Thursday, October 28, 2010

Bogle on Target Date Funds

Target date mutual funds, or those whose asset mix changes in order to fulfill a fund's target date investment objective, have been a hot innovation in the mutual fund industry in recent years. After all, it's awfully convenient for investors to buy a target date fund based on their retirement yet (or some other goal), plow money into it and not worry about the legwork.

Unfortunately, this is where many investors are in the wrong because they do not do the necessary legwork and simply take the fund's objective at its word. This is a dangerous strategy because as John Bogle points out, many of the funds may own investments that you wouldn't touch on an individual basis.

After all, if a target date fund has a target date of 2050 or beyond, the fund is likely to be very aggressive given its long time horizon. In order to be aggressive, the fund has to take more risks, sometimes more than the investor in the fund realizes. A better option is to find the target date funds which own a basket of index funds whose allocation percentages change as the target date gets closer. In fact, this is what Bogle advocates and as the "father of index investing", who better an authority to trust on the subject?

Wednesday, October 27, 2010

Looking Beyond TIPS

On Monday, Treasury Inflation Protected Securities (TIPS) were auctioned for the first time at a negative yield. This means that the Treasury note will only have a positive return if consumer prices jump up more than half a percentage point. TIPS are a way to hedge against inflation because the Treasury securities' par values are indexed to the Consumer Price Index (CPI). With this, you are getting a low risk investment in the form of a Treasury security that also protects you from the ill effects of inflation.

Writing in The Wall Street Journal, Ben Levisohn notes that commodities, currencies and dividend stocks are three other investment areas that may protect you from inflation should the negative TIPS anomaly continue to play out.


I agree with the notion that dividend paying stocks are a good way to fight inflation and by buying a basket of them either individually or via an ETF, you're going to share in future dividend growth which will likely outpace inflation.

The best way to do this when building an individual basket is to buy dividend paying stocks of blue chip, consumer-related names. Basically, companies that make recession-resistant products such as food, personal care and medical items and the like, are all likely to continue to grow dividends faster than the inflation rate which will act as a natural hedge against inflation. Be careful not to put "too many eggs in one basket" and instead diversify around the basket of dividend paying stocks so as to spread out risk. Buying dividend paying stocks to hedge against inflation will likely prove to be a wis
e long-term investment as the potential for longer-term capital appreciation is there, as well.

Tuesday, October 26, 2010

Buffett Chooses Successor?

This morning, Warren Buffett, the billionaire investor who runs Berkshire Hathaway has announced the addition of hedge fund manager Todd Combs to his team. Combs, a 39 year old who runs a long/short financial services-focused hedge fund will join Berkshire immediately.

This news is quite interesting because at 80 years old, Buffett is in need of a successor to run the investment portfolio at Berkshire when he is no longer able to do so. Combs is an interesting choice and someone whose name I've never heard mentioned with Buffett's before. It will be interesting to see in what type of capacity Buffett chooses to put Combs, but if he has the Oracle's seal of approval, it's likely he'll play a significant role in portfolio management going forward.

How does this news impact Gen Y? When the world's greatest investor announces a new addition to his investment team and someone that's likely to play a large role in portfolio management at Berkshire in the future, you tend to listen. Even more interestingly, Mr. Combs is only 39 years old - could he be the next big star in the financial world?

Monday, October 25, 2010

The Bogleheads Meet

Investors who follow Vanguard founder John Bogle's investment advice are often referred to as "Bogleheads". There have been books written by Bogleheads, and the faithful followers even congregate at an online message board - www.bogleheads.org - which was an offshoot of the original Morningstar.com "Vanguard Diehards" message board.

Forbes has a great article from Laura Dogu, a writer and leader on the online Bogleheads' forum, which recounts the recent gathering the group had in Pennsylvania. The Bogleheads' are a great group of people following the excellent advice given by one of the champions of the individual investor - John Bogle. The article is worth reading because Bogle's advice is so worth following.

