This life is what you make it. No matter what, you’re going to mess up sometimes — it’s a universal truth. But the good part is you get to decide how you’re going to mess it up.
— Marilyn Monroe

I spent much of my childhood in Los Angeles. I’m convinced that people in Los Angeles are more image obsessed than any other city in the world. This leads to a number of odd phenomena.

While the aspirational in the rest of the country are often house poor, for example, many in Los Angeles are what I’ll call “car poor” — guys making $30,000 per year driving a Porsche while living in a microscopic concrete box with one window and no furniture.

A Porsche doesn’t do you much good in L.A. — after all, you can rarely break 30 MPH, what with the traffic and all. But we all know it’s not really about going fast. These guys aren’t even all that into cars, per se. They just want to look cool.

In short, in their heart of hearts, they don’t really want a Porsche. What they want is to be the guy who has a Porsche. That guy is cool. He gets invited to the hottest parties in town. He gets laid. And the car-poor guy wants you to think he’s that guy, even though he is in fact the guy who can barely afford a Kia.

We can laugh at the folly of the car-poor guy, but are the house-poor in the rest of the country all that different? We already know they don’t need a McMansion, but do they even want one? Or do they just want to be the family that has one? I wonder.

The same sort of thinking can land you in the wrong career, if you’re not careful. If you recall, I went to law school. It didn’t work out so well. When I look back on my decision to go in the first place, I wonder — Did I want to practice law? Or did I just want to be a lawyer? I honestly don’t know the answer, now — but I have my suspicions.

Life isn’t about what you “are,” or what you have. It’s about what you do. If you devote your life to being something, or owning something (or many somethings), chances are you’ll wind up disappointed.

Epilogue: The Challenge Comes to an End

I’ve dreamed all my life of being a writer, but did I actually want to write? Or did I just want to be a writer? To have written?

I embarked on this 30-day posting commitment in part to help answer that question once and for all. It’s been a challenge. I’ve written on nights when I was exhausted and really wanted to be doing something else. On a number of nights I struggled to decide what to write about. The quality of the posts was mixed, in my estimation, but I expected that going in.

The challenge ends today. And while I’m looking forward to a break, I think I have an answer to my question: I want to write.

Thanks to all of you who take time out of your days to read my ramblings.

“Confessions of an Index Investing Skeptic” will continue next week.

When I was young I thought that money was the most important thing in life; now that I am old I know that it is.
— Oscar Wilde

The first Baby Boomer turned 65 in 2011. This generation has a number of qualities that make this an event that is likely to change the market landscape dramatically.

A few items to note:

• Boomers are on pace to live much longer than their predecessors.
• They have presided over the relentless decline of defined-benefit pensions in favor of defined-contribution plans like 401(k)’s.
• They thus have much more of their assets in the stock market than previous generations.
• They also are the first generation to enter retirement with so much debt, and many are on shaky ground, financially.

In short, Boomers find themselves faced with a much longer retirement, and many won’t have the resources to fund it. No matter which way you slice it, this is worrisome news for younger workers. Boomers faced with outliving their savings will either have to work past the traditional retirement age, which will increase the supply of labor, driving unemployment up and wages down, or they’ll have to rely on public assistance.

Let’s set the gloom-and-doom scenarios aside for the moment, however, and focus on just one aspect — namely the shift to defined-contribution plans, and the resulting greater concentration of wealth in the stock market, which is unprecedented in history.

When a sizable chunk of a person’s net worth is tied up in the stock market, and that person retires and begins living off their nest egg, what happens? Unless they can live off dividends alone, the answer of course is they begin selling.

The retiree may be invested in index funds, actively managed mutual funds, or even individual stocks. It hardly matters. In all cases, they will gradually liquidate their holdings, not because a stock’s price had been bid up too high, or a product flopped, or a key member of management retired, or any other factor that might bear some relevance to the company’s value. No, the retiree will sell because they need to buy groceries. Yet those sales will move the prices of those assets every bit as much as the sales of a person who acted based on fundamental analysis.

