How should you invest your 401k?

Last time I wrote about my dislike of mutual funds as investment vehicles. The problem is that mutual funds are usually the only investment in 401k plans. So should you just avoid investing in a 401k then?

No. The tax benefits of using a 401k are way too good to pass up. The maximum 401k contribution for 2008 is $15,500. If you saved that $15,500 in a savings account instead, and you were in the 25% tax bracket, you’d pay $3875 in taxes, leaving you with just $11,625 in savings. So by depositing that $15,500 into a 401k, thus getting to keep it all, you get an instant, risk-free gain of 33% over what you would have had. If your tax bracket is higher, your risk-free gain is even higher.

That tax gain is over and above any matching your employer gives you, which would just be icing on the cake.

So now the money is in the 401k, but I’ve still said mutual funds are bad, and since that’s the only investment option, what should you do?

An ignored investment option

Mutual funds aren’t exactly the only investment. There’s another one that most financial advisors will frown at and call a “bad idea”. But just like electricity, kitchen knives, and options investing, dangerous tools can still be used safely and profitably if you use them right.

The investment I’m referring to is 401k loans. Most 401k plans allow you to take a loan against your balance. In many cases they allow you to borrow up to 50% of your balance.

You pay interest on the loan at a rate set according to the current interest rates, and you make payments on the loan generally straight out of your paycheck.

Benefits

The foremost benefit is that you can now invest the money that you borrowed in whatever you want.

The second is that you are now paying your 401k interest, so you’re depositing more money than you would have otherwise been able to and that money can grow tax-deferred. Also, you’re usually getting a pretty good interest rate. And because you know the borrower better than anyone, there’s a good deal less risk involved in making the loan (as opposed to loaning money to a company through a bond).

The third benefit would be that if or when you leave your job, you’d be able to roll the 401k into an IRA. IRAs allow you to invest the funds pretty much any way you want (there are a few restrictions), so putting more money into a 401k now in the form of loan interest will give you more money to freely invest later.

Dangers

The one that you should be most aware of is if you leave or lose your job, you usually only have about 30 days to pay the money back to your 401k or you will owe taxes on all of the money. So that means you shouldn’t invest the money in anything where it will be tied up for a long time, or that might fall in value.

Another danger is that you might be required to pay back money faster if the value of your account drops. Remember you are only allowed to borrow 50%, so if you have $20k, and you borrow $10k, leaving the other $10k in your 401k in a mutual fund, and that mutual fund takes a nose dive dropping your account to $5k, you’ll now be borrowing 66%. But since I don’t like mutual funds anyway, that’s not really a problem. Just stick the funds that are still in the 401k into the money market fund in your account. Those funds will earn about 2-3%, which isn’t very high, but there’s no chance they’ll go down in value.

The remaining danger that comes to mind is a willpower weakness. Don’t borrow from your 401k if you are planning to spend the money or you think you might be tempted to spend it. This money is for investing only. Spending the money would be like sticking your tongue in a light socket, or juggling the kitchen knives. It’s not the safe way to use this tool.

Other

Borrowing money from your 401k only really makes sense if you are maxing out your 401k contributions and want to get more money in there to grow tax-deferred, or if you already have a large 401k balance (more than the maximum contribution), and don’t want to invest in mutual funds.

In the last article I asked the question, “If you’re going to dull both [gains and losses by diversifying], why not just avoid investing altogether and just save your way to retirement?”. I was being half serious about just saving. Sometimes just saving and not investing is a good move to make. If you don’t have enough in the 401k for it to make sense to borrow, then I would suggest just leaving all the money in the money market in the 401k. You already received a 33% gain just by making the deposit, so be happy with that and keep feeding the nest egg until it grows big enough to make borrowing make sense.

Something else to note is that the interest you pay on the 401k loan is generally paid with after tax money. This means that you might pay taxes twice on the interest you pay to your 401k. You’ll pay once when you take it out in retirement, and possibly once when you pay it in as interest.

Personally, I have taken a 401k loan and invested the money and then claimed the interest as investment interest on my taxes. I was following the spirit of the law, the interest was an investment expense, but I’m not certain that the IRS will see it the same way. So you may or may not be able claim the interest as a tax deduction. If you’re willing to gamble on paying the fines or your tax advisor says its copasetic, then give it a whirl. But just to be clear, I’m not advising you to claim it on your taxes, just pointing it out as an option.

Perfect investment for a 401k loan

Last weekend, the No Lose Stocks service started taking subscribers. That link explains the service and has the link to subscribe via PayPal.

