The Stoic’s Arbitrage: A survival guide for modern consumer financial services products

Updated: Oct 11


Consumer financial services products, like Mortgage, Auto, Credit Card, Student Lending, and Investment help us reach our life goals. These same products, not used correctly, may inflict significant long-term financial damage. Applying a stoic’s mindset provides focus and tools to successfully navigate the complex consumer finance landscape. While thinking like a stoic is not always intuitive, with practice, it is VERY achievable! This article provides several consumer financial product arbitrage examples. I hope these examples may help you identify and implement the stoic’s arbitrage in your life!

Jeff Hulett is a banking industry executive. His roles have included operational leadership, data science, process automation, risk management, and risk consulting. Jeff is a member of James Madison University College of Business Finance and Business Law board and past chair. Jeff lives in the Washington DC area.


Article Sections:

  1. Key Points

  2. Stoicism and your purpose statement - an auto lending example

  3. Credit Card Arbitrage

  4. College Arbitrage

  5. Mortgage Arbitrage

  6. Investment Advisor Arbitrage

  7. Adaptability

  8. Conclusion - Why should I use the Stoic's Arbitrage?

  9. Notes and Stoic's Arbitrage Models available for download


Next, allow me to define the key points:

First, a stoic believes knowledge fuels personal power and that education is our greatest source of that power. Also, a stoic believes in using that power to avoid getting played or taken advantage of. They tend to be practical and utilitarian-focused, and they tend to choose courage and calm over anger. Courage and calm govern the stoic's emotions. A stoic provides kindness to others. Kindness is a source of strength. By the way, Warren Buffett, the legendary investor, certainly has stoic attributes. One of my favorite stoic-like Buffett quotes is: “Price is what you pay. Value is what you get.” Second, almost all consumer financial services products (1) have a statistical nature to them. For example:

  • Credit loss rates are probabilities applied to loan pricing, credit decisions, or loss reserves.

  • Marketing response rates are probabilities applied to sales and marketing programs to predict demand and revenue.

  • Program breakage is a probability assigned to usage programs (like credit card loyalty programs) that predicts how much of the program is not used, thus lowering program costs.

  • Investment advisors, like Personal Financial Advisors, charge annual fees based on a percent of Assets Under Management (or "AUM")

Statistics are a key source of profitability measurement and ultimately help drive consumer financial services product growth. Third, arbitrage is the buying or selling of similar assets in different markets to take advantage of price differences. In this article, our use of arbitrage is more for knowledge arbitrage. That is, being more aware of how consumer financial services product programs work and taking appropriate action will allow you to minimize your costs or maximize your own value! The statistical nature of consumer financial services products helps create the arbitrage opportunity.

Stoicism and your purpose statement:


A little later in this article, we will define the statistical part of the arbitrage, but first, let’s cover stoicism as it relates to purpose. Very important to reaching a goal is a well-considered purpose statement. A well-defined purpose will act as a guiding light as accurate decisions help reach any goal. In the context of consumer financial services products, related purposes cover pretty much anything you buy, like a college education, a home, a car, or furniture. As an example, the next section covers the car buying purpose.


What is your purpose for buying a car?

The stoic auto buyer will be open to lower-cost transportation options that may not need a loan (or they may not even need a car!....if they can use public transportation, ride-sharing, or other transportation substitutes). A non-stoic buyer may be exposed to higher-cost decision options. The point being, whether you apply stoic principles or not, you should be very clear about your guiding light purpose. (See my Auto Buying and Financing Thoughts article for more information.)


Another aspect of the stoic’s purpose is long-term value consideration. (Please see my The Time Value Of Money Values The Young article for more information) While you have the choice of different cars to fulfill the “safe transportation” purpose, you also have a choice about the time frame your decision value is received. Let’s take the car example. If I buy a

more expensive car, I will be able to afford the payment. If I buy a less expensive car, I will be able to afford the payments, plus, save money. The issue is, our brains are more wired to favor the present than the future. So, a non-stoic may say, “Hey, I can afford both cars, so I’ll take the ‘nicer’ (more expensive) one.” A stoic's response will say, “Hey wait, what is the long-term value of my savings?” Using the example from our Auto Buying article, both cars provide “safe transportation” However, one of the cars also provides $500,000 for retirement! Doesn’t this one sound much better? The point being, taking a long-term financial view to our decisions is a beneficial mindset. This will add realistic significance to your savings and a bunch of money for retirement!


