How Young Americans Can Profit From Today's Economy

Economy got you down? Well then chin up, young folks! You haven't got as much of a reason to worry as your older neighbors do. In fact, today's down market could have an incredible positive impact on your retirement if you play your cards right! I'm going to show you why you shouldn't beat yourself up about the nightmarish economy, but rather why (and how) you should invest. But be careful -- this is by no means a free pass to completely overhaul your personal financial plan (if you have one). My core values still stand: get out of debt, don't spend too much, and save your money. Let's get started.

Random optional side-notes:
First let me say that conspiracy theorists and skeptics and hard-core political enthusiasts are welcome to give me their comments about how the bailout and/or the election of a Republican/Democrat will doom us all. They may think that capitalism as we know it is over and before we know it, the government's interest in our financial institutions will create a socialist (or even communist) state and my words will be rendered irrelevant. Well, I hope that doesn't happen. But if it does, it's completely out of our control. The purpose of this post is to help average young Americans take advantage of this economy so they will benefit later in life. Future relevancy aside, this post assumes that the economy and government will function in the future as it has in the past.

On another side note, if everyone followed my advice and became completely debt free, the nation's economy would actually crumble. But don't worry -- it's impossible for an entire nation to become debt free. There is literally less money out there than there is debt. Sounds crazy, but it's true. :-)

Today's economy could actually help today's youth, and this theory is partially proven with the principle of dollar cost averaging. Essentially, the principle states that an investor's exposure to risk (risk of losing your money, that is) is reduced by buying investments incrementally instead of in one big lump sum. This works because in the short term, the stock market fluctuates frequently and unpredictably. So by buying stocks incrementally, you spread out your investment, buying in small batches for varying prices. On the other hand, the long term market is very predictable and its fluctuations are uncommon, minimal, and easily spotted. As you know, the idea of investing in stocks is to "buy low and sell high." In the short term, because it is difficult to know when you're at a peak and when you're in a valley, it's better to just keep buying a little bit at a time; sometimes you buy at the short term peaks and sometimes you buy at the short term valleys. In the end, you end up buying stocks for a dollar cost that is an average of its short term peaks and valleys.

Let's look at an example of short term fluctuation. You have $1,200 sitting around that you can invest in the stock market. Sure, you can take it all and invest it immediately, but it would be better for you to invest $100 it each month for the next year. Or even better, $50 every two weeks.

If you had invested that $1,200 in a mutual fund last October in one fell swoop, you probably would have lost quite a bit of your money (the Dow was at 14,000 last October and is at about 9,000 today). Let's say you bought the stock at 10 dollars per share -- 120 shares total. Let's also assume that because of the poor economy, the market has gone down 3% each month for a year (a realistic estimate given our recent history). So at the end of a year, your 120 shares would be worth about $912 -- about $7.60 apiece .

Now let's see what would have happened if you had invested $100 per month instead of putting it all in at once. In the first month, you would have bought 10 shares ($100 investment/$10 share price). But in month two, you would have been able to buy more shares with that money. Because the market had gone down, that stock was selling for $9.70. The next month, it would be selling for $9.41, and so on. By investing $100 per month for the full year, because of the discounted price, you would end up with 143 shares instead of 120 -- 19% more.

By investing incrementally, sure, you still lost money, but you also bought 90% of your stock for less than you paid for it when the Dow was at its peak a year ago. Because the market has gone down in the short term, the average price that you paid for that stock has also gone down. But because the market always goes up in the long term, you'll be better off when you eventually sell your stock because you will have a lower average cost per share and therefore, more shares. And the more shares, the better. When the stock eventually goes back up, you'll have 19% more money. When the stock pays a dividend, you'll get dividends for 19% more shares. More shares equals more money.

Of course, this theory goes both ways. Dollar cost averaging minimizes your short term gains as well. But if you want to guarantee your success in the stock market while maintaining your sanity, you need to give up on the notion of becoming a millionaire overnight or being the next Jim Cramer. Yes, dollar cost averaging will minimize both short term losses and gains, but it also ensures that your long term benefits aren't spoiled by the unpredictable daily/weekly/monthly peaks and valleys of the stock market.