Since a 401k loan investment needs to be something that doesn’t tie your money up for a long time and that doesn’t have a possibility of falling in value, No Lose Stocks fits the bill perfectly. The put option protects the invested money so that it can’t be worth less than the initial investment, and since the put option can be exercised at any time, it allows you to close out the position at any time and get the money back if you need to quit your job or get fired.

In case you’re interested, here’s the link to the No Lose Stocks spreadsheet for today (Friday, August 29, 2008).

Personally, I like to sort the list by “Percent To Profit” from smallest to largest. “Percent To Profit” is how much the stock has to gain to be above the strike price of the put option. After the list is sorted, I start looking down the list for stocks that are 3-6 months out in their put option expirations, and that aren’t in some kind of possible buy out situation. It seems that a stock that is about to be bought out usually has a very low “Percent To Profit” because people don’t think it will go higher than the buy out price.

If the service interests you, sign up and try it out. There’s a 6 month free-trial for all subscribers, and if you don’t like it, you can cancel from your PayPal account and don’t even have to contact me.

Advertisements

Why NOT mutual funds

The conventional wisdom is that mutual funds are the perfect investment for the small investor. The idea being that a small investor can easily buy them, have instant diversification, and have a professional managing their portfolio.

Since I advocate investing in individual stocks and not mutual funds, I figured it would be a good idea for me to lay out my grievances, so you can decide for yourself if you agree with me or not.

Easy to buy

On the first point, I would agree, mutual funds are easy to buy. But that’s not really sufficient for me to endorse them as a good. Lots of things are easy to buy, including individual stocks.

Instant diversification

On the second point, I would tentatively agree, some mutual funds do provide some diversification. But the root assumption is that diversification is good. It does cushion the blow of large losses, but it also lessens the impact of big wins.

For example, let’s say you had $10,000 to invest a year ago, and you decided to ignore diversification and put it all in Fannie Mae. At this point you would have only about $700 left (7%), and would have lost the other $9,300. That’s pretty painful. If you had diversified, and only put 2% of your portfolio ($200) in Fannie Mae, then you would only have lost $186.

On the flip side, if you had invested that 2% in Wal-Mart, which went up about 36% over the last year, you would have a profit of $72 dollars. Not too exciting. But, if you had invested the whole $10,000, then you have $3600 dollars. Way more exciting.

So diversification is really just a way to dull both the gains and the losses. If you’re going to dull both, why not just avoid investing altogether and just save your way to retirement?

Professional management

This is where my biggest objections are.

It’s all luck

An extremely high amount of the results from the markets can be attributed just to luck. I would highly suggest reading Taleb’s “Fooled By Randomness” to get a more in depth description of this, but I’ll give it a shot here.

If a manager has 5 years of good returns, it doesn’t mean he’s actually a good investor. It’s actually more likely that he just happened to be lucky. There’s so many mutual fund managers out there that many of them are likely to have long winning streaks even if they just flipped a coin to decide what stocks to buy.

Let’s say we start with 10,000 mutual fund managers who use each use a coin toss to decide their purchases. Each year there’s a 50% chance they pick a winner and a 50% chance they pick a loser. So the first year, 5,000 pick a winner, and 5,000 pick a loser. The second year, the 2,500 of those who picked a winner pick another winner, and 2,500 pick a loser. The third year, 1,250 pick winners, then the fourth year 625, and finally the fifth year 312 mutual fund managers have managed to pick winners 5 years in a row, just by chance.

That doesn’t mean that none of the managers have any talent at picking stocks, but it does mean that it’s extremely difficult to tell which ones do have talent and which ones are just on a lucky streak. And it also means that even the ones that do have talent could hit an unlucky streak and not have a good record.

So it’s almost impossible to tell who is a good manager and who is not, and given how much luck affects their performance, it may not even matter.

Conflicting incentives

Mutual funds make money by taking a small percentage of the money that they have under management. These are the fund fees. If a mutual fund does well one year, more investors will give them money because those investors think that means the mutual fund manager knows something (rather than that the mutual fund manager was just lucky).

The more money that a fund manager has to manage the harder it is for him to find good places to invest it. So if a manager only has a few really good ideas, but 10 times the amount of money that he can invest in those ideas, then the other 90% of the money is going to be invested in something less well performing.

So we’ll get the same effect that we saw above with diversification. Even if the manager can make a 50% profit on those good ideas, that’s still only a 5% benefit to each of the investors since that 50% profit is spread over 10 times the money.