Some worry-warts have suggested that this will lead to a massive stock market crash. I don’t think that’s likely, personally.¹ However, at the risk of beating a dead horse, it does add still more to the massive wave of trades that are based on absolutely no information about the intrinsic value of the assets whatsoever.

It’s Not Just About the Boomers

From 1980 through 2008, the percentage of private sector workers with defined-benefit pension plans declined from 38% to 20%. This trend toward 401(k) plans serving as the primary basis of people’s retirement shows no signs of abating. If anything, it’s accelerating. If it continues apace, by the time Generation X’ers like me retire, it will be near ubiquitous in the private sector, and the public sector is beginning to move in that direction as well.

The debate is fierce as to whether defined benefit pensions or defined contribution plans are superior. I offer no opinion one way or the other — I see good points and bad points with both. The trend away from traditional pensions is clear, however, and the inevitable result is ever more trades that are not driven by judgments of valuation, distorting asset prices still further.

Welcome to the new normal.

Price is what you pay. Value is what you get.
— Warren Buffett

You can stand on the shoulders of giants, or a big enough pile of dwarves. Works either way.
— Anonymous

Devotees of index investing also tend to be strong proponents of the Efficient Market Hypothesis. There are a number of variants of the theory, but the basic idea behind it is this: the market effectively prices in all information that is realistically knowable to a non-insider. Thus the market price is always the “right” price, and it is “impossible” to consistently beat the market. Anyone who does so, adherents claim, is just lucky.

As you might imagine, I have some serious doubts about this theory, to put it mildly. But let’s set that aside for the time being, and assume that, at least until 1992 or so, it was more or less accurate.

The key thing to understand about the Efficient Market Hypothesis is that its entire foundation rests on the notion of a broad array of actors discovering all information that is knowable and relevant to the intrinsic value of an asset, then acting in aggregate on that information to provide a highly accurate real-time price. (Remember the Parable of the Ox?)

In short, it depends heavily on the idea that most people trading the assets in question are doing so based on some conception of what they are really worth. I’m prepared to believe that this held at least some measure truth for much of the stock market’s history.

What it fails to account for is the potential effect of a large and ever growing array of actors taking actions that significantly affect asset prices for reasons that have absolutely no relationship to their actual value whatsoever. If you recall from Part I, that’s precisely what index investors do. (They’re not the only ones, either. More on that to come.)

When Everyone Wants to Piggyback, No One Gets To

The very same Efficient Market Theory whose adherents claim makes active investors gamblers and fools, requires active investors to work. It’s hard to piggyback on crowdsourced pricing when no one in the crowd is actually making an effort to assess the proper prices.

We’re not quite at that point just yet, of course, but the greater the percentage of market participants who move asset prices based on anything other than what they believe the assets to be worth, the greater the risk that they’ll overwhelm the information-based investors, leaving prices to be ever more divorced from reality.

What would you expect to see in such an environment? What would drive asset prices if not some notion of their underlying value?

It’s hard to know for sure, but I’ll offer a theory: Perhaps macro conditions — perceptions about the state of the economy as a whole — would begin to take a larger role. Seems logical, right? After all, sufficient pessimism about the economy could move even the most ardent devotee of passive investing to at least shift some assets from a stock index to a bond index.

So hypothetically, if macro conditions began to dominate over individual valuations in determining price movements, what would you expect to see?

Oh, that’s right. Greater market correlations.

This is just the theory of one non-professional, non-academic, non-expert, of course, so take it for what it’s worth. But it would explain a lot, wouldn’t it?

Nobody goes there anymore. It’s too crowded.
— Yogi Berra

I first heard of index funds in the 90s, although they had been around since 1975. Their popularity grew relatively slowly at first, but has skyrocketed in the last 20 years or so.