The credit card arbitrage:


The statistical part of the Stoic's Arbitrage is a little tougher conceptually, so the following is a credit card example to help frame the general approach. Credit card profitability, like most products, is measured as Revenue minus Costs. They will also discount cash flows (the timing of the revenues or costs) to take into account that a dollar received or spent today is worth more than the same amount realized in the future. Credit card companies create very sophisticated models to estimate profitability and related statistical drivers. Some of those drivers were mentioned in the initial key points section. The consumer's arbitrage occurs because the bank applies statistics at the credit card program level to measure profitability. The bank will often utilize averages for each profitability driver to calculate whether a credit card program is successful. Also, importantly, they make decisions at the margin to decide whether to expand a program. Your individuality as a divergent data point provides your arbitrage power!


So, let’s say a credit card program has, on average, 40% of its customers revolving their balance. (that is, NOT paying off the balance every month and paying the bank interest revenue). That leaves, on average, 60% of its customers transacting their balance (that is, paying off the balance every month so the bank gets NO interest revenue.) Let’s assume it takes the revenue of at least 20% program revolvers for a credit card program to break even.


So, the bank will continue to market and add customers until they reach that marginal break-even point. Here is the thing, the credit card companies guess at who is a revolver vs. a transactor. While their models do attempt to predict payment behavior, there is a statistical error. Also, because revolvers provide more revenue than transactors, the banks can afford monetary incentives to encourage usage, like cash back programs. For example, Citibank has a “double cashback” program that gives cardholders 2% of their spending back. So, hopefully, you can see where I’m going. The arbitrage is being a transactor in credit card programs that provides cashback or some valuable incentive. The value of the arbitrage is: 1) You will pay no interest or fees, 2) you will get the convenience utility of a card for purchases, and 3) you will get paid an incentive. In effect, you are arbitraging the statistical nature of the credit card business with your transactor discipline. To be fair, there is a downside. We are all human, so if we mess up one month and forget to pay, it could cost us. This is something that you need to watch carefully!


Also, as a stoic, given the choice of equivalent cashback or some other incentive program, like airline miles, ALWAYS take the cash. Cash is fungible, airline miles are not. Thus, cash has more utility. Also, people are more likely not to use an earned airline miles incentive than not using an earned cash incentive. (In the industry, a customer not using an earned incentive is called “breakage.”) Breakage is an important part of profitable credit card loyalty programs. Better to arbitrage credit card loyalty programs by using low breakage incentives. Alternatively, one may arbitrage a higher than average breakage incentive by behaving with lower breakage.


Now, let’s consider what the credit card arbitrage is worth. Let’s assume you revolve a balance on a card and pay the minimum due. Generally, the minimum due paid is just enough to pay your interest. So if you pay the min due, your balance should not grow (unless you spend more).

As an example, say you revolve a $10,000 balance at 18% interest to buy really nice furniture. As a result, you will pay $1,800 a year in interest. But let’s apply our stoic’s long-term value principle. What if you acquire used furniture instead of that really nice new furniture. As a result, you did not revolve that balance and instead invest the $1,800 that would have otherwise been paid as interest. Let’s follow and compare the scenarios, assuming each is run for 10 years while you are in your 20s. By retirement at age 65, the opportunity cost of the 10 years of interest on a $10,000 purchase is foregoing a retirement of about $300,000! (2)

So, is the really nice furniture you financed (and is probably long gone) worth the $300,000 you gave up at retirement? I think you know how the stoic would answer that question!


The college arbitrage:


Now, let’s turn to student lending, and, more importantly, the college choice itself. To begin with, student lending has become a BIG problem in the United States. Long-term student loan default rates are almost 20%, graduation rates are down, and college costs are way up. (Please see my article The College Decision: Proceed at your own risk for more information) Making the choice of going to college and which college to attend has become increasingly important to long-term financial health. As a former recruiting leader of a Big 4 firm, I do have a unique perspective about the value of college. To illustrate my perspective, the following is my typical Q&A exchange:

The reason is straightforward. I simply cannot think of a good reason to pay more money for the same value. My Big 4 recruiting experience will help clarify my reasoning. Think of the Big 4 firms’ recruiting approach as a representative model for all industry recruiting. The Big 4 recruits highly capable college graduates, at scale, and across almost all business, STEM, and related disciplines. Here is the thing. The Big 4 recruits broadly, from big schools and small schools, public schools and private schools.