So if the manager thinks he can make a 50% profit on only one tenth of the money, then why doesn’t he only take one tenth of the money and reject the other 90%?

The reason is that it doesn’t make sense for him. Since the manager gets paid a percentage of the money he manages, he can get a 900% raise by taking 10 times the money that he can invest well. So there’s no incentive for the manager to stop taking money when he has more than he can profitably manage.

No control

Another objection I have is the lack of control. You can’t control when stocks are bought or sold, and so the tax bills for those buys and sells are going to come whether you wanted them or not. The same for the transaction costs. You’re going to pay the transaction costs whether you think the buying and selling was a good idea or not.

Secrecy

It would be a bad idea for mutual funds to tell everyone what they were buying. If they told everyone they thought a stock was a good buy, then everyone would buy it in anticipation of the mutual fund buying the stock and push the price up.

But since they can’t tell everyone what stocks they are buying, you as the investor in the mutual fund don’t know what is being bought. This actually leads to at least two problems.

The first is that you could be more exposed to a particular stock than you wanted to be. Let’s say you own two mutual funds and both of them think that Google would be a good investment. If they both buy Google, and Google goes down, then you just took twice the damage you were expecting to take from exposure to Google. This is actually one of the dangers of expecting mutual funds to give you instant diversification. In some cases they can hide how not diversified you are.

The second problem is that mutual funds can try to cover their mistakes. Mutual funds do report their holdings, but not frequently. So if a mutual fund knows they have to report their holdings, they can sell any stocks they own that performed badly, and buy the ones that did well. This makes it look like they may have been holding the good stocks all along. However it also means that you the investor had to pay the transaction costs, and now you’re invested in what was the hot stock over the last year. Which means you’ve probably missed all of the upside and now you might be in for a downside slide.

This article on mutual fund window dressing goes into a little more detail.

Paying for what you already have

Since there is so much luck involved in investing, you pretty much already have an equal or better chance to do what the mutual fund manager is doing. And since you likely have a lot less money to manage, you can look for much smaller opportunities to invest in than the large funds could. And of course by investing for yourself, you avoid the fees that the mutual fund would have charged you in the first place.

Doing nothing would be better

I’ve read it quoted in many places that 9 out of 10 mutual fund managers don’t beat the benchmark they are measured against. The benchmark is usually an index fund of some kind. This means that you can beat 90% of the mutual fund managers just by buying an index fund instead of an actively managed fund. And since the index fund doesn’t need a manager, it usually has much lower fees too. Given how much luck can affect a manager’s performance, what are the chances that you could pick the 1 in 10 that is going to do better than the index fund?

My only real objection to index funds is that I don’t like riding down with the rest of the market. I don’t like exposing that much of my portfolio to downside risk because of how painful losses are and how much effort it takes to get back to zero. That’s my main reason for looking at strategies like the No Lose Strategy.

Conclusion

Managed mutual funds are about the worst investment you could make because the incentives are wrong, and there’s way too much luck involved to know what’s really going on. Index funds are definitely better than managed mutual funds, but that doesn’t make them good enough. In the end, I’d avoid funds altogether and stick with individual stocks and options, and make the effort to avoid taking losses as well.

What is a put option?

A couple of weeks ago, I wrote about a strategy for investing with no losses. Part of the strategy requires buying a put option. When it came to the part of the article where I might have explained what a put option is, I said:

“If you’re not familiar with put options, I encourage you to invest some time in understanding them. I promise that investment of time will be a no loss investment as well.”

That was mainly an attempt at keeping the article short, and an attempt at leveraging the rest of the Internet where other people have already explained put options. However, I’ve had many people tell me that options are just too complicated for them.

What that means to me is that the explanations these people have received so far are just not good enough. So I’ll see if I can do any better. (And if I don’t, let me know. If you do not understand the explanation, I’m just not explaining it well enough because options are not that difficult.)

I’m going to explain put options from the perspective of the No Loss Strategy. [1]

Purpose

Sometimes it’s easier to describe something by what its purpose is, rather than by describing it directly. If I told you something has 4 wheels, a steering wheel, and a gas tank, you might guess that I was describing a car. But if I instead told you its purpose is to cut grass, you’d be pretty sure I was talking about a lawnmower.

So the purpose of buying a put option is to protect your investment. If the price of your stock on the market goes down but you own a put option on the stock, the put option is a guarantee that there is someone that will buy that stock from you for a higher price. This means that even if the stock goes down, you don’t lose money. Keep that purpose in mind as we go through the definition.