Thursday, October 21, 2010

Bad Advice: Creating Your Own Hedge Fund

CNBC has an article on how to build your own hedge fund which tops the list of potentially devastating investment decisions you can make. Hedge funds are investment vehicles typically limited to high net worth investors which can use a variety of investment strategies that the average investment fund cannot. These funds can employ large amounts of leverage, short stock and trade derivatives, among many other things. While we have all heard of the wildly successful funds like Ken Griffin's Citadel Investments or John Paulson's Paulson & Co, there are thousands of funds that fail for each one that revels in exorbitant returns.

Retail investors are at a disadvantage to hedge funds and other institutions because those firms typically have large amounts of capital to move around and with that capital comes speed, efficiency and information flow which helps them make money on their trades. Secondly, the people who run hedge funds are typically brilliant financial minds, and while brilliance does not equate to consistently posting market beating returns, the minds at hedge funds usually understand the nuances of the securities and markets in which they trade.

All of these reasons make CNBC's article - how to start a "poor man's" hedge fund - ridiculously bad. After all, if the financial crisis saw many of the aforementioned brilliant managers blow up given large derivatives exposure, how can the average retail investor navigate the derivatives market successfully? In short, we can but the odds are against us. More importantly, who has the time to bother to trade and understand currencies, commodities and long and short positions? The pros at the large hedge funds do - they employ thousands of experts in each market - but the average investor like you and I certainly have more important things to be doing.

Sure, creating your own hedge fund sounds like a neat idea. The thrill of beating the market as well as the pros at their own game, certainly holds a lot of appeal. However, when you realize that the odds of this occurring, especially with any consistency, are slim to none, why not save yourself the time and aggravation involved in this endeavor and instead just buy index funds?

Tuesday, October 19, 2010

Are Allocation Funds a Good Option?

Morningstar.com has a very good article on Vanguard's allocation funds - mutual funds that strive to maintain a set asset allocation over the life of the fund, or tweak it according to the fund's mandate. For example, Vanguard has a series of "LifeStrategy" funds which invest in other Vanguard index funds to achieve a stated goal. The Vanguard LifeStrategy Growth Fund (VASGX) therefore has roughly 85% of its assets in stocks and 15% in bonds and is aimed at investors who have investment horizons greater than 5 years. These funds have grown in prominence because all of the work is done for you at a minimal fee - the fund rebalances itself according to its stated objective and you get the added diversification of owning a fund of funds - yes, a mutual fund that owns more mutual funds.

The Vanguard LifeStrategy Growth Fund owns four separate Vanguard index funds in varying proportions and only has an expense ratio of 0.23%. The risk with allocation funds are that you view them too much as a one stop shop and pin all of your investment goals and expectations upon the fund, which otherwise may be unrealistic. Yes, allocation funds can be a great start but make sure you do the legwork to understand the fund's fee structure, rebalancing policy and what it actually owns. The potential for overlap - owning a fund that's already owned elsewhere - is a lot higher when dealing with a fund of funds - people may not realize what that fund owns in its entirety.

Monday, October 18, 2010

Take the Free Money!

It's been said that there are "no free lunches on Wall Street" and that is indeed very true...except in one circumstance. Granted, this isn't a "fully" free lunch - you're not getting something for nothing - but it's basically free money. So what am I talking about? The answer: taking advantage of your employer's matching 401(k) contribution policy. If your employer matches your 401(k) contribution, you're basically receiving free money. While you do have to contribute something to be eligible to be matched (hence why it's not entirely "free"), there isn't a single sound argument out there as to why you should avoid contributing so as to receive the match.

In a weekend article in The Atlantic, Daniel Indiviglio points out the following:

"When your company promises to match some contribution to a 401(k), it's like giving you a raise. Refusing the match is like telling your company that you don't want extra money. Imagine an example where you make $1,000 per paycheck. Now imagine if your company agrees to match 50 cents per dollar up to 6% of your 401(k) contribution per paycheck. That means you can put up to $60 per paycheck into your 401(k) and your company will also contribute $30."


If your employer offered you free money, wouldn't you take it? If your employer does indeed match your 401(k) contributes, you should max out your contributions so as to receive the highest employer match possible. In doing this, you'll be well rewarded in the future when your retirement goal is attainable at a younger age
.