The Big 4 has figured out, 1) it is the individual student that matters, more so than the individual school and 2) no one school has a monopoly on high quality students. Said another way, all schools have a subset of good students, the hard part is identifying and recruiting them.

So the Big 4’s recruiting approach is to target colleges broadly and target high-quality students narrowly. In the case of the Drexel/Virginia Tech example, the Big 4 has a long history of recruiting excellent students from both schools. From this recruiter’s standpoint, other than price, there is no difference between the schools.


If you are choosing a school, my advice is:

  1. Do not get too hung up on the college’s brand name,

  2. Pick a state public school (or a school with the equivalent of or lower than in-state tuition), and

  3. Pick a school you are committed to getting good grades.

College grades are an important recruiting signal suggesting readiness for the working world. Think of grades as the “3Cs” recruiting signal. That is, your grades signal recruiters the trinity of:

  • intellectual Competence → ability and willingness to learn

  • Conscientiousness → hard worker

  • Collaborativeness → team player

Said another way, if you are not ready to commit to getting good grades, do not waste your money. Just wait until you are ready! By the way, if you are not ready for a four-year college, I am a big fan of the community college system. Done appropriately, it can be a lower-cost way to build study habits and good grades, as preparation to transfer to an undergraduate institution. (Please see my article Diamonds In The Rough - A perspective on making high-impact college hires for more information.)


Now, let’s consider the stoic’s college arbitrage value, based on annual tuition, room, and board estimates:


The difference in total cost between the schools is $50k / year or $200k total for 4 years. Assume the difference is invested and is available for the student’s retirement at age 65 (graduate at 22, retire at 65). The future value at 7% (after-tax annual yield) available for retirement is $4,662,484! Important to note: This calculation does not include student lending. Assuming a student loan is more likely needed for a more expensive school, the arbitrage opportunity could be significantly higher. (4)

To some degree, society makes the college decision more difficult than needed. The confusing decision dynamics are influenced by our desire to help our kids, societal pressure, college recruiting professionals, college marketing, loan considerations, etc. Even former Maryland Governor and presidential candidate Martin O’Malley fell into financial difficulties because of his children’s college decisions. His experience is worth reading as a cautionary tale.

"We can second-guess the wisdom of the O'Malleys' decision, and I do. But now that they've made it, I hope the family given their public platform– will use their experience as a cautionary tale that, for most families, it's not okay to cave to an 18-year-old whose dreams of a particular college will create decades of debt."

-Michele Singletary, Washington Post reporter


The mortgage arbitrage:


There is an important distinction between a mortgage and other consumer loans. The collateral of the mortgage is generally a long-term appreciating asset. That is, a house usually increases in value over time. With other loan types, the collateral (or loan proceeds

usage) generally depreciates in value. (5) As such, my mortgage mindset is different. While I try to minimize exposure to other loan types (card, auto, student loans, etc), a case can be made that housing debt creates a positive net interest margin. That is a positive difference between the after-tax interest rate one pays on the mortgage and the appreciation rate of the house. As such, a mortgage can make good financial sense as part of an overall investment strategy. It has the added benefit that one lives in their home! Thus it has multiple points of utility. Driving a low rate arbitrage strategy requires periodic refinancing to maintain the positive interest margin. Also, keep in mind, your mortgage servicer owns what is called a Mortgage Servicing Right (“MSR”). An MSR is the value of the servicing and fees created by your loan. Here is the thing, the value of an MSR is extremely sensitive to interest rates. Why? Because, when interest rates drop, there is a higher probability of you refinancing elsewhere. As such, the Mortgage Servicer is very motivated to keep your loan. In a low rate environment, they can lose significant MSR value as loans refinance.

Here are a few suggestions to make the most of the mortgage arbitrage:

  • In most cases, Adjustable Rate Mortgages (“ARMs”) have lower rates than their fixed-rate cousins. While you will need to refinance more frequently, you will generally get lower rates to maintain a positive interest margin.