Definition

Investopedia’s definition of a put option is:

“An option contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying security at a specified price within a specified time.”

This definition can be found in most textbooks, which doesn’t say anything about its helpfulness. I understand it now, but if I didn’t already know what a put option was, I don’t think I would. So let’s break it down and see if we can make some sense out of it.

“…option contract…”

So when you buy an option, you are making a contract with someone else. A contract is just an agreement. So you’re making an agreement with someone else.

This is not that unusual. When you buy something you are making an agreement that you will give the seller the money, and the seller will give you the thing. Another contract might be when you pay for insurance and the insurance company agrees to cover you for the next month. Or when you buy an extended warranty and the warranty company agrees to repair or replace your item for the next year.

“…the right, but not the obligation…”

This is a convoluted way of saying that the person who pays the money gets to decide if they want to use the service they paid for. If you bought a ticket to a baseball game, but then weren’t feeling well on the night of the game, it’s your choice if you go or don’t go. The ticket seller can’t force you to go. So when you buy an option, the person you buy it from is waiting for you to decide if you want to use what you bought or not.

If you do decide to use it, that’s called exercising the option, exactly the same idea as exercising a right, like exercising your 1st Amendment rights.

“…to sell…”

So buying a put option gives you the choice of whether or not to sell your stock. But you always have that choice. The difference here is that the person that sold the put option in the first place is required to buy your stock when you want to sell.

“…to sell a specified amount of an underlying security…”

Underlying security just means a stock. So it means, “to sell a specified amount of stock”. The specified amount is how many contracts you bought.

Options come in contracts, like eggs come in dozens. A contract is a fancy way of saying a “block of 100 shares”. So if you buy one put option contract, then you have bought a warranty on 100 shares of stock. If you buy two contracts, then it’s 200 shares of stock. [2]

“…to sell…at a specified price…”

So the other side is agreeing to buy your stock for a specific price, which you decide at the time that you buy the put option. This specified price is called the strike price.

“…to sell…within a specified time”

So the other side is agreeing to buy your stock for a specific amount of time, which again, you decide at the time that you buy the put option. This specified time is the time until the expiration date. The expiration date is the same day of each month for all options.

Example

Now let’s put that all together in an example and see if it makes sense.

Let’s say you buy 200 shares of Johnson and Johnson (JNJ) for $71.33 per share. But you realize that there is always a possibility that a stock will fall in price. So you want to protect against your investment falling in value. So you buy a put option.

You decide to buy 2 contracts, since you want to protect all 200 shares. If you bought only 1 contract, then you’d only be protecting 100 shares of your stock and the other 100 shares have the potential to fall all the way to zero.

You decide that you want to protect the stock for at least the rest of the year. So you go take a look at the options for sale. There are contracts for sale on JNJ that expire in September 2008, October 2008, January 2009, and January 2010. The best fit for the time frame you want is the January 2009 options.

Now you need to pick a strike price. The price that you want to be able to sell the stock at no matter what it’s worth on the market. The amount of insurance you want. The available strike prices for sale are $40, $50, $55, $60, $65, $70, $75, $80, $85, $90, $95, and $100.

If you pick a strike price of $40, you’ll only be protecting $40 of the $71.33. If you pick a strike price of $100, you’ll be paying for way more protection than you need. So ideally for this strategy you want to pick something closer to the price you paid, but still high enough to protect your entire investment.

The strike price of $75 costs $5.30. So if the stock drops in price, and you exercised the option, you get paid the $75 for the stock, and paid out $5.30 for the option and $71.33 for the stock originally. You would have a net loss of ($75 – $5.30 – $71.33 =) -$1.63 per share. That’s still not a complete protection from losses.

So let’s move up one strike price to $80. The cost of this option is $9.30. So if you own this put option and the stock drops in price, then you would have a net loss of ($80 – $9.30 – $71.33 =) -$0.63 per share.

But we’re forgetting the two dividends that JNJ will likely pay out between now and January 2008. One is expect on 8/22/2008 and if history repeats, then the other is expected around 11/24/2008. And the dividend amounts will probably be about $0.46 per share. So if you add the two dividends to the expected net loss, you get a net gain of (-$0.63 + $0.46 + $0.46 =) $0.29 per share.

So the worst-case scenario is you make a gain of $0.29 per share.

Summing up

So that’s it.

– You choose the stock you want to protect.
– You choose how many shares you want to protect.
– You choose the expiration date.
– And you choose the strike price.