A number of factors have contributed to this growth, but one of the biggest has been the steady trend away from defined-benefit pensions to defined-contribution retirement plans like 401(k)’s. These plans typically offer limited choices, most often comprising a defined set of mutual funds to choose from. As word got out that few managed funds could consistently outperform the indexes (a point I certainly do not dispute), it’s no surprise that more and more Americans have elected to invest their retirement savings in them.

Millions upon millions of people now steadily pour money into index funds every month. While it’s great that so many people have figured out that it’s a good idea to avoid the high fees and spotty performance of actively managed mutual funds, this also presents a problem.

The Crowd Ruins Everything

The trouble with great investment ideas is that they almost always contain the seeds of their own destruction. In anything resembling an efficient market, as soon as word gets out about any edge that can be gained, hordes of people pour in and shift prices until the edge disappears.

I hate to say it, but I’ve come to suspect that index investing is no exception. To see why, have a look at the following chart: ¹

This chart shows correlation levels among the stocks that make up the S&P 500 index since 1993. Correlation essentially measures the extent to which stocks move together as opposed to independently.

During period the chart covers, the percentage of all U.S. equity assets being passively managed grew from roughly 10% to about 30%. As you can see, during the same period, correlations have trended steadily upward, hitting all-time highs over the past couple of years.

This is hardly surprising, when you think about it. Almost a third of all equities in the market are now bought and sold in massive quantities, all together, based on absolutely no analysis whatsoever of their individual worth. That is, after all, what index investing is. And when all stocks in an index are bought and sold together, the natural result is that their prices will tend to move together.²

Not Your Father’s Diversification

One of the biggest selling points of index funds is the great diversification they provide. Diversification helps mitigate risks, lowers volatility, and smooths out returns, at least in theory. Unfortunately, that all starts breaking down when correlations rise. The more stocks move together, the less protection from volatility buying them all at once provides.

Does that mean diversification no longer has any benefit? Of course not. But the same level of diversification offers much less protection now than it used to. In my mind, that raises a question: What would happen if everyone invested exclusively in index funds?

Well? What do you think? What would happen?

I will leave you with a story to reflect on. It’s called the Parable of the Ox. Read it, and see what ideas it gives you.

See you next time.

Uncertainty is the only certainty there is, and knowing how to live with insecurity is the only security.
— John Allen Paulos.

Today I’m kicking off a new series on index investing. I’m going to run the risk of offending the hive-mind with this series, so let me preface it with a couple of reminders: I am not a financial professional. I do not have a degree in economics. I offer only the opinions of a guy who spends a lot of time thinking about these sorts of things. There are many extremely smart people with extremely impressive degrees who disagree with me, and I highly recommend reading what they have to say.

Now that that’s settled, I’ll just come right out and say it — I have grave doubts about the future of conventional index investing. My reasons for this are many, and each could sustain a lengthy discussion and debate. The following series of posts will discuss a few of them in broad strokes.

The Siren’s Call

Index funds have been touted for some years now as a sort of panacea. It’s hard to argue with their appeal. Wouldn’t it be great if your entire investment education could begin and end with buying equal proportions of 2 or 3 index funds, and rebalancing occasionally? Perhaps with a few tax issues thrown into the mix? I’d really like for that to be true. I just don’t think it is.

Don’t get me wrong, by the way. I’m not suggesting that the champions of index investing¹ make that claim — not exactly, at least. Many of their adherents seem to, though. ²

The trouble is that many of the features that made index funds so good in the past, such as safety in diversification, piggybacking on efficient market pricing, and good historical performance, might not hold in the future. In fact, some appear to be breaking down already.

Here’s a quick sneak peak of some of the topics I’ll be getting into:

• Rising correlations — diversification ain’t what it used to be.
• The efficient market theory — it requires active investors to work.
• Boomers retiring — the Great Grey Menace.
• Economic growth — the exponential function revisited.
• The fate of superpowers — this time it’s (not) different.

I’d like nothing more than to be proven 100% dead wrong on each of these points, by the way. I’ll be looking forward to the conversation.

In the meantime, why not subscribe to my rss feed to make sure you don’t miss the future installments?