  • Refinance when new mortgage rates drop .25% below your current rate.

  • Refinance with no out-of-pocket costs. That is, roll all costs into the rate.

  • Check with your current mortgage servicer, they should be very motivated to refinance your loan at an attractive interest rate.

  • I’m a fan of interest only (“IO”) ARMs. Only use IO ARMs if you have the discipline and staying power to invest the additional cash flow. If not, it is fine to get a regular amortizing mortgage and build more equity in your home.

(See my paper Investment Thoughts For My Children for more information.)

Now, let’s consider the stoic’s mortgage arbitrage value. First, let me tell the story of two prospective homeowners, Jack and Jill.


Jill is a conscientious 25-year-old. She graduated from college not long ago and is ready to buy a home. Based on her income, she qualifies for a $400,000 loan with 5% down. She has been saving. She is also going to get an IO ARM because she feels comfortable she can invest the payment difference.


Jack is a hard-working 30-year old that has been working for 10 years. He has built his expertise in the construction industry. Based on his income, he qualifies for a $400,000 loan with 5% down. He has been saving. He is going to get a standard ARM because he feels more comfortable building equity.


They both want to retire at 65. The good news is, they will both create retirement value through homeownership, but they will do it differently. See the following comparison table. (This is also available in my Stoics Arbitrage Models in the file at the end of this article.) Jill’s value at retirement is about $3.6mm! She will get a 5 year longer period to build investment value. Also, Jill’s discipline to invest in the payment difference will effectively increase her retirement value. Jack is also in good shape, he will create a retirement value of about $2.1mm. He does this primarily through home value appreciation and paying down his mortgage. Notice the assumed appreciation rate and investment rate are higher than the mortgage rate. This demonstrates the positive net interest margin referenced earlier.

The investment advisor arbitrage:


What is the value of a personal financial advisor (or a PFA)? These are advisors with significant education and experience in finance, investment products, and portfolio management. They work with their clients to make optimized decision recommendations for your long-term financial health. Recently, the value of the PFA has come into question. With low-cost ETF and mutual fund firms coming into vogue, like BlackRock and Vanguard, one can maintain a passive approach to investing without paying higher PFA fees. A PFA will charge about 1.25% of Assets Under Management and that is after the cost of administering the underlying funds they manage. Also, PFAs often have minimums that make it hard to get started with a PFA until you have already built some wealth. A bit of a "chicken or egg" problem.


From my standpoint, a good PFA does a few things very well (6) that a low-cost passive fund cannot.

  1. They create "set it, and forget it" investment strategies. These are sensible, risk-based strategies that rely on automatic payments and payroll deductions to ensure proper and consistent investment funding. Even when the market is cratering, these automated mechanisms fire to buy low and help manage down your basis in market corrections. While psychologically challenging, this approach helps build long-term wealth.

  2. They automatically rebalance portfolios across multiple fund types to maintain your long-term investment risk tolerance. Over time, funds will grow at different speeds, so periodic rebalancing is important to maintain your risk strategy.

  3. They manage your fund strategy in a way that optimizes your tax liability. The Tax Loss Harvesting approach swaps similar funds at the appropriate time. This approach purposefully reduces your tax liability and improves your after-tax yield.

Could you do this yourself? Yes, but it would take a decent amount of a) technical understanding, b) self-discipline to overcome the fear-based psychology mentioned earlier, and c) the desire to regularly balance trade mutual funds and ETFs. Also, there is a risk that you miss a key trade or otherwise become occupied with other pressing matters. It would be really great if there was a lower-cost way to automate the PFAs "3 key things" at a lower cost and without those annoying minimum investment requirements. Well, you are in luck! There is another solution. That is called a Robo-advisor.


In our article Budgeting like a stoic, we discuss how Robo-advisors work and we reference Robo-advisor companies we have previously used. In this article, we focus on the Robo-advisor's much higher long-term value in the context of the Stoic’s Arbitrage. The Robo-advisor has higher long-term value because their costs are significantly lower. The PFA cost can be 1.25% of assets, whereas the Robo-advisor cost is around .25%. A 1% difference may not seem like very much, but as we will show below, it can be worth many $millions over your life. The problem is, people do not really think in terms of percentages or naturally understand the time value of money. Our brain has no way to ground 1% as a meaningful number plus the exponential functions associated with the time value of money are not naturally intuitive. But this is where the Stoic's Arbitrage thinking comes into play. It is important to educate yourself and take actions to impact the long-term. This could mean projecting decades in the future to your retirement or even multi-generationally.


