Recently Anitha and I were talking about whether someone we knew was “good with money” and we disagreed. We were momentarily confused until we realized our definitions of that phrase were different.

When I said “good with money,” I meant behaviorally. For example, we know a couple who are a perfect example of the point I’m trying to make. For several years when they were young, the wife stayed home with their first child while the husband worked a blue-collar job that was seasonal. Since he was going to be laid off for four months every year, they saved half his pay during the months when he was working steadily. (If you are doing the math and thinking that doesn’t work out – to levelize spending they should save a third of the income – you are correct, but that is what they did.) Then, during the four months of no income (aside from odd jobs), they still never touched the savings. In other words, they had enough left over from the “spending” half to make it through the four months of little or no income without touching the half they had put away for that purpose!

Conversely, when Anitha used the phrase, “good with money,” she meant technically. In other words, does someone have the knowledge to invest the funds wisely in a well-diversified, low-cost portfolio, take advantage of tax-advantaged retirement vehicles such as IRAs and 401(k) plans, etc. And the folks in the example above left their savings in a bank savings account for decades – imagine if it had been invested! They were not “good with money” in a technical sense.

But of course those folks are doing just fine in retirement because of their frugal lifestyle.

Conversely, if someone possessed all the technical knowledge to optimize their financial planning, but they stayed perpetually in debt and never saved, their retirement would probably be a disaster.

So, there are two versions of “good with money”:

1. Behavioral – which is mostly the ability to delay gratification (i.e. have income exceed outgo by a reasonable amount).
2. Technical – efficient portfolio construction, optimal tax strategies, etc.

In other words, simply increasing savings is clearly a more effective road to financial success than conducting an in-depth analysis of the investment choices offered in a 401(k) plan while not contributing.  Far too many people focus on improving their finances by the second definition without realizing the first is usually much more important to their financial future.

It sounds trite, but not spending is a prerequisite to wise investing.

My latest quarterly ramblings to my Financial Professionals list are out: Financial Professionals Summer 2019

ESG investing (avoiding investments with “bad” Environmental, Social, or Governance aspects) is becoming more popular but has been around a long time. The approach was previously known as SRI (Socially Responsible Investing) or colloquially as avoiding “sin stocks”.

A quick note on terminology first. If I talk about a “good” or “bad” investment, it isn’t clear whether I mean in the moral sense or in the risk-adjusted-return sense, so I am going to use good/bad to refer to the expected risk-adjusted returns and virtuous/evil to refer to moral qualities. I’m also going to avoid scare quotes even though in many (perhaps most) cases reasonable people could disagree about the virtuousness or evilness of an investment. Of course, when I say “evil investor” I merely mean one that invests in companies that fail the ESG screen – not that they are literally evil people. With that out of the way …

There are a few issues with ESG investing, some of which may not be obvious:

1. There is no universally, or even widely, accepted definition of an evil company. One person’s “arms dealer” is another person’s “defense contractor.” So, it isn’t clear which investments should be avoided. Google’s motto was “don’t be evil” yet they are frequently considered evil by at least some people.

2. ESG investments are screened, not weighted. In other words, if it is evil it gets zero investment. If it is “not-evil” (which is different from virtuous) it gets full investment. So, rationally, companies should be a little evil – little enough not to be screened out, but as much as is consistent with high returns otherwise.

3. Evil investors will get higher returns. As virtuous investors avoid evil investments the price declines, which is simply another way of saying the expected return rises.

4. There is a temptation to think that by investing in virtuous companies the returns will be higher – virtuous investors can have their cake and eat it too. It is easy to imagine that evil companies will have higher costs or lower sales (or both) because of their practices. But if that is true, they are not just evil, they are stupid. An evil businessman might not particularly care about the environment or women’s rights, but he is unlikely to actually reduce earnings to try to harm either! Thus, the argument that virtuous stocks are good investments, can ignore the ESG part. Unless, somehow, you believe the market is not pricing the expected returns of evil investments correctly. This seems unlikely.  My guess is that management errs more frequently the other direction – a CEO would actually give up some shareholder return to be seen as virtuous and this is actually an agency cost problem, not a benefit.