If you’re interested in the No Loss Strategy or you have any questions about it, feel free to send me an email at contact@dividendium.com.

[1] There are other ways to use put options for investing or speculation, and I may come back and explain those in the future if it seems like there’s some interest.

[2] There are some option contracts that are “non-standard” and are not 100 shares. You should check with your broker if you aren’t sure if the contract you want to buy is standard.

Book Review: “Happiness: The science behind your smile”

I just finished what will probably be the last book I read on the subject of happiness. It was a thorough treatment of the subject and wrapped all the ideas in to a package that made sense to me. The book was “Happiness: The Science behind your smile”, by Daniel Nettle. However I’m not necessarily recommending you read the book because I recommended it to my wife and she found it agonizingly boring and “happily” decided not to finish it.

So here’s my disclaimer, if you don’t care about the results of studies, don’t want to see graphs or charts, and just want to know the conclusions, then this review should be perfect. Otherwise grab a copy from the library and dig in.

The book focuses on the topic of happiness from the perspective of feeling good, contented, and satisfied. The bases of the observations and arguments are scientific. There was a head nod to the idea of happiness as fulfilling one’s potential, but not much more since that is more of a philosophical or moral judgment.

Evolutionary psychology

The touchstone for the book is evolutionary psychology. Most of the findings and results of the studies discussed are checked against this theme to see if they make sense in the larger picture.

Evolutionary psychology looks at the brain in light of the problems it was formed to solve. The brain hasn’t changed that much from the brain of our ancestors, and the main problem it evolved to solve was how to avoid being eaten long enough to mate and produce offspring.

A crucial point of the book that flows from this is that if our brains evolved to primarily keep us alive, and not specifically to keep us as happy as possible, we may need to manage them some to be happy rather than to just stay alive. Our brains may actually try to trick us at points to try to help keep us alive, assuming that “miserable and mating” is better than “happy but dead”. [1]

Long-term vs. short-term

The brain has to balance the long-term goals against the short-term goals. In doing so the short-term goals of staying alive and avoiding danger are given preference. So he explains that negative feelings, such as fear and worry, don’t die off and can actually trigger more feelings of fear and worry.

If you’re worried about a specific social faux pas you made, you might lay awake that night and turn that into a worry that no one likes you. I think the idea here is that the brain wants to keep you alive to mate, and so from it’s perspective, better safe than sorry. If you have to worry a little more than needed, but that keeps you out of danger, the brain has done its job even if that keeps you from being happy.

The opposite side of this is the positive or good feelings like pleasure from getting a raise, eating, sex, and so on. These feelings tend to wear off a short while after the appetite has been satisfied. This is so that we will go on to do the other things we need to do. If sex felt so good that you never wanted to do anything else, eventually you would starve to death.

So in the battle of joy versus fear, joy will die off to let us do other things, but fear will hang around to make sure we keep running just in case something is still chasing us.

Tricky brain

So if our brain is willing to let us be tricked into being more fearful than we need to be. How else is it willing to trick us?

One of the most interesting parts of the book for me was the discussion of wanting versus liking. Our brain tells us that we want something like a raise, or an increase in living standards, and that thing does make us happier when we get it. But the happiness is extremely short-lived, like on the order of a few weeks to a few months. So you strive to get a raise all year long, and then when you do get it, you are only happier for a few weeks.

He goes into great detail about how we would have evolved brain mechanisms that would continually trick us into striving to do better because our ancestors that did better were the ones that survived to mate and produce us. Which means that we are programmed to want more and more stuff, even if we don’t need that stuff. And no matter how much we get, we always want just a little more because if we were ever satisfied for too long we would stop striving.

So he spends a lot of time talking about adaptation. The idea that we are happy that we got something (new toy, new raise, etc.), but only for a very short time before we start wanting a new thing or more of that thing than we have. This is the same idea above with wanting versus liking. You keep wanting these things, but you won’t actually like them when you get them. But you’ll still want more even though you don’t really like it.

He also mentions a few other ways that our brains trick us.

Framing is the idea that our most recent thoughts are going to color how we feel about our entire life. So if we are asked about how happy our entire lives have been on a gloomy day then we would be more likely to give a lower happiness rating. But the thought is really used as a comparison point. So if you were asked to think of a time in the distant past when something bad happened to you, and then asked how happy your life is, you would rate it higher because life has gotten better than that bad thing way in the past.

Relative fitness is the idea that the best way for our ancestors to tell if they were doing well was to be better than the people around them. At the time we lived in small tribes and were not exposed to the best of everything like we are now through the news. So it was a good solution to the problem. Now however we always feel like we need to push harder to get more to “keep up with the Joneses” to maintain our relative fitness.

