its portfolio about 10 years.

The higher a fund’s portfolio turnover, the higher its transaction costs in the form of brokerage commissions and the more capital gains are generated (leading to a higher tax bill).  All else being equal, the lower a fund’s portfolio turnover, the lower its total investment expenses (many of which aren’t reflected in the expense ratio figure above).  Portfolio turnover statistics are another benefit available to those with a free Morningstar account.

Reputation Of The Fund Company

Some fund companies are above reproach while others engage in questionable business practices.  More to the point, some fund companies are more likely to raise fund expenses in the future while others are likely to lower them.  Since switching funds in a taxable account involves significant tax costs, it makes sense to keep an eye on the future when making purchase decisions.  Vanguard funds, for example, are likely to be less expensive in the future than they are today because of Vanguard’s unique corporate structure.  Several Vanguard competitors such as Fidelity and Schwab currently have a slight cost advantage over comparable Vanguard funds, however, these for-profit companies are likely operating these funds at a loss in an effort to attract more business to their more profitable actively-managed funds.  What happens when these companies decide it’s no longer worth the effort?  That’s right, you’re stuck in an expensive fund.  So long as the overall current cost difference is minimal, it makes sense to consider the future.

Much-maligned real estate guru Robert Kiyosaki (of Rich Dad, Poor Dad fame) is often criticized for misleading aspiring real estate investors by giving advice that is either impractical, illegal, or downright inaccurate.  Many of these inaccuracies are harmless, but some cause real damage.  One of the ideas often attributed to Kiyosaki by his followers and critics is the idea that if you receive a positive cash flow on a property you acquired for no money down, meaning your revenue is higher than all your combined expenses associated with that property, you’ve just earned an infinite return on your investment.  This idea has been subsequently propagated all over the internet by mathematically-challenged individuals.  I’m sorry to burst Kiyosaki’s bubble, but an “infinite return” on any investment, including real estate, is a mathematical impossibility.

No Such Thing As An Infinite Return

To the uninitiated, the myth of the infinite return on investment at first seems plausible.  After all, if you were able to acquire a profitable asset without investing any of your own money, the profit on that investment would be infinite relative to the magnitude of that investment, right?  Wrong.

The utter ridiculousness of the myth of the infinite return on investment becomes obvious when one reflects on the meaning of the word “infinite.”  First, think of all the money in the entire universe that exists, has ever existed, or ever will exist.  Got a number in your head for how much that might be?  There’s no telling how large that number is but one thing is for certain:  it’s less than infinity.  There is a finite amount of money in the universe.  It might be an astronomical number, but its still a finite one.  When you say you’ve achieved an infinite return on an investment, what you’re really saying is that you received all the money in the universe and then some.  Did you receive all the money in the universe on your last investment?  The $20 bill in my wallet right now says you didn’t.  Unless you are the only one in the universe with any money, you didn’t earn an infinite return.

Remember Middle School Algebra?

The formula to calculate return on investment is simple:  ROI = (gain from investment - cost of investment ) / cost of investment.  If you bought a stock for $100 and by the end of the year it was worth $110, your ROI = ($110 - $100) / $100 = 10%.  The zero-down-infinite-return proponents will say “well wait a minute, if my investment is $0, that’s an infinite return!”  Wrong.  Let’s run the numbers using the above example except this time, the “cost of investment” is assumed to be $0.

ROI = ($110 - $0) / $0 = ???

Do you see the problem with the equation above?  The more mathematically-inclined among you will immediately note there is a $0 in the denominator.  This poses a problem since in math, division by zero is illegal.  You simply cannot do it.  Ever.  For any reason.  Thus, the correct thing to say is that in this case, the return on investment is undefined.  You can’t calculate what the return is but one thing is for certain:  it is not infinite.

Don’t believe me when I say you can’t divide by zero?  Just ask the U.S. Navy.  In 1997, the U.S. Navy aircraft carrier USS Yorktown’s propulsion system ceased to operate, rendering one of the mightiest ships in the history of the world dead in the water.  The reason?  An error in the ship’s database caused the on-board computer to attempt to divide by zero, crashing the entire system.  The ship had to be towed into harbor.  If the U.S. Navy can’t even divide by zero without catastrophic results, you haven’t got a prayer.

But The Return Is Still Huge, Right?

Hopefully by now I’ve managed to convince you an infinite return on investment is possible.  “Fair enough,” you might say, “but the financial rewards on the transaction is still huge.”  Well, maybe.  But probably not.