Being broke is a temporary situation. Being poor is a state of mind.
— Mike Todd

Another entry in our financial Hall of Horrors — Check Cashing! One of the sure hallmarks of a scary neighborhood — along with bars on residential windows, the constant sound of sirens, and bulletproof windows at gas station booths — are big, brightly colored signs, saying “Checks Cashed! No ID Required!”

Check Cashing storefronts proliferate like rats in blighted neighborhoods in order to feed off the poor. It’s hard to imagine a more cynical, exploitative business.

A Story From my Misspent Youth

Let me tell you a little story about the one and only time I ever walked into one. I was 19, blessed with a 19-year-old’s naïveté, and had my dad’s Christmas present in my pocket — a check for a couple hundred bucks. In other words, I was rich!

I was home from college, visiting family. It was the weekend, and the banks were closed. These were the days before universal ATM access (God, am I that old?), and my bank had no location in town. I was dying to get my hands on the cash for some reason that seemed extremely important at the time, but which I can’t for the life of me remember, now. I’d also, foolishly, allowed my ID to expire. What a pickle!

Then I remembered — the neighborhood Check Cashing place would cash that check, with no ID. Plus, they were open 24/7! Problem solved!

I walked in the door, but before I handed over my precious Christmas check, I had a moment of sanity. I asked the friendly person manning the counter (behind bulletproof glass, of course), “Hey, what’s you guys’ commission, anyway?”

The friendly look on her face changed to befuddlement. “Our what?” she asked. I got the impression that she had never actually been asked that question before. At least not in that way.

“Your commission. You know, what are you going to charge me.”

“Oh, I see,” she said. “We charged fifteen dollars per hundred dollars in the check.”

I blinked. “Wait, what? You charge Fifteen percent?”

“Fifteen per hundred,” she said.

“Which means fifteen percent,” I said.

“If you say so,” she said, and smiled tightly.

I left, wondering in my glorious 19-year-old’s naïveté how such a place could stay in business. How could anyone be so stupid as to pay 15% to get a check cashed? Let alone enough people to allow this place to stay open? 24/7, even?

I then went on and did whatever 19-year-olds do (I’ve long since forgotten), and managed to get through the weekend without cashing the check.

Older and Wiser

My older, wiser, grumpier self has some answers for 19-year-old Sean’s naive questions. First, 15% is pretty typical for these places (yes and no, see update below). As you might have guessed, fraud is pretty common at no-ID check cashing establishments. Guess who picks up the bill for that?

Second, at 19, not cashing my check meant a few less treats during a weekend home from college. To a member of the working poor, however, not cashing a check may mean no groceries for their family. That person may not have a bank account where they can deposit the check come Monday, because no bank will give them one. They may be an illegal immigrant, and thus have no ID they can use to cash their check at a more traditional location.

There are a hundred different reasons why a person who is down on their luck may wind up thinking (usually incorrectly) that they have no other choice. There must be, after all — because there sure are a lot of those places around. Exploiting the poor is a lucrative trade.

And don’t make the mistake of thinking these are mom-and-pop businesses, either. Nowadays, many check cashing storefronts are owned by the very same banks that find reasons to refuse to give the working poor traditional accounts in the first place.

Alternatives

I doubt any readers of this blog will ever find themselves in a position where they absolutely must have a check cashed quickly, and can’t get to a bank or ATM. If it does happen, though, I’m sure it will come as no surprise to you that I recommend other options:

• Walmart is open 24/7, and will cash payroll and some government checks for up to $1000 for a flat fee of $3, and for up to $7500 for $6.
• Safeway will often cash non-person checks. Their commission is a little over 1%.
• The issuing bank, i.e. the bank the check writer used, will usually cash it for you for free if you show up during business hours. This works for personal as well as payroll checks.

All three of these options require an ID and possibly a social security number. If you’re stuck without those, as well (we’re getting more and more far-fetched here, but what the heck), some prepaid card providers allow for direct deposit to your prepaid balance — it can serve as a last-ditch alterative to a real bank account.