Thursday, October 14, 2010

Avoiding 10 Dumb Money Moves

Stacy Johnson at MoneyTalksNews has a great list of "10 dumb money moves". All of them have merit in one way or another but #5 in particular stood out to me:

5. Starting to save large and late rather than small and soon
If you're 25 and you save just 5 bucks every day ... call it $150 a month ... and earn 10 percent, by the time you're 55, you'll have $340,000. If you wait till you're 45 to start accumulating that same 340 grand, you'll have to save $1,700 every month for 10 years. True, you can't earn 10 percent today, at least without risk. But over time and by taking a measured amount of risk, you can.

I can't emphasize enough have important starting early is. Most people don't realize that even if you start with a small amount now, you'll have plenty of years to watch that money compound and you'll ultimately wind up with a lot more than you started with. For example, if you start with $1,000 at age 25 and add $5,000 yearly at an average return of 7% until you retire in 40 years, you'll wind up with $1,013,150.02 - yes, you'll be a millionaire! Granted, that calculation doesn't take into account the effects of inflation, but building a million dollar nest egg to retire on while only starting with $1,000 is quite impressive. The list may point out "dumb money moves" but all of them are easy to learn from and to correct.

Wednesday, October 13, 2010

Gen Y and "The Scarring Effect"

During recessions, Gen Y college graduates are likely to make 5%-15% less than those starting out during a better economy. A recent Wall Street Journal article noted that, "Notre Dame labor economist Abigail Wozniak calls it 'the scarring effect.' If you graduate in a good year, your career may get off to a strong start. But if it's a bad year, you are essentially scarred in the labor market for years to come."

This is indeed very scary for Gen Y because it means that we as individuals simply cannot control our own destiny. Growing up, we are taught that we can accomplish any goal that we set our mind to. When we are preparing for college, we get to pick our university, our degree program and the types of people that we associate with during those years. What this research is telling us, is that regardless of how hard we work and how many connections we make, it all may not be good enough if the job market is poor when we graduate and we either don't get a job or make substantially less than we would have had the economy been growing.

Unfortunately, this is the state of the labor market for recent college graduates. However, when the economy starts to hum again, it's likely that salaries will increase across the board because the same companies who weren't looking to hire when we graduated will then have to raise their price of labor in order to reach a supply/demand equilibrium.

Tuesday, October 12, 2010

Pfizer Keeps Making Deals

Mergers and acquisitions always interest me because I like to see the structure of the deal - how much stock and cash are involved, who's acquiring who and why and also because such deals also tend to indicate economic strength or weakness. This morning, drug giant Pfizer (PFE) has announced plans to acquire King Pharmaceuticals (KG) for $3.6 billion in cash. Amazingly, this comes exactly a year since Pfizer's deal to acquire Wyeth last year for $68 billion closed.

Companies that are flush with cash - particularly those involved in health care related fields - are putting more money to work to grow their portfolio of products to cope with the sour economy. In acquiring King, Pfizer gains venerable products in Avinza, a pain drug, and EpiPen the well-known injection used to treat allergic reactions. Interestingly, pharmaceutical companies have worked hard on acquiring both established players (Pfizer buying Wyeth) and biotech firms who may have potential blockbusters waiting in the pipeline (Sanofi-Aventis bidding on Genzyme). Since bringing a new drug to market is quite costly, many times it's easier buying a biotech firm who's already involved in extensive clinical testing of their potential drugs.

This news may seem like your run of the mill big pharma deal, but it also shows that the most cash-flush companies are willing to put large amounts of capital on the line to better position themselves for an economic turnaround.

Monday, October 11, 2010

Understanding Investment Risk

Today, Chuck Jaffe wrote in The Wall Street Journal about a variety of different investment risks and made the case that investors are investing at precisely the wrong times because they don't understand the risks inherent in investing. Ultimately, on average, the riskier an asset, the higher potential return that comes along with it. It's impossible to eliminate all investment risk - even if a portfolio is diversified properly - as you will still face "systematic" risk or the risk that's inherent to the entire market.

Jaffe makes an excellent point in saying that "People will say they can tolerate risk, so long as they don't experience losses. They will settle for a near-zero return in a money-market fund because it is better than posting a loss without recognizing that they are losing buying power—ultimately the same impact as a loss-every day their investments fail to beat inflation."