Zero-down deals are quite rare, and they are never easy.  If there really were plenty of zero-down properties out there that would yield positive cash flow right from the very beginning, everybody would be doing it.  Obviously, it’s not that easy.  In fact, it’s extraordinarily difficult.  It takes a lot of time, research, and careful calculation to find these deals and after closing, there’s often a lot of work that needs to be done, since the vast majority of these properties are fixer-uppers.  The financial investment required might be zero, but the labor and time investment required is huge.  Once you take the value of your time into account (and the associated opportunity cost of not being able to do something else), the picture changes dramatically.

An Example Of The Time Costs Involved In Real Estate Investing

Continuing the example above, let’s assume you are able to buy a $100,000 property with no money down that at the end of the year appreciates 4%.  Furthermore, let’s be generous and assume the above property yields $100 per month in positive cash flow after expenses, or $1200 per year.  Overall, the property returns $5,200 over the course of the first year, most of it unrealized appreciation.

Let’s assume the investor in question earns $50,000 per year at her day job, which equates to about $25 per hour (assuming two weeks vacation) and let’s furthermore assume it takes approximately 50 hours of work to locate, research, and renovate the property.  I believe 50 hours of work is a very reasonable assumption when you take into account the time spent on MLS websites looking at listings, visiting properties, negotiating, dealing with lenders, arranging inspections, attending closing, and a weekend renovating.  Nobody who has ever bought a property would balk at the 50 hour figure.  All told, 50 hours x $25 per hour equals $1,250.  This is the amount of your actual initial investment, not $0.  In the end, this works out to a 316% return on investment, which is nice but hardly anywhere close to infinite.  Looked at from another perspective, you earned approximately $104/hr on this real estate deal, which is over four times the hourly rate from your day job.

But wait, there’s more!  Rental properties don’t manage themselves.  Assuming it takes approximately 2 hours per month to manage your new property (24 hours per year), you’ve just added another $600 to your upfront investment, bringing your total to $1,850.  In the end, you get a 280% return on investment equating to just over $70/hr.  All in all, not a bad return, but it’s certainly nowhere near infinite.

First off, congratulations to the U.S. national team for making the Confederation Cup final in South Africa!  Last week’s amazing victory against Spain will go down in the U.S. soccer history books as being a major turning point for the sport in this country.  They the U.S. eventually lost 3-2 to Brasil in the final, their performance was nothing short of fantastic.

Carnival of Personal Finance

I actually have 2 carnivals to link to this evening.  Special thanks goes out to Living Almost Large for including my article How To Create Passive Online Income in the 209th carnival of personal finance and to Suburban Dollar for including my post 4 Money “Fixes” That Will Put You In The Poor House in the 210th edition.  Here are some other posts I enjoyed.

Helen from Affine Financial Services posted a monte carlo calculator anybody can use to calculate the probability of running out of money in retirement.  I suggest you try it!

Fiscal Fizzle presents 24 excuses for why you haven’t saved any money yet.  How many are you guilty of?

Kevin from No Debt Plan brings us how to thrive during layoffs.

My Two Dollars discusses when spending money is worth it.  Sometimes, paying somebody else to do something you could have done yourself is worth every penny.

The Weakonomist weighs in on which is more likely, hyper-inflation or deflation.  My best is on neither.

Fiscal Geek tells you how to fix a water-logged cell phone by yourself.  As somebody with a penchant for dropping my phone in various liquids, I can vouch for the effectiveness of these tips.

There are two primary causes for the decline of the American automakers over the past decade.  The first is rapidly rising gas prices.  If you want proof, just ask your local Chevrolet dealer how difficult it is to sell a 12 mpg Suburban when gas is $3 per gallon.

The second and most important reason Detroit has been rapidly losing market share to Japanese automakers is poor product quality.  For years (going back at least to the mid 70’s), American-built vehicles have simply been inferior to their Japanese competitors in nearly every respect.  By the early 90’s, Japanese dominance was beginning to show in the annual quality ratings and by 2003, Detroit had already begun its downward death spiral.

American Auto Quality Making A Comeback

This year’s J.D. Power & Associates Initial Quality Survey illustrates just how far Detroit has come in improving the quality gap.  Overall auto quality improved a solid 8% this year, but American steel improved an even more impressive 10% over the same period.  Overall, American automakers snagged two first-place spots this year in their respective categories (Ford Mustang, Mercury Sable) and tied for first place three more times (Chevy Trailblazer, Ford Edge, Chrysler PT Cruiser).  Additionally, several other American models snagged respectable second and third place finishes.