Let's use an example, let's say you are like Liam from our article They kept asking about what I wanted to do with my life, but what if I don't know? Liam is in his 20s and recently graduated from college. He is ok with some career uncertainty and works for a company in a high-growth industry. Also, Liam was able to graduate with little or no college debt. After he sets aside money in his company 401(k), he still has some money left over to invest in a taxable account. Liam is consistent and able to increase his taxable account distribution every year. Also, he periodically makes and maintains a few bigger annual increases.


By consistently investing over a 45-year career, Liam's investment outcome at age 67 is north of $20 million! Please see the attached excel spreadsheet for the model. This is our contribution to inform your stoic's mindset.


The key drivers are:

  1. He started young,

  2. He did not have significant student loan debt,

  3. He worked in a growth industry and was not afraid to periodically change companies.

  4. He was consistent in his contributions and financial discipline, along the lines of the "3 key things" discussed earlier.

So, if a PFA and a Robo-advisor can both do these "3 key things" equally well, what is the value of using the less expensive Robo-advisor? In Liam's case, the Robo-advisor approach is worth $6.3 million at retirement! To be clear, Liam will receive over $6 million more at retirement simply by using a Robo-advisor instead of a PFA. This is an example of the Stoic’s Arbitrage in action.


You can see why PFA's market their costs as obscure sounding percentages instead of long-term value opportunity cost.


A PFA saying:

"Come work with me, I only cost 1.25% of assets and you will never have to write me a check!"

is a very different marketing message than:

"Come work with me, I will cost you over $6 million at retirement!"

You may be wondering, what if you have a college loan and are not as comfortable changing companies as Liam? As such, your situation is more like Bob's. Bob has student loans, so he can not start taxable account investing until he is 30. Also, he does not change jobs as often, so his escalators are smaller than Liam's. Even so, investing using a lower-cost Robo-advisor is still meaningful. In Bob's case, the arbitrage is worth $1.8 million at retirement! Still very worthwhile!


The following are some notable investment stoic-based rules of thumb:

  1. Start as young as you can. Even small amounts of money invested when you are younger can be worth many multiples at retirement. The time value of money is powerful! (7)

  2. The "3 key things" discipline is important to maintain for decades. Consistency is important.

  3. Managing down college costs is critical. Unfortunately, there is significant misinformation floating around about "College as an investment." Please see our article The College Decision: Proceed at your own risk for more information.


Adaptability:

Being adaptable is a beneficial arbitrageur's mindset. The previous consumer finance-based arbitrage examples have certain long-term assumptions that may change. Keep in mind, a “bad” year or 2 does not mean the assumptions are wrong. These are long-term assumptions and I expect some years will be below average. But what if your analysis suggests different long-term trends? For example, the prior mortgage arbitrage example uses an assumption of 4.5% annual appreciation. But what if your favorite city is different? This Case-Shiller graph (8) demonstrates a pretty wide home appreciation dispersion between Phoenix, at almost 10%, and Chicago, at just above 1%. To achieve arbitrage value, your adaptability may mean:

  1. Geographic Flexibility: Willingness to move to higher appreciation rate areas. Again, a couple of bad years may not change your perspective, but taking a long-term view and adapting is helpful to achieving arbitrage value.

  2. Arbitrage Risk Management: Your adaptability will also help you manage risk. If a change occurs, your ability to adapt will be helpful to maximize your long-term arbitrage value. For example, from a home value standpoint, the pandemic may cause long-term trend changes. That is, from a housing standpoint, dense urban areas may not be as attractive and less dense areas may be more favorable.

  3. Adapting for the long term: In some cases, you may not immediately be able to complete your desired arbitrage. It is important to take a long view and implement as possible. For example, in the mortgage example, what if Jill does not qualify for the IO ARM? That’s ok, she can take out the closest qualifying product and seek an IO at her next refinance opportunity. Thinking in terms of “process, not perfection” is a stoic’s mindset. (9)


A concluding thought: Why should I use the Stoic’s Arbitrage?