Short term fluctuations are impossible to predict unless you've got the research budget of an investment bank. But in the long term, it's much easier to spot your "elevation" and buy when you're in a valley. Since 1978, there are only a few very obvious valleys. There was one in the late 80s, one in the late 90s, one just after September 11th, one in 2003, and one today. Today, stocks are cheap. This stinks for retirees that need to cash out to pay their mortgage, but it's wonderful for younger Americans that are just starting to save.

Just as it's true that short term ups and downs are unpredictable and should be handled with caution, it's also true that long term growth is quite predictable and its ups and downs can be more easily exploited. In the long term, when the market is growing quickly, it becomes proportionately more difficult to make a buck. But in days like these, when the market is down, it's the perfect storm for young folks to buy low and eventually sell high.

Those that understand the principle of dollar cost averaging and incrementally invest will minimize their short term losses (and unfortunately, short term gains, too). And those who, in the long run, slow their investing when the market is up and hasten their investing when the market is down (like today) will retire younger and more quickly enjoy a financially independent lifestyle than their get-rich-quick peers.

When Do We Eat? The Value of Financial Individuality

Do you remember when you were growing up and your mother told you that you were special? Or maybe it was a teacher or your grandmother or a family friend. Chances are, a caring adult in your life encouraged your individuality and, more importantly, your independence. The lesson may have been taught in different ways, but was nonetheless important. Maybe you were encouraged to think twice before jumping off a bridge if all of your friends decided to do it. Maybe you were taught to "just say no" when presented with an opportunity to engage in an activity that threatened your moral fiber. However it was taught to you, I'd like to discuss the lesson's importance and relevance to your financial wellbeing.

Individuality and independence are important traits for people to possess in many respects. The right kind of individuality will set you apart from other candidates when applying for a job or admission into college. The wrong kind of individuality might earn you inquisitive glances from strangers and fearful looks from small children clutching their mothers' legs.

The ability to think critically and independently will also fuel your ability to responsibly manage money and increase your wealth. Lots of Americans have been frightened of the downward trending stock market and have been selling their stocks like nobody's business. The band wagon is speeding away from Wall Street just as fast as its little wheels can carry it, and the value of our investments are falling as a result. But just because so many people are jumping on, should you do it as well?

I guess it depends.

When I was in college, the most popular dining hall was called West End Market. It had a fun atmosphere and the food was diverse and delicious. But in my opinion, it was an absolutely miserable place to be at 6pm. Every evening, West End looked like Times Square on New Years Eve. Hokies arriving at dinnertime lined up like motorists at the DMV, often waiting more than 30 minutes for a sandwich or a plate of the ever-famous Chop House london broil.

I like eating at a normal time like everyone else, but being the impatient person that I am, one experience at West End during dinnertime was enough for me. I avoided it altogether for months, eating at the non-award-winning dining halls, until one day when I decided to pop in an hour early. You'd be amazed at the difference that hour made. At five, though I had worked up less of an appetite, I could hear crickets chirp as I leisurely approached every food station that I desired. Free tables were bountiful and I was able to feast in peace like Kevin McCallister on Christmas Eve. At six o'clock, patrons would be reminded of an overcrowded high school cafeteria on a day where all but one of the lunch ladies called in sick. Sure, it was easy to socialize, but those that came with the crowd wished they had brought a snack for the line.

So what does a dining hall have to do with investing? Well, when everyone is selling -- to the point the Dow falls to its lowest value in five years -- you have to ask yourself what your strategy is. You might not be starving until six, but at six, everyone will be starving. So chances are, you might not eat until seven. So you have to ask yourself, are you a six o'clock person? Or are you a five o'clock person?

The six o'clock person will sell, sell, sell and wait until the market is trending upward before they buy again -- just like everyone else. The five o'clock person will start buying when no one else is. He will understand that stocks are on sale and remind himself of the history of the market, which has always stood the test of time, despite its sometimes significant peaks and valleys. He's not famished yet, but he knows that hunger will come soon and he had better get in line before everyone else does.

Warren Buffet once said "Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can't buy what is popular and do well."