Yes, investment risks encompass a variety of forms but one of the most important that Jaffe highlights is purchasing-power risk. If an investor is afraid to put any money in the market, they will commonly hoard it away in a seemingly "safe" investment vehicle like a savings account, CD or simply withdraw the cash entirely. This is a bad move for a variety of reasons, but the biggest is because inflation will likely erode the long-term purchasing power of the dollars as the interest earned on any bank deposits won't keep up with the rate of inflation. 


In fact, today, 5-year CDs are only averaging 2.40% according to BankRate.com. If inflation is 4% over the next 5 years, you wind up losing 1.60% on an investment that you deemed "safe". Worse still, depending on the policies of your bank, you probably won't be able to withdraw money from your CD without incurring a penalty and you will be locked in at the stated interest rate for the 5-year term. Thus, it's important to understand the risks you face when investing because they can take shape in a variety of different ways.

Friday, October 8, 2010

Economy Sheds More Jobs

The U.S. lost 95,000 jobs in September, much worse than the anticipated drop of 5,000 that was the median estimate of economists surveyed by Bloomberg News. The government continues to cut temporary Census hires and the private sector's employment growth is lagging.

This news tells me that the much-anticipated economic recovery is still faltering. Fiscal support from government stimulus quickly wore off and the unemployment rate, sitting stubbornly at 9.6%, will get worse before it gets better.

Interestingly, while the economy remains deep in the tank, the stock market has performed well. The
Dow Jones Industrial Average (DJIA) is nearing 11,000 and stocks' reputation as a leading indicator may indicate a quicker economic recovery than some economists are forecasting. A more likely explanation, however, is that the round of cost cutting that companies initiated in response to the recession has lead to higher earnings all around and subsequently, an expectation for higher profits once these leaner companies start growing again.

Have a great weekend! Enjoy the football games. Geaux Tigers!

Thursday, October 7, 2010

ETFs vs. Index Funds: Expenses Matter

The Wall Street Journal recently had an article extolling the virtues of exchange traded funds (ETFs). Basically, ETFs are baskets of stocks that trade openly on an exchange. Most of them are like index funds in that the ETF tracks a specific index by holding the stocks in the benchmark index in proportion to their weight in it. For example, the Vanguard Total Stock Market Index (VTSMX) has an ETF counterpart, the Vanguard Total Stock Market ETF (VTI) which trades all day just like a stock. This can be a good or bad thing. When you send money in to buy a mutual fund, your trade is typically processed at the price at the end of the business day in which your money is received. The constant price changes in an ETF make it appeal to traders who may play the continuous price movements by buying and selling constantly.

However, as a rule, the one time I will recommend an ETF over its index fund counterpart is when the ETF has lower expenses associated with it. For example, the article mentions how "the average ETF expense ratio is 0.6% of assets, compared with an average 0.8% for traditional index funds, according to investment researcher Morningstar." This amount will differ on a firm by firm basis, but the lower the expense ratio, the better. However, make sure that you're not incurring any type of substantial commission by buying the ETF - after all, purchasing an index fund through a firm like Vanguard is free - you will simply incur year end expenses deducted from your fund's assets.

Wednesday, October 6, 2010

Vanguard Cuts Fund Fees Further

There's some great news out there today for individual investors: Vanguard, the index fund giant, has announced that they are cutting fees further on most of their index fund offerings. They are doing this by cutting the minimum investment required for their Admiral shares. Before the cut, it required $100,000 to invest in the Admiral shares but now it will only be $10,000. Amazingly, the AP report states:

"For example, Admiral shares of Vanguard's Total Stock Market Index Fund will charge $7 in annual expenses for every $1,000 invested, provided an investor has at least $10,000 in the fund. That's down from $18 in annual expenses for Investor shares in the $138 billion fund, which requires a minimum of $3,000."

Yes, that's only $7 in annual expenses for every $1,000 invested or about 0.007%! It's important to remember that these fees are deducted directly from the fund's assets and are not charged so that you have to write a check to cover the expense amount. Overall, this is fantastic news for retail investors who have seen fees and expenses skyrocket in recent years. It's clear that Vanguard "gets it"!