Overall, Asian manufacturers still dominate the rankings, but their hold on the top spots has been slipping significantly the past few years.  If current trends continue, American manufacturers should overtake their Asian competitors in overall quality sometime within the next 5-10 years.  So if you’ve been avoiding American cars due to past quality issues, now just might be time to take a second look.  You’ll probably be pleasantly surprised by what you find.

Despite all the attention paid to the stock market in the financial media, real estate has long been the asset class of choice for many of America’s wealthy individuals.  Indeed, in 2004 approximately 40%** of the top 10% most wealthy households held investment real estate, or about the same as the amount holding stocks and mutual funds combined.  By contrast, only 20% of the bottom 90% of the wealth spectrum held investment real estate.

An Investment Made For The Rich

Traditionally, real estate has been an asset class mostly restricted to the wealthy.  To this day, the costs involved in buying, selling, and leasing real estate can be prohibitively expensive, nevermind the difficulty of acquiring enough properties to be sufficiently diversified across both property types and geographical regions.  A portfolio like that would cost tens of millions of dollars in invested capital, an amount well outside the means of the middle class.

REITs For The Rest of Us

Fortunately, Congress saw fit to foster the proliferation of Real Estate Investment Trusts, or REITs, as a way for the middle class to participate in the benefits of real estate ownership.  REITs are required by law to pay out 90% of their net income as dividends to shareholders, and in return are allowed not to pay any corporate income taxes.  These securities routinely yield between two and three times more than the overall stock market, making them ideal for income investors.

REITs Vs Rental Properties

Income

The income return of REITs is relatively straight-forward to measure:  the Vanguard REIT Index (VGSIX) currently yields 5.81%.  The income potential on investment real estate, on the other hand, depends entirely on the specifics of each individual deal.  It’s difficult to generalize across all property types, but a reasonably-priced, responsibly-leveraged small residential income property (1-4 units) can yield between 8-12% on your invested capital.  However, during the go-go days of the real estate bubble, cash yields were often much lower and in some cases negative in many markets.

Winner: Rental Properties

Appreciation Potential

Since REITs are required by law to pay out 90% of their net income to investors as dividends, they aren’t able to retain much cash to grow their real estate portfolios.  Small individual investors, on the other hand, are free to re-invest 100% of their earnings back into income-generating properties.  On the other hands, large REITs are often able to borrow on much more favorable terms than small investors (once they exhaust owner-occupied financing opportunities) and have teams of professional analysts scouring the market for deals, an effort small investors just can’t match.  Overall, the appreciation potential of individual investment properties versus REIT portfolios is a toss-up.  It totally depends on local market conditions and which real estate sector is currently in favor:  commercial or residential.

Winner: Tie

Leverage

REITs typically carry loan-to-value ratios of between 50-70%, making them moderately leveraged by real estate standards.  By contrast, the norm for small investors is 80% and sometimes even 90% or higher for ultra-aggressive investors.  Sure, you could buy REITs on margin, thus bridging the leverage gap with direct real estate investment, but the interest rate on a margin account is likely to be significantly higher than a mortgage on an investment property.

Winner: Rental Properties

Safety

Rental properties are very expensive, and true diversification is far beyond the means of any middle-class real estate investors.  Additionally, individuals rarely have the opportunity to invest in non-residential real estate sectors such as industrial properties, hotels, shopping malls, and even large apartment complexes.  By contrast, a top-quality REIT mutual fund owning hundreds of REITs spanning tens of thousands of properties in every sector imaginable spanning the entire globe can be bought for as little as a few thousand dollars.  Direct control over small rental properties helps mitigate the risks of direct somewhat, but still fall far short of the safety promised by broad diversification.

Winner: REITs

Cost

Anybody who’s ever owned their own home knows real estate is expensive to buy, sell, and maintain.  By contrast, the Vanguard REIT Index charges a miserly 0.21% of assets, or many times less than the cost of direct real estate investment.  Closing costs alone would amount to more than 0.21% of any real estate deal you’d be likely to find, nevermind the costs of actually maintaining the thing and keeping it leased.