Of course, investing in the stock market during a troublesome time is much more complicated than determining what time to go to dinner. But at a high level you have to ask yourself why you're there. Are you there to socialize? Or are you there to eat?

Prosper.com: Convincing My Wife, Part 2

...she ain't convinced yet.

In my continued efforts to convince my wife that Prosper.com is a good investment, I'll analyze another aspect of the website today. Today I'll study what makes the successful lenders successful, what makes the average lenders average, and what makes the biggest losers, well, the biggest losers. I'll be moving my analysis platform to a fabulous website that focuses solely on Prosper.com lender and loan data, EricsCC.com.

To get things moving along quickly, consider the following graph that shows all lenders' rates of return on a seemingly normal distribution curve (please click any graphic to enlarge it):
As you can see, the majority of lenders are making money, and a significant majority are also earning a higher rate of return than they would earn in a traditional savings account. However, of all the non-average lenders, there are more that are doing exceptionally poor than doing exceptionally well. This indicates that if you do not follow a reasonable, disciplined investment strategy, you are more likely to lose at a high rate vs gain at a high rate. I guess the same could be said about the stock market. Essentially, it's easier to make mistakes than it is to get lucky.

Do you ever watch that show called The Biggest Loser on NBC? Well meet the biggest loser on Prosper.com: scoobydoo. Here is a graphical representation of his investments:
As Antonio from the Merchant of Venice would say, His "ventures are in one bottom trusted." This guy has invested a lot of money into Prosper.com and has given several large loans to people with C-grade credit. If one or two of those loans defaults, his ship will have sunk.

Let's look at another big loser's profile. How about jasonpeery:
Here's another guy that has a poor, lazy investment strategy. He has invested over $50,000 in Prosper.com listings and has scores of late payments and defaults. This guy has made several individual loans over $1,000, including one that is in default for $11,000! Why in the hell would you EVER loan $11,000 to a person with high-risk credit? And without even asking them a question! I sure hope that jasonpeery is better at personal finance than he is at determining to whom he should lend his money. As Neil Boortz would say, I bet that this guy has a lot of rent-to-own furniture in his house. My guess is that this guy's grandmother died recently and left him a bunch of money. No one that worked for $11,000 and saved it would ever be that careless in giving it to a single high-risk stranger.

One thing to remember about Prosper.com's fee structure is that all individual loan fees are passed along to the borrower except for a 1% loan servicing fee which is paid by the lender. This means that, statistically speaking, there is no reason to invest more than $50 in ANY candidate. Period. If I lend $500 to one person or $50 to ten people, I will pay the same loan servicing fee. And though I may save a little time by investing more money in lower-risk candidates, it's just plain silly to not diversify to the max with sub-prime borrowers.

OK, so let's look at someone with an average return. Consider the portfolio of helpishere777:
Ahh, this is refreshing. This user is right in the middle. He is earning about 11% interest, which takes into account the probability of his late payments going into default. He has invested the same $50,000 that our last big loser had invested, but in a completely different way. Look at the nice even relationship between all of the blue and green lines. Do you know why they're all equal? Because he invested the same $50 into every single loan. He understands that in order to mitigate his risk, he needs to diversify -- especially if he can do it at no additional cost!

Now let's look at the best lender. I'm not going to evaluate the person earning the highest return on his money. Currently that person is DrakeCO, who is earning about 33.6% interest. However, the average length of his loans is less than one month and most of his loans have been large amounts (max of $1,500) to high risk borrowers. Because of the youth of his loans and the nature of his strategy, he is bound to fail. Instead, I'm going to look at someone earning about 20% return with a reasonably large average loan period (if it's not old, the borrowers don't have time to be late!) and a significant amount of money. It looks to me like the golden child of Prosper.com is brother_tam. Here is his portfolio:

brother_tam is obviously smart and probably a little lucky. He has invested a little more than $10,000 in Prosper.com, mostly in $50 increments. Of his 224 loans, he has given more than $50 only 13 times, probably just to spice up his account. As a lender that understands the need to diversify. He is aware that he can invest in lower-credit borrowers because of his discipline. But he doesn't invest in only low-credit borrowers. He has a nice normal distribution of his loans that has a mean slightly on the low-credit side.