Whatever you do, though, don’t let yourself fall prey to a Check Cashing storefront — even if you have to go without treats for a whole entire weekend to avoid it.

I know, things are tough all over.

Update

As James pointed out in a comment below, a number of states now regulate check cashing fees to some extent. According to this site, 24 states now have at least some level of restriction on check cashing fees.

Of the states that regulate, more than half still allow fees of 10% or more on personal checks, but the fee limits tend to be more restrictive on government and payroll checks (which makes sense).

The remaining states still have no limits at all on what fees can be charged, though, so it’s a good idea to find out what the rules are in your particular state.

James is correct that I really should have thought to look this up before posting the original article.

The greatest enemy of a good plan is the dream of a perfect plan.
— Prussian General Carl von Clausewitz

Today I am pleased to present our very first guest post! Hailing from the Land Down Under, the Mortgage Mutilator writes an entertaining and informative blog focused on paying down mortgage debt as quickly as possible. He kindly offered to give me a one-day reprieve from my 30-day posting challenge. I decided this was within the rules, because hey — they’re my rules, I make ‘em up. ¹ So, take it away, Mutilator!

A colleague of mine told me an interesting story not too long ago. You see, he rides his bike to work most days (a decent 25-mile ride each way at that). However, he rides a relatively old $500 hybrid bike.

He described many of his “biking mates” that are continuously obsessed about the weight of their bikes. “Oh my bike is pure carbon with weave damping and only weighs 1/10th of an ounce!” ² Or, “I just ordered these new replacement carbon components and now my bike weighs 20 ounces lighter!”

Through all their boasting and conversations, though, he never cared, because he knew whilst they were always fiddling with their bikes, he’d actually be riding his.

They were obsessed with getting their tools just right, getting them correctly tuned and weighing as little as possible. With having the right brand lights, riding pants, drink bottles and fancy helmets. So obsessed with perfection that they barely had time for riding at all. They may have considered themselves “professional riders,” but he rode hundreds of miles more than they did every single week.

Although planning and fine tuning what you do is always important, it’s all irrelevant if you never put any of it into action. The same can be said for your Investment Portfolio.

Modern Portfolio Theory

The idea behind Modern portfolio theory is working to maximize your expected return given a certain amount of risk. Usually you hear the old adage of “the higher the return, the higher the risk“, however the efficient frontier is a relatively new concept that flies in the face of all that. It proves, through some fancy maths that won Dr. Harry Markowitz the Nobel Prize in 1990, that you can actually increase your return, and at the same time, decrease your volatility (or risk).

This fantastic result is achieved through holding a number of different asset classes instead of just investing everything in one class. For example, rather than investing everything you have in the U.S. Stocks asset class, you might hold 34% in U.S. Stocks, 33% International Stocks, and 33% in government bonds. This is called the 3-Fund Lazy Portfolio, and is quite easy to set up and maintain over time.

As you add more and more asset classes you can, as a general rule, continue to increase your risk-adjusted return. However, the catch comes with the fact that the more asset classes you add, the more costs you tend to incur. This obviously drags down the performance of your investments, and as such, there’s a balancing point between the two factors. You want as much return with as little risk (more asset classes), whilst still limiting your costs (fewer asset classes). This subject is also referred to as “Asset Allocation”.

You’ll Never Get Perfection

There are many different and more complex portfolios you can choose from, but there’s one thing personal finance experts will rarely say — None of them will ever be “perfect”. You see, even if you do study the theory, talk to advisors and experts, and choose the best option you believe you can — which many people spend all their time doing (just like those “professional bikers” did with their bikes) — it’s quite certain that you’ll still be outclassed by another type of portfolio. Maybe the US Stocks asset class really soars this year. If it does, that overly simple 100% in US Stocks portfolio design would have been the best! Unfortunately, predicting this ahead of time is impossible.