Winner: REITs by a mile

Effort Required

The ultimate goal of most investors is to be able to generate enough income from investments to be able to retire.  Thus, passive income is key.  Direct real estate investment, however, is not even remotely passive.  You have to find tenants, handle repairs, and keep track of accounting details.  If you own more than a few properties, the effort involved can easily turn into a full-time job.  Sure, you could hire a property manager to do the dirty work, but that would take a significant bite out of your profits and you’d probably lose some valuable tax benefits to boot.  REIT mutual funds, on the other hand, couldn’t require less effort.  Buy once and then cash your dividend checks until the day you die.

Overall Profit Potential

Overall, direct real estate investment has far greater profit potential than REITs due to higher amounts of leverage and lower borrowing costs;  however, it is also much riskier in many (if not most) cases.  With high returns comes high risk.  In the long run, REITs are unlikely to return more than they have in the past, which is about 10% per year since inception.  A properly-leveraged direct real estate investment program, on the other hand, could easily return 20-30% per year indefinitely as long as you were willing to put the work in.

Winner: Rental Properties, but with higher risk as well

The Choice Depends On You

It goes without saying that real estate belongs in every investor’s portfolio, but in the end the choice between REITs and direct real estate investment depends entirely on your individual needs and wants.  If you want to earn excess returns and retire a millionaire at a young age, direct real estate investment is probably the best choice for you.  If you just want to set it and forget it, however, REITs offer an ideal balance of return, risk, and required effort.  In the end, the choice will probably boil down to how much work you’re willing to do.  As always, hard work pays off.

Where To Learn More

The bookstore is the best place to learn the ins and outs investing in Real Estate and REITs.  Here are a few books I highly recommend.

• Investing in REITs: Real Estate Investment Trusts by Ralph Block
• Investing in Real Estate by Andrew McLean and Gary Eldred
• The No-Nonsense Real Estate Investor’s Kit: How You Can Double Your Income By Investing in Real Estate on a Part-Time Basis by Thomas Lucier
• Investing in Duplexes, Triplexes, and Quads: The Fastest and Safest Way to Real Estate Wealth by Larry Loftis

Sources:

** Domholf, Willam Who Rules America:  Wealth, Income, and Power.  September 2005

Last year was a pretty bad year for me, financially.  First I lost my job and now I’ve come to find out my condo lost approximately 18.6% of its value in 2008.  Generally, I completely ignore price fluctuations on my property.  After all, it’s not an investment, it’s a place to live.  However, there is one time of year its impossible not to pay attention to your home’s value:  tax assessment time.

Last week, I received this year’s property tax assessment and sure enough, the assessed value of my home reflects prevailing market conditions in my area.  I had a general notion in my mind that my condo had probably lost 10-15% in the recent real estate bust so the 18.6% figure wasn’t all that shocking; however, it still wasn’t pleasant to have my suspicions confirmed.

Make Sure You Get Your Tax Break

One positive aspect of the real estate crash is that since real estate taxes are based on market value, a drop in the value of your home should correspond with a drop in you property taxes.  Of course, property tax assessments aren’t meant to accurately reflect your property’s market value down to the penny, but tax assessment trends can give you a broad overview of general price trends in your neighborhood.  Altogether, my 2009 property tax will be about $138 lower than in 2008 (due to a combination of value and millage rate changes).  Small consolation, but I’ll take it.

Fortunately, my taxing authority lowered my tax appraisal voluntarily so it wasn’t a problem.  Some cash-strapped municipalities, on the other hand, may try to slip one past inattentive homeowner and continue to tax area properties at now-far-too-high valuations unsupportable by a realistic market appraisal.  If you have the bad fortune of living under one of these dishonest regimes, you’ll have to contest your property tax assessment.

Contesting Your Property Tax Assessment

There are a number of reasons your real estate tax assessment may be wrong but in the end, all you really care about is getting it fixed.

1. Act Immediately - You only have a limited amount of time to contest a property tax bill from the time you receive it, so you don’t have any time to spare.  The time limit should be listed on your property tax bill.
2. Schedule A Review - Your bill will contain steps to contest your appraisal, or at least point in to where you can find that information.
3. Gather Market Information - The first step is to gather relevant information about the value of your property.  Comparable sales lists of the kind found on zillow.com or homegain.com will come in very handy here.
4. Arrive On Time With Your Documentation - Your fate is entirely determined by how well you do in the hearing, so dress nicely and arrive on time.  If your tax appraisal is grossly inaccurate, the review should be a shoe-in so long as you have the data to back up your claims.