To be a successful lender on Prosper.com, you need to stick with a disciplined strategy that is formulated around the values of diversification and a normally distributed loan strategy. When choosing which loans to bid on, consider your current portfolio and establish a quota. "Right now, 75% of my loans are to high-risk borrowers. I should invest in some low-risk borrowers."

Remember: there is no penalty for investing the minimum amount in a person. And with more than 2,300 active listings, you shouldn't run out of people to lend to.

If she's still not convinced, I'll have to write more tomorrow.

Prosper.com: Convincing My Wife, Part 1

My friend and frequent tepom.com commentator Steve Butcher has an active account with Prosper.com and is doing quite well with it. His current rate of return is about 16.9%. I'm interested in joining him and trying my hand at peer-to-peer lending, however, my wife takes a very conservative approach to lending and will definitely need some "talking-into" if I ever want to open an account.

I will write a small series of posts that will attempt to justify peer-to-peer investing and convince my wife at the end that it's a good idea. The end goal of my analysis will be to prove my hypothesis that Prosper.com provides an excellent lending opportunity by using their empirical loan data. If my hypothesis is proven, I will convince my wife to start investing and share with you all my plan of attack.

Day one analysis: The correlation between debt-to-income ratio and loan delinquency
Prosper.com evaluates borrowers' credit reports and assigns them an alphabetical risk rating, from AA (the best) to HR (high risk -- the worst), with A, B, C, D, and E in the middle. In today's analysis, I decided to evaluate the correlation between a borrower's debt-to-income ratio (DTI) and the delinquency rate for each credit classification. My analysis assumes that any amount that is not current (>15 days late) is considered delinquent. It should be noted that these numbers do not suggest a loan default, just the probability of delinquency. Here I evaluate both the number of default dollars and the number of default loans. In my opinion, the number of delinquent dollars are more important than the number of delinquent loans because we intend to diversify our money as much as possible. The more you diversify your money, the more important the number of deliquent dollars become. The less you diversify, the more important the number of delinquent loans become.

Though my analysis evaluates delinquencies as a whole, it should be noted that those with poorer credit that go into delinquency are much more likely to have their loans written off than those with better credit. Essentially, those that have better credit are better at getting themselves out of trouble.

Click a chart to enlarge:
Looking at all loans regardless of the borrower's DTI (the blue line), it comes as no surprise that as the borrower's credit rating declines, there is a higher probability of the loan becoming delinquent.

However, when three bands of DTI are considered, the equation changes. With a DTI of anywhere from zero to 50%, the curve doesn't shift or change significantly for any classification of borrower. However, with a DTI above 50%, the curve is flipped nearly upside down. This suggests that a dollar loaned to a person with great credit but a high DTI ratio is more likely to be late than a dollar loaned to a person with poor credit and a similarly high DTI.

Similarly, when looking at the number of delinquent loans, the curves are closely aligned for borrowers with DTI less than 50%. But once the DTI rises above 50%, the difference in likelihood of the loan's delinquency rises substantially, especially for borrowers with great credit.

To summarize, the number of loans that will become delinquent do not vary significantly as the borrower's DTI changes except when the borrower has great credit. A borrower with great credit and a high DTI is much more likely to become delinquent than a borrower with great credit and low DTI. A borrower with poor credit and a high DTI is just as likely as a borrower with poor credit and a low DTI to become delinquent on his or her loan. When you consider a dollar loaned, a dollar loaned to a person with great credit and high DTI is much, much more likely to be late as opposed to a dollar loaned to a person with great credit and a low DTI. The reverse is true for poor credit borrowers. A dollar loaned to a person with poor credit and a low DTI is more likely to be late than a dollar loaned to a poor credit borrower with a high DTI.

So what do we learn from this? When lending to people with great credit, be wary of those with a high DTI requesting a lot of money. Don't lend to them unless you can obtain a premium rate. When considering lending to a borrower with poor credit, be sure to diversify your money across different loans. If you're torn between two poor credit borrowers, if the only difference between their profiles is their DTI, consider lending your money to the one with the higher DTI, especially if their rate is higher!

More to come on other Prosper.com lending strategies.