The endowment effect is the idea that we think it would be hard to get along without something, but we don’t remember that we did just fine without it before. Because of this effect, losing something you had can be worse than never having had that thing at all.

Another was how we remember and compare experiences. When judging if an experience in the past was good we mainly consider two factors. How good or bad the peak was, and how good or bad the end was. One experiment that demonstrated this was one where in the first trial participants were asked to hold their hand in 14 degree water for 60 seconds. Then in the second trial they were asked to hold their hand in 14 degree water for 60 seconds, and then the water was warmed up to 15 degrees for an additional 30 seconds. When asked which one they preferred to repeat, the majority chose the second trial, the one that lasted 90 seconds instead of 60 seconds because they said it didn’t hurt as much, even though they had the same 60 seconds of 14 degree water exposure. So duration doesn’t actually matter, only the peak and the end.

Happiness Set Point

According to the studies cited if you want to find out how happy someone will be in the future, the best predictor is how happy that person is today. This implies that we have a genetically set default level of happiness. However our current happiness level can be skewed above or below that default level.

So the first goal would be to get back to that default level.

Getting back to neutral

There are a few things that if we lack, we will be less happy than we otherwise could be. According to this book those are:
– health
– autonomy
– social embededness
– quality of environment

Health is an obvious one. If you don’t feel well, you likely aren’t going to be very happy.

Autonomy is something that I’ve talked about before in the article on maintaining control of your life. Evidently people don’t like being told what to do.

Social embededness is the idea that we like being part of a community. We were originally part of small tribes so not being part of those communities can be stressful. We need friends and communities to ease that stress.

Quality of environment refers to external stimuli that might be threatening. Noise, chronic cold, and food shortages for example are all things that we don’t adapt to. Our brains continually tell us that these mean danger and that we need to correct the problem or run away. So again we are looking at stress.

Another one to note here would be that bad feelings like fear and worry create more bad feelings. One way he discussed of breaking that downward spiraling snowball effect is to practice Cognitive Behavioral Therapy. This is basically the practice of using logic to refute the irrational and exaggerated thoughts that lead from “I shouldn’t have said that” to “Everyone is going hate me forever”.

Once you’ve removed all the hindrances to your default happiness level, it might make sense to try to keep from falling back below it.

Building defenses

There are a number of things that you can do to help protect against those downward mental spirals and keep your level of happiness resilient.

One is to have more social definitions or roles for yourself. Most people have a definition of themselves as an employee. But if you have a setback at work, then your only definition is threatened and you have no other definitions to fall back on to support your confidence. So it was suggested that you have many different definitions for yourself by doing more things like hobbies or community organizations. Some of these roles might be employee, coach, writer, husband, father, volunteer, mentor, cook, surfer, softball player, a religion member, and so on. The idea is to provide a broader context to refute the bad thoughts your mind starts generating from that one setback in that one area..

Another defense is to connect to things. Some examples were communing with nature, connecting through religion, belonging to community organizations, doing volunteer work, and having rich/deep social connections. The idea here is to give yourself again another role, but also to give you a connection to the world and make you less likely to want to voluntarily leave it. The stat he quoted was that 1 in 10 people contemplate suicide at one time or another.

Another suggested defense is mindfulness meditation. The idea here is to detach you from the bad thoughts and help you realize bad thoughts are transient and will pass. This keeps you from spiraling down until the thoughts go away or the external stimulus causing the thoughts goes away.

An alternative to meditation would be writing like journaling or keeping a diary. The idea here is to put distance between the feelings and you, which allows you to reflect on them and again realize that they are not as big as your brain makes them out to be.

Reaching a little further

So now that we are at neutral and relatively stable there, we can start thinking about how to push just a little higher.

I’ve already mentioned that good feelings will wear off after a while even if you keep doing whatever it was that brought the good feeling. And I’ve mentioned framing, which is the idea that we compare our lives against our most recent memories. So keeping those two things in mind, one strategy is to do things that bring us joy more often. The joy will wear off but if we do the things often, then on average we can raise our happiness level. And in doing them often, we will always have a recent example to frame against so we will feel like our life is happier too.

You can keep a journal and try to figure out those things that make you happy and do them more often, but he suggests that the things that most people find joyful include, interactions with friends, food, drink, sex, success in some domain, sports, cultural activities, going out, and visiting new places.