When money is tight, it’s tough to resist the temptation to look for short-term solutions to long term problems.  But resist you must!  Going down any of the following self-destructive paths may keep the bill collectors at bay for the time being, but you haven’t really solved the problem.  On the contrary, you’ve greatly exacerbated it since you now owe massive amounts of interest in addition to your original obligations or are otherwise worse off than before.

4 Quick Money “Fixes” To Avoid At All Costs

1. Payday and Title Loans - These  types of loans are worse than a last resort:  they are financial suicide!  Payday and title loans routinely charge interest rates in excess of 50% and sometimes over 100%!  If you can’t afford a $500 debt payment, what makes you think you can afford a $300 interest charge in addition to the $500 debt?  Financially speaking, declaring bankruptcy is probably a better option than these types of loans.  Seriously.
2. Credit Card Cash Advances - Credit card cash advances lose their luster right from the start owing to their 3% upfront transaction fees (on average) and high interest rates.  Paying a $30 transaction fee for the privilege of paying 18% interest on a $1000 credit card loan is hardly my idea of a good deal.  While an 18% interest rate is better than the triple digit rates charged by payday loan peddlers, it’s more than sufficient to put you in an insurmountable financial hole.
3. 0% Balance Transfers - 0% balance transfers aren’t all bad.  If you are fiscally responsible and play your cards right, you can actually manage to turn a decent profit from credit card arbitrage.  For those in debt, a 12 month 0% balance transfer offer may even offer some much-needed breathing room and allow them to pay down their debt more aggressively.  I include 0% balance transfers here for two reasons a.) they offer a false security.  In an ideal world, deeply-indebted consumers would learn their lesson, pay off the transferred balance before the promotional rate was up, and henceforth become a model of financial discipline.  Unfortunately, the majority of borrowers would simply use it as an excuse to rack up more debt.  After all, if they were disciplined they probably wouldn’t be in this situation to begin with.  And b.) 0% balance transfers are probably only available to those with sterling credit post-financial-crisis anyway, which disqualifies most desperate borrowers anyway.
4. Tapping Your HELOC - Putting your home at risk to pay off unsecured or non-recourse debts such as credit cards, car loans, etc is extremely unwise.  If you default on a credit card payment, the worst that is likely to happen is your credit rating (get your credit score) drop like a rock for 7 years.  If you default on your HELOC, on the other hand, you lose your home.  Which scenario is worse?

A better alternative to all four of the above actions is to get a second job, drastically cut back on spending, and pay off your debts the old-fashioned way:  by spending less than you earn.

Traditionally, I’ve held my emergency fund in the Vanguard Prime Money Market Fund (VMMXX).  Several years ago, the Prime fund was riding high on the then-generous short-term interest rates, its yield topping 5% and staying there for a significant period of time.  At that point, Vanguard Prime was the highest-yielding high-quality cash-equivalent I could find, beating the yields on most of the newly-popular high-yield online savings accounts, such as HSBC and WTDirect.

Dawn Of The Online Savings Account Era

As interest rates have dropped like a rock, so has the yield on my Vanguard Money Market Fund, which now yields a paltry 0.37%.  Top-tier online savings accounts, however, still routinely yield between 1.5% and 2%.

Why the discrepancy?  For commercial banks, the deposit base is everything.  How much a bank holds on deposit directly affects how much money it can lend out, which ultimately determines how much profit a bank generates.  In tough economic times, there often isn’t a lot of spare savings to go around, so banks have to compete aggressively for what’s left in the form of higher-than-average interest rates.  In the end, the bank with the most deposits generally wins.

Money Market Mutual Funds (in contrast to money market deposit accounts at the bank, which are a different animal), don’t work quite the same way.  Money market funds are generally run by large institutions with hundreds of millions if not billions of dollars to invest.  When you’re running that much money, small-time operations like an online savings account just don’t cut it.  Money market funds demand a.) safety and b.) liquidity, which they attempt to get by spreading their money around between short-term Certificates of Deposit (just like the ones you can buy at your local bank), commercial paper (short-term loans between large corporations), short-term government securities (such as 90-day Treasury Bills) and other safe, secure short-term investments.  It is important to note, however, that Money Market Mutual Funds are not FDIC insured and are ever-so-slightly more risky than their savings account cousins.  To compensate, money market funds tend to offer slightly higher returns over the long term.