If you want to make the world a better place, it is far more efficient and effective to do it through direct contributions of time or money to charities and causes you support than to try to indirectly help through your investment portfolio.

I have been thinking for a while about how much umbrella liability coverage someone should have.  The rule of thumb that people should carry an amount equal to their net worth seemed wrong a few ways:

• Warren Buffett needs a $85 billion dollar policy?
• Assume a $2mm claim where the insureds used the rule of thumb:
  • The person with $1mm net worth is wiped out
  • The person with $2mm net worth is fine

I think I have solved the problem though.  To simplify the analysis, assume for the moment that:

• The insurance is priced at the pure cost of insurance.  In other words, the magnitude of the claims times the probability of the claims.  Thus, there is no profit margin, expenses, etc. for the insurance company.
• The insured is essentially risk neutral.  In other words, we don’t care about being insured, and given the previous assumption we are indifferent to carrying the insurance.  (Because on average we lose the same amount either way – through claims or through premiums.)

Because the odds of a claim go down with the size of the claim the initial amount (the first $1mm say) will cost more than additional amounts (the second $1mm should be cheaper, the third $1mm cheaper still, etc.).

Since the insurance is accurately priced, it might seem that there is no way to determine how much to buy.  The first $1 million is fairly priced, but so is the second, etc. and we are indifferent.  BUT we don’t actually get that amount of coverage.  Imagine I have a net worth of $1mm and I buy a $1mm policy.  I have paid (in my idealized example) exactly the right amount for it.  But suppose I have a net worth of $50k and I buy a $1mm policy.  It costs the same amount (it’s still a $1mm policy after all), but it is only “saving” me $50k – I can’t lose more than my net worth!  So in this case I am paying 20x the amount I should for coverage.  (I know I am ignoring wage garnishment, but I am keeping this simple for the moment – I’ll make this more complete below.) So I should buy the amount that matches my net worth so as to match the cost to the value to me.

Of course my example above is too simplistic, so here are the other considerations:

1. Reasons to buy less than net worth:
   1. Insurance companies charge more than the expected losses (of course) to cover their overhead, direct expenses, and to profit.
   2. There is likely an adverse selection problem where if you are buying out of an abundance of prudence, you are likely in a risk pool that includes at least some people who know they are prone to problems.  I.e. the premium covers the average person and you are likely less risky than average if buying this as part of a well-thought-out and prudent financial plan rather than because you know you sometimes drive while impaired.
   3. Much of your net worth may not be attachable by creditors (which is what the folks suing become if they win).  “Net worth” should be reduced by retirement plans, insurance and annuity cash values, spendthrift trusts, etc. In short, anything that isn’t available to satisfy a judgment.
   4. Competition (and lack thereof) probably makes small amounts correctly priced, but larger amounts less so.  In other words, there are so many companies that will write a $1mm policy the prices are probably not too much above the expected claims.  A $20mm policy is probably priced well above the expected claims.  (I have no data on this, I am merely speculating – but I am pretty sure I am right.)

2. Reasons to buy more than net worth:
   1. Since we are in fact risk averse, having extra (to avoid our $1mm net worth being wiped out by a $2mm claim) can make sense.  Since wealth has decreasing marginal utility, the small amount we pay for premiums costs much less in utility (happiness) than then large possible losses in utility – even adjusted for the differing probabilities (100% chance of paying a small premium vs. much less chance of a large claim).
   2. To the extent your wages can be garnished (even after going through bankruptcy) the PV of future wages (i.e. human capital) should be insured too.

So, here’s how to determine the appropriate amount of coverage:

1. Compute your net worth.
2. Add the PV of your future wages to account for 2b above.
3. Subtract any protected amounts (retirement plans, PV of protected portion of wages, home equity that has homestead exemption, etc. – see here for a comprehensive list) to account for 1c above.
4. Round up by $1mm (or more depending on risk aversion) to account for realistic risk aversion.  In other words, I think 2a trumps 1a, 1b, and 1d for most folks.

My latest quarterly ramblings to my Financial Professionals list are out: Financial Professionals Spring 2019