He points out that some people don’t realize they would like these things and actually need to make themselves do them. Ideally forming habits around them to make it more likely that you would do the act and bump your happiness level up.

He also points out that you should distract yourself from trying to seek happiness. It’s something that will creep up on you when you aren’t pursuing it directly. Constantly worrying about if you are happy or not will actually take away from being happy.

And lastly, I mention this just because it was mentioned in the book; he notes that studies show there does seem to be a lasting increase in satisfaction from breast surgery. I have a hard time believing this, as it seems to me that a person would just find something else to obsess about. Similar to how we always want just a little bit more income than we currently have.

Correlations with happiness

There were a few things that were correlated to happiness, but he didn’t argue causation. Meaning that the two things seemed to be related, but it wasn’t clear if one caused the other or if there was a third thing that affected them both.

Health and longevity were correlated with happiness. He hints that there might be a causation in that higher happiness leads to a longer life, but above he noted that poor health leads to lower happiness, so there may be more interrelation there than just one causing the other.

Higher social class, but not income, was correlated with happiness. And when you control for higher social class, personal control is highly correlated with happiness. So evidently if you want to be happier just maintain more control over your life.

Conclusions

According to the findings discussed in this book, to reach their potential happiness, people should work part-time, take on hobbies, control their own lives, join community organizations, and get involved in active leisure like sports.

The working part-time comes from the idea that you won’t actually like the amount of stuff that you want, and that the stuff will not make you any happier for an extended period. So if you don’t need the stuff, you don’t need the income to get the stuff, and can work less time. Which is important because you need that extra time to concentrate on spending time with friends, your hobbies, community organizations, and active leisure commitments, all of which do affect your happiness.

As far as vacations go, since we only consider the peak and the end, and not the duration, you might shoot for short, intensely enjoyable vacations that end with a bang. They’ll be cheaper since they are shorter, and you’ll have just as fond memories of them afterward.

In light of our tendency to continually try to out do our neighbors; it might make sense to move to an area where you are already better off than the neighbors. So instead of stretching to barely afford the swanky house in the up scale neighborhood, you save the difference and buy the nicest house in the blue-collar neighborhood.

Another implication is that we should avoid the news. The news exposes us to the best of everything, the prettiest people, the most talented, and the richest, so we are continually being reminded that we are not the top dogs, which is a stressor because of the effect of relative fitness. Better to avoid this and spend the time on things we do enjoy. A further point about the news is that it also serves to exaggerate our fears of the world since the worst things are also thrown in our faces.

So the idea is to live more simply and to voluntarily take ourselves out of the competition. We should realize that we already have more things than we need and stop pursuing more stuff. The extra stuff is actually dragging us down in terms of money costs and psychological costs. Think about how much maintenance you have to do on the stuff you already own, like cleaning a large house, paying insurance on it, paying electricity, etc. This introduces more stressors, which will push us below our happiness set point.

Finally, we will always think we can be happier than we are now because this is how evolution keeps us striving. But above neutral and below max is probably as good as it gets. So if we’re already above neutral, we should stop worrying about being happy, and just sit back and enjoy being happy.

[1] That our brains may intentionally try to trick us was a key theme in the book “Stumbling on Happiness” from a previous article.

How can we invest while avoiding losses?

The short answer is we get someone else to take the risk, while we keep most of the gain.

The long answer

We want to expose ourselves to the positive side of luck, and shun the negative side. If a stock goes up, we want to be right there riding it up, but if it goes down, we’ll get off and let someone else take that part of the trip. But we need someone to agree to take our place before the stock starts going down, because no one is going to agree after it goes down.

The way to do this is with put options. If you’re not familiar with put options, I encourage you to invest some time in understanding them. I promise that investment of time will be a no loss investment as well.

The no loss strategy

In a nutshell, the strategy is to buy a stock, and a put on that stock with a strike price near the current price (“near” in this case is usually at least 10% higher than the stock price, and often closer to 20% or 30% higher). The put will protect our investment value from going down, and we’ll be able to wait until the expiration date to see if luck happens to take our stock up and hand us a profit.

Since we had to pay for the put, this strategy will often end up in a net loss if the stock does go down. But we don’t want to take any losses. So lets switch out the stock for a dividend stock, and have the dividends on the stock pay for the put and cover any gap between the strike price and the current price.

A stock that can pay for its own put with its dividend isn’t too easy to find. It’s kind of like looking for a needle in a haystack. But assuming we could find these stocks, let’s look at the benefits of this strategy.