So far, we have covered the Stoic’s Arbitrage framework, in terms of the stoic’s mindset, including education and learning deeply about your environment. Keeping in mind, your long-term financial health is not necessarily aligned to the profitability of consumer financial services companies or related providers. Once in the habit, you may apply stoic principles to your financial life. We provided a few high-impact examples in terms of building your consumer financial products knowledge and demonstrated a few stoic’s arbitrage scenarios to help you build significant long-term value. As shown in table (10), the Stoic's Arbitrage is real money and can be realized across multiple financial services products. Thinking long-term, or even multigenerational, is very helpful to clarifying consumer loans and related decisions. Remember, a stoic believes in using the power of knowledge to avoid getting played or taken advantage of.


You still may be wondering “why?”….what is the purpose of building long-term value using the Stoic’s Arbitrage? This is where the stoic’s kindness to others principle comes into focus. A stoic believes kindness to others is central to life. Building value and living in a modest, utilitarian manner can build your wealth capacity for kindness to others. While there are certainly other means to provide kindness, wealth will likely give you more options to deliver kindness to family, friends, and/or community. One of my favorite related bible verses is from 1 Peter 4: “Each of you should use whatever gift you have received to serve others, as faithful stewards of God’s grace…”


Your Personal Finance Journey Guide:


Core Concepts

1. Our Brain Model

2. Curiosity Exploration - An evolutionary approach to lifelong learning

3. Changing Our Mind

4. Information curation in a world drowning in data noise


Making the money!

5. Career choices - They kept asking about what I wanted to do with my life, but what if I don't know? - Part 1

6. Career choices - They kept asking about what I wanted to do with my life, but what if I don't know? - Part 2

7. Career success - Success Pillars - Maximizing luck with an adaptable mindset to reach your goals!

8. Career choices - Do I need to be a Data Scientist in an AI-enabled world?

9. Career choices - Diamonds In The Rough - A perspective on making high impact college hires


Spending the money!

10. Budgeting - Budgeting like a stoic

11. Car Buying - Auto buying and financing thoughts from a Behavioral Economist, a Banker, and a Dad

12. College choice - The College Decision - Framework and tools for investing in your future

13. College choice - College Success!

14. College choice - How to make money in Student Lending

15. Event spending - Wedding and event planning guiding principle


Investing the money!

16. Investment thoughts for my children

17. Using the Stoic's Arbitrage to choose a great investment advisor

18. Anatomy of a "pump and dump" scheme

19. The Time Value of Money Benefits the Young

20. How Would You Short The Internet?


Pulling it together!

21. Capstone - The Stoic’s Arbitrage: A survival guide for modern consumer finance products

Notes


(1) Consumer loans are the class of loan products provided directly to people, like credit cards, auto loans, home equity, mortgage, and student loans. A broader class of consumer financial services products includes investments and loans.

(2) See my Stoics Arbitrage Models found at the end of this article for assumptions and calculations. The end of year 65 accumulated principal balance is $303,997.

(3) I picked Drexel and VA Tech as examples, but I could have used many others. I picked them because my kids and immediate family members considered both of them, but did not attend either of them. They are both excellent schools.

(4) The tuition, room, and board amounts assume full payment is required. If scholarship or grants are provided, it is assumed each school and student has equal access so the comparative effect will net to 0. See my Stoics Arbitrage Models for assumptions and calculations.

(5) Or, in the case of student lending, the usage appreciation rate is uncertain. That is, some students graduate to underemployment.

(6) A PFA may claim they can beat the market. There is a tremendous amount of literature that suggests this is simply not true. But, even if they could, then they certainly would not be working as a PFA and chasing your business. They would be a mega-billionaire living on an island.

(7) See our article The Time Value of Money Benefits the Young for more information.

(8) Sources: S&P Dow Jones Indices and CoreLogic, data through August 2020

(9) This reminds me of the Pareto Principle and Voltaire's famous aphorism, "Perfect is the enemy of good." See my Jeff's Favorite Aphorisms.

(10) This table is aggregated from the prior examples. See my Stoics Arbitrage Models for assumptions and calculations.


The Stoics Arbitrage models (2)
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