It gets even worse when you constantly research and analyse the different configurations and possibilities of what your portfolio will be. This is normally based off the latest nice sounding argument about where the market is going. If you go down this path, you might not ever startinvesting at all! Your money could sit there in a low interest savings account, being eaten away by inflation year after year, all because you can’t make a decision. You’ll just keep spending more and more time trying to get that perfect mix, getting it just right before you start. And therein lies the problem; as humans we always want to be better than the other guy, and having our investments make more money is no exception. So we end up sitting there forever trying to “figure it out” or “fix it up just a little more“.

In the beginning you do have to research, plan and investigate this part of investing properly because it is important. Read a few books on the subject and do some more research, but be careful that you don’t spiral into just constantly reading what the hottest new tip is or where the market will go this year, and never take any actual action. It’s much easier to read more about the subject than to actually do something, because if you do and fail you might feel horrible. If your assumptions or plans turn out to be incorrect, then you might be embarrassed, and worse yet, lose some of your money.

Other reasons for avoiding action include the fact that it’s just simpler to read about someone else doing it as opposed to doing it yourself. The only way to get out of this type of funk is to grit your teeth and take action. So how can you get that perfect portfolio ready to actually take the first step and invest?

Accepting The Inevitable

Instead of searching for the perfect portfolio, the one that will always perform the best, I subscribe to the method that you should take a more calm or “chillaxed” approach to the subject matter.

As part of being human we compete with each other all the time. It comes from an evolutionary trait of survival of the fittest. It’s human nature to always want our investments to outperform others, to “beat the market,” as we’re so obsessed with saying. People spend millions every year researching and coming up with increasingly complex plans to create a foolproof portfolio. It can’t be done. Make sure you never let this obsession, this drive, get in the way of actually investing your money.

Sit down, do some research and analyse your position as well as what you want to achieve. After you’ve done some of this, choose a “good enough” portfolio. The next step is a little more challenging for some, but you just have to realise and accept that this choice you’ve made will not be perfect most of the time. Implement the portfolio plan anyway, and enjoy your life as your investments grow. Nobody’s perfect, and as long as you can develop and learn to live a rich life, does it really matter if your performance isn’t the absolute best?

Not for me it doesn’t.

The Mortgage Mutilator is a Telecommunications Engineer, Photonic Scientist, published author, computer/mobile geek, and extreme financial efficiency expert that has honed his skills towards destroying his large mortgage debt. He is an experienced volleyball player and writes weekly at Mutilate The Mortgage, hoping to share his knowledge and help others to pay off their mortgages, usually in under 7 years.

He that is of the opinion money will do everything may well be suspected of doing everything for money.
— Benjamin Franklin

A dollar is a dollar, right? Setting aside rare collectibles, of course, and assuming they’re both in spendable condition, a particular dollar is worth as much as any other, right? Surely that must be true. Our entire monetary system is based on it. It’s what money is for, really — to provide a uniform medium of exchange.

Except it isn’t true. I’ll prove it to you.

The Value of $1 Million

Let’s say you woke up in the morning, checked your bank account balance, and found an extra million dollars had been added. Tax free, legal, nothing shady going on, no strings attached. How valuable would that be for you? How would that make you feel? What effect would it have on your life? What would you be willing to do to make that happen?

The median individual American would have to work for forty years just to earn that much money, and that’s before deducting a single cent of living expenses. Imagine it — the fruits of an entire working career, in an instant. How would you react?

Now imagine how Warren Buffett would react if the same thing happened to him. I can’t say for sure, but I imagine he would say something along the lines of, “Oh, is it Thursday already? This week has flown by.”

The truth is that the value of a dollar in terms of overall human welfare changes enormously based on whose hands it lands in, and depends a great deal on how much money the person already has. If you’re broke, in debt, and being hounded by hyper-agressive collection agencies, $1 million dollars would change your life. If you’re a billionaire, however, it’s a rounding error. You probably gain and lose millions of dollars before lunch every day from market fluctuations.