Benefits of put protected stocks

So assuming we can find one of these dividend stocks that can pay for it’s own puts, we now have a one way position. We are fully exposed to positive surprises like new products, high priced buyout offers, good earnings surprises, etc. And protected from negative surprises like scandals, lawsuits, bad earnings surprises, etc.

We’re also protected from inflation in a way. If prices in general are rising because of inflation, then the price of the stock that we own will also increase. So inflation is actually working for us in this case.

Lastly if an investor is willing to sell a cheap put on a stock, one that can be covered by that stock’s dividend, then that investor is indicating that they think the stock will not go down. And since no one else is buying that put at this cheap price, they don’t think it will go down either. So we get a nice little boost in that the market seems to think that the stock we are buying is not going to go down. And as the market turns around and investors gain confidence, more and more of these opportunities will become available.

Risks

It’s always good to know the risks of an investing strategy, no matter how remote they are. So let’s go through those and see what we can do to hedge against them.

One risk is that the dividend could be reduced after we buy. If the dividend were reduced before the expiration date of the put, then we would end up paying for the put protection out of pocket rather than with the dividend.

To hedge against this risk we can concentrate on stocks with long histories of paying dividends and generally stay away from high dividends that look like they are about to be cut.

Another hedge would be to look for put options with shorter expiration dates, as those put options will be cheaper and not so painful to pay for out of pocket. But we don’t want to go too short on the expiration or we’ll be paying too much in transaction fees.

Another risk is time risk. Consider the situation where we buy a stock and put combo that has an expiration date a year in the future, and then the stock drops 50% the next day because of some scandal, and it’s pretty clear the stock is not coming back any time soon. We would still have to hold on to the stock for the rest of the year to collect the dividends to pay us back for the put. That means that all the money in that stock is basically tied up for a year and not earning anything. Again the solution here is to go for the shorter-term expiration dates.

Another risk is not being diversified enough. We are basically fishing for luck here. We have a nearly zero risk of losing money, but most of the upside. So if we put all our money in one stock, and that’s the one stock that doesn’t go up, then we’ve missed out on the opportunity to make some gains. So we want to try to spread our bets on multiple different stocks. Since put options can only be bought in contracts of 100, you’re probably going to be buying stock and options in groups of 100 shares. So that’s probably a good amount to stick on each stock. Although if you just happen to have a feeling that a particular stock is going to rocket up, there’s nothing to keep you from putting all your money on that one and protecting the downside with this strategy.

Lastly there is the systemic risk. It’s extremely unlikely, but possible that the whole financial system could crash and that the exchange that guarantees the options would not be able to cover the options in the event that the original seller is bankrupt. If this really happened, we’ve all got much bigger problems, so it’s not really something to worry about, but it is there so I mentioned it to be thorough.

Get a magnet

So we’ve got the strategy, we know the benefits, and we know the dangers. The only thing left is to figure out a way to pull those needles out of the haystack. Best way I can think of is to use a magnet. Turns out I just happen to have written one.

I recently finished writing some code to sift through the haystack of stocks and pluck out those specific needles that match this strategy. However right now the output is just a spreadsheet. And it takes a fair amount of work to go from just a spreadsheet to a full-blown subscription service. Before I go through all that work, I’d like to know if anyone is actually interested in this service (other than me).

If you are interested please let me know by emailing me at contact@dividendium.com. And if you could, please specify answers to the following questions:

1) Does it matter if the service is displayed in a web page, or is a downloadable spreadsheet just fine?
2) What would you expect to pay for this subscription service?
3) How often would you want the spreadsheet updated? Nightly, weekly, monthly?
4) Do you want to be notified via this email address when the service starts taking subscribers?

I’m also looking for a few readers that are willing to help me refine this service. These readers would need to understand the intent of the strategy and be able to make suggestions for improvements. For example, if there is a specific piece of data that would be helpful, but is not currently being captured, you would send me an email request to add that data. If that sounds interesting to you, please mention it when you email the answers to the above questions.

Lastly, here’s an example from the most recent output.

Example

Stock: SO
Stock Price: $34.59
Annual Dividend Yield: 4.86%

Option: SOWH
Option Ask: $5.80
Option Strike: $40.00
Option Expiration: 11/21/2008

Dividends Expected By Expiration: $0.42
Minimum Profit: ($40.00 + $0.42 – $34.59 – $5.80) $0.03
Max Loss Without Dividend: ($40.00 -$34.59 – $5.80) $-0.39
Percent Gain Needed For Profit: ($40.00 / $34.59 – 1) 15.6%