Money Market Vs High Yield Savings

Safety

High-yield savings accounts are FDIC insured and backed by the full faith and credit of the United States Government.  Money Market Mutual Funds are technically not FDIC insured; however, many of the underlying securities they invest in are actually backed by the U.S. Government.  For instance, almost 50% of Vanguard Prime’s portfolio is invested in ultra-safe treasury securities.  That said, several money market mutual funds actually “broke the buck” and lost money in the recent financial crisis.  So far, all investors in failed funds have been compensated by the fund manager, but there’s no guarantee that will always be the case.

Winner: High-yield savings

Performance

Currently, high-yield savings accounts yield more than the average money market mutual fund, which is common during recessions when interest rates are very low.  When rates are high, however, money market mutual funds tend to have significantly higher yields than savings accounts.  Because of their slightly riskier nature, money market funds will tend to outperform savings accounts over the long run, if only slightly.

Winner: Money Market Funds

Liquidity

Both money market funds and online savings accounts allow for easy electronic transfers to and from your checking account.  Savings accounts, however, tend to have a monthly transaction limit while many (if not most) money market funds don’t.  Money market funds also allow you to write checks directly from savings instead of first having to transfer the cash to your checking account.  Many savings accounts allow this too, but they are rarer.

Winner: Money Market Funds

Convenience

Both money market funds and savings accounts offer similar types of online account management and electronic funds transfer.

Winner: It’s a tie

Overall Winner

Which type of account you prefer ultimately boils down to your needs.  If you demand absolutely safety, an FDIC insured savings account is probably the way to go.  However, if you’re willing to give up a very small amount of safety in exchange for slightly higher returns over the long run, a money market fund is probably your best bet.

Overall, both types of accounts are very safe and pay reasonable rates, on average.  At the end of the day, a few tenths of a percentage point on a few thousand dollars in your emergency fund isn’t going to make much of a dollar-amount difference to your net worth.  The important thing is that you’re saving for the future and not so much where you save it.

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HSBC (1.55% APY) | WTDirect (1.76% APY) as of 6/17/2009

There’s something comforting in following the crowd.  It is often said “it’s better to fail conventionally than succeed unconventionally,”  which is why humans have always had a tendency to come up with general rules of thumb;  guidelines that while not perfect, provide as good a starting point as anyway for solving otherwise difficult problems.  Well, some things never change, but the times do, and as modern science has improved the quality of medical care available at reasonable cost to the general population, life expectancies have steadily increased, causing once-hallowed rules-of-thumb regarding proper asset allocation to become out-dated.

The Old Rule Of Thumb

The first asset allocation “rule of thumb” most people used to be exposed to was that you should invest 100 minus your age in the stock market with the rest going to bonds.  That is, if you are 60 years old, you should have approximately 100 - 60 = 40% of your portfolio in stocks and the rest in bonds or cash equivalents.  That was all well and good 50 years ago, but in this day and age, most professional financial advisers would argue 40% is a bit light for a 60 year old, who may have a good 20-30 years left to live.  Unless you have huge quantities of money socked away, a 40% stock allocation just isn’t going to churn out the returns you need to be reasonably certain you won’t run out of money.

The New Rule Of Thumb

In response to lengthening life expectancies, the old rule-of-thumb was modified to be 120 minus your age in stocks.  Under this rule, that same 60 year old would now have 60% of his portfolio invested in stocks and an 80 year old a full 40% in stocks.  Some might complain that’s too aggressive an allocation for an 80 year old, especially in light of the recent market turmoil.  But let’s take a look at a real-life mutual fund with approximately the same asset allocation as our hypothetical 80 year old and see how it would have turned out.  The Vanguard Target Retirement 2005 Fund (VTENX)  invests approximately 40% of its portfolio in stocks, 35% in bonds, and 5% in cash equivalents.

The Vanguard fund performed admirably in 2008, losing only 15.8% of its value.  Think that’s a big deal for an 80 year old?  Maybe, but the fund actually posted a gain of 8.1% in 2007 and is up 4% year-to-date 2009 (as of 5-31-2009).  Overall, the fund has posted an average annual compound return of 1.12% per year over the past 3 years.  I don’t know about you, but I consider a 1% average gain in one of the worst markets since the great depression a resounding success.  It may not have kept up with inflation, but it wouldn’t have resulted in massive losses like many would assume either.  All in all, an 80 year old would have been just slightly worse off having been 40% invested in stocks in over the last few years than avoiding stocks altogether.  Keep in mine, however, that in 80% of the 3 year periods out there, this same 80 year old would have come out far ahead in stocks than in bonds or cash.  Overall, it’s a risk well worth taking that has continually paid off in the past and is likely to continue doing so in the future.