In other words, for my fellow nerds,¹ money has roughly logarithmic value:

Those first few dollars you save after getting out of debt feel really, really good. But once you have a good cushion built up, your monthly contribution doesn’t bring in quite as much joy as it once did. Importantly, blowing it on something frivolous doesn’t hurt as much as it once did, either.

A Double-Edged Sword

This effect can be insidious if you’re not careful. It can lead to you sabotaging your progress just when you’re starting to build some real momentum. That tempting new toy you’ve been eyeing for a while might start to look like it will bring more satisfaction than a few hundred more dollars in your already respectable brokerage account. Beware!

It can also set you free, however — once you discover that the graph is pretty flat once you hit financial independence. At that point, growing richer isn’t likely to make you all that much happier. Realizing this can help you give yourself permission to let go of the grind.

A Story to Reflect On

Legend has it that Kurt Vonnegut and his friend Joseph Heller once attended a party at the house of a billionaire hedge fund manager. Vonnegut noted that their host had made more money in one day than Heller ever made from his most famous novel, Catch-22. ²

Heller responded, “Yes, but I have something he will never have: enough.”

I have always considered that choosing a companion for life was a very important affair and that my happiness or misery in this life depended on the choice.
— Ezra Cornell

Just so there’s no confusion about my prior post on 401(k) loans, let me be clear: while Suze Orman and her ilk are dead wrong to say that they are always a bad idea, that doesn’t change he fact that they are usually a bad idea, in the same way that credit cards are — most people tend to use them poorly, and can get themselves into trouble by doing so. So don’t go thinking I was recommending you go willy nilly with them.

Now that that’s settled, let me share an example of putting a 401(k) loan to good use. A while back, a friend of mine was fretting about not being able to save as much as she’d like, in part because of having to make student loan payments every month. I looked over her finances, and discovered a few things:

• She had over three times as much money in her 401(k) as her student loan balance.
• The loans were at 6% interest.
• Her savings rate was already substantial.
• She had a solid emergency fund, but she didn’t want to raid it to pay the loans down.
• Her job situation was stable — she had been at the company for over 13 years.
• She lived in a rented apartment, and had no other debts.

This situation practically begs for a 401(k) loan. She was able to borrow enough to pay off her loans completely at 4.25%. Not only was her interest rate reduced, she was now paying it to herself instead of the bank.

To understand how this pans out, it helps to look at the 401(k) and her post tax finances as separate entities.

From the perspective of her 401(k), since she borrowed about 30% of her balance, we moved the remainder into a stock index etf, for a roughly 70/30 stocks-to-fixed-income ratio — a perfectly reasonable allocation for almost any age group. As a bonus, the fixed income portion (i.e. her loan) was now earning much more than the bond etf options she had available. In short, her 401(k) was actually in better shape than before.

From the perspective of her after-tax accounts, she was now paying a lower interest rate. Her new payments were slightly higher, since the 401(k) loan had only a 5-year term (as is typical), but as I mentioned earlier, her savings rate was high, and she could easily handle the temporary reduction in cashflow. All in all, she’d pay off the balance faster, and pay much less interest, so the post-tax side of her finances was better off as well.

As you can see, this move was a winner all around. In fact, she was so impressed with how well my plan worked out, she married me! ¹

Some things to note:

• Sure, the interest (but not the principal!) she was paying herself was post-tax, and will be taxed a second time — in 30 years. Compare that to higher interest payments made to the bank — a “tax” rate of 100%.
• Like most profitable financial moves, this entailed some risk. She could have lost her job, for example, or some other misfortune could have arisen that kept her from being able to make the payments, resulting in a nasty tax liability. She also could have been hit by a stray meteorite or run over by a bus. There are always risks in life — the best you can do is manage them sensibly.
• This worked for her because she had a responsible relationship with money, a stable employment situation, extra cashflow to cover increased payments, a solid emergency fund, no other debts, and no proclivity to take on new ones. (Yep, I married well.) If you can’t say the same, better think twice before trying this.

Score — Blind allegiance to “Experts”: 0. Thinking for yourself: 1.