Tuesday, October 5, 2010

More Parents Raiding Retirement Accounts for College

A study released today by student loan provider Sallie Mae and the Gallup Organization shows that 25% of the nation's parents are now raiding their retirement accounts to pay for their children's education, regardless of the tax consequences. This news is disconcerting on a number of levels, namely that parents don't have enough money saved up elsewhere for college but also because of the large tax burdens that can arise from tapping a 401(k) or IRA prematurely.

Even worse, parents are using investment vehicles that have a dubious track record when it comes to producing the returns needed when college comes calling. CNNMoney reports that "the most common way that parents reported saving for college was with CDs or general savings accounts. Some 50% used those more traditional forms of saving, according to the survey." Adjusted for inflation, these savings accounts aren't going to produce the returns necessary for a tuition payment. Thus, that means that parents using them will have to save that much more, just to be in the ballpark of a tuition payment.
The moral of the story? Save early and often for whatever goal you would like to achieve so that you're not stuck tapping funds that should be used only for retirement.

Monday, October 4, 2010

The Difficulty of Decision Making

Shirley Wang at The Wall Street Journal has an interesting article on a psychological issue - the difficult nature of decision making. A lot of the information in the article pertains to investing, as well. Generation Y may find that it's very difficult to make the tough decisions about financial issues because so much seems to be at stake. After all, if you plan incorrectly, have a mix of the wrong investments or the like, you risk financial ruin at a very young age. However, high stakes do not have to mean that decision making should be difficult.

Ultimately, almost everything in the world of individual investment can be whittled down into investment policy - the act of defining long-term financial goals and the means by which to achieve them. Every investor both young and old needs to have a sound investment policy. So, what does that policy consist of? As investors, we must first develop financial goals. For example, a goal may be that you would like to retire at age 55 with a nest egg of $2 million. Secondly, we should outline the appropriate ways to achieve those goals including the investments that we can use to help us get there. Lastly, we should determine the exact investments to put into our overall asset allocation and evaluate them accordingly.

This is a simplified way of creating a sound investment policy but you will find that if you work hard on it now, the amount of work required in the future on it will simply be a matter of tying up the loose odds and ends. Yes, it may be difficult to make decisions. With a rock-solid investment policy, it doesn't have to be.

Friday, October 1, 2010

The Moral of the Story Is...

A few days ago, The Wall Street Journal's Brett Arends penned an article entitled, "You Should Have Timed the Market". Arends bases his assertion on the fact that recent research from TrimTabs indicates that regular investors bought into equity mutual funds during the boom and needlessly sold them when everyone was panicking and selling their positions. As a result, investor losses were pegged at $39 billion.

Arends points out that TrimTabs, "calculates that mutual fund investors bought into the Standard & Poor's 500-stock index at an average of 1,434. That's close to its record high of 1,565. If investors had invested at random times instead, their average purchase price would have been 1,171."

The conclusion shouldn't be that we should time the market. Yes, we should buy when everyone else is selling. As was famously said, you should buy stock when "there's blood in the streets". However, by tacitly agreeing to market time, you are setting yourself up to head down a very slippery slope. By engaging in this, you'll soon see that you find yourself jumping into and out of equities at precisely the wrong times because your emotions play such a big role in investing.

For example, suppose you've held a stock for a few years and have done extremely well with it. You have done the appropriate research and realize that the stock is still undervalued and so you continue to add to your position. When the company releases a poor earnings report, should you sell because everyone else is? Of course not! It's almost always a bad bet to follow the herd and to let your emotions get the best of you. You should always have the courage to stick to your convictions until the underlying fundamentals prove otherwise.

Instead, rather than "timing" the market as Arends advocates, it's a better idea to dollar cost average (DCA). With this, you simply buy into your investment (index fund, stock, etc.) without paying any attention to the price. This is helpful because you'll find that over the long-term, your average purchase price will be quite small and it will make up for any of the problems you would have had if you had tried to time your purchases based on the prevailing "wisdom" in the market. Dollar cost averaging beats market timing - always.