Tuesday, October 4, 2011

It's Time for Some Inaction!

Like most people, I'm finding it very hard to distance myself from the grim news that has dominated the financial headlines over the past few months. Everyday seems to bring another story of a European bank or country on the brink of failure, the U.S federal government's fiscal issues leading the country to the verge of financial meltdown and more and more bad news on the economic front. It's safe to say that all of this is leading to heartburn for many investors, particularly those who are most exposed to equity markets and have thus received the brunt of the market's move to the downside. 

We will thus hear the requisite talking heads on CNBC and other financial news networks extolling the virtues of "buying aggressively" or from the opposite end of the spectrum "moving assets into cash, Treasuries, precious metals and other safe havens". My advice to you is relatively simple and may seem to go against the grain but it's battle tested and makes sense: simply stay the course, continue with your investment plan and let the market work its issues out. 

As soon as we become reactionary and allow market movements severely dictate how we invest in the here and now, we have let our emotions get the best of us. This is not to say that we shouldn't put some more funds to work since stock prices are low - in that case, it may make sense to buy some more shares of your index funds to better dollar cost average - but avoid any actions that run contrary to what your investment plan is. If, for example, you contribute 10% of your pre-tax pay to your 401(k), it may make sense to up that percentage to 15% or so if you can afford to do that. However, slashing that rate to 0 or upping it to 30% simply doesn't make much sense. Believe me, that type of reaction to current market gyrations occurs a lot more frequently than you realize! As the legendary John Bogle noted, "Don't do something. Just stand there."

Wednesday, September 28, 2011

Wall Street's Flavor of the Week

It seems like it was just yesterday that John Paulson was the darling of the investment community, earning billions of dollars in personal profit and causing fellow institutional investors to hang on his every word and action. How times have changed! A headline on WSJ.com today states, "Rivals Scout Paulson Assets" - if that doesn't sound dire, I don't know what does! I've brought this subject up before but it bears repeating because it shows how fickle investors are - you can be the "can't miss" investment manager one day and a goat the next. 

On Wall Street, you're only as good as your last trade. This goes for all types of investors and helps make the case for passive management much easier. After all, a handful of institutional investors - from hedge fund managers to mutual fund managers - are wildly outperforming their benchmarks at any given moment. The question then becomes how much staying power do those managers have; in Paulson's case, it appears, only a couple of years worth. In the case of the actively managed mutual fund manager, the same is true. It was only a few years ago that Bill Miller, the manager of Legg Mason's Value Trust had his 15-year streak broken of beating the returns of the S&P 500. From 1991-2005, Miller's fund posted returns that were greater than those of the index and was lauded in the press as an investment titan. There is no doubt that Miller is a great finance mind but even he admits that much of his streak was due to luck: "As for the so-called streak, that's an accident of the calendar. If the year ended on different months it wouldn't be there and at some point the mathematics will hit us. We've been lucky. Well, maybe it's not 100% luck—maybe 95% luck."       

The problem for investors like you and I comes when we're tasked with picking the managers who can consistently outperform year in and year out. Here's some food for thought: What's amazing about Miller's success is that consistent outperformance is so rare (1 in 2.3 million, according to Michael Mauboussin), yet the ultimate goal of most individual investors is to invest in mutual funds that can post that type of outperformance...which never comes. If that's the case, why are we throwing good money after bad?

Sunday, September 18, 2011

It's Much Easier to Spend What's Not Yet There

Much of what there is to be learned about managing your finances properly comes when we tame our emotions and focus on the psychological aspects of financial decisions. A mistake that many people make when they get paid is that they have much of their cash on the way out as soon as it comes in. This typically happens when an individual has credit card bills and other debts to pay. The easiest way to avoid this type of occurrence is to make sure you only charge to your credit card(s) that which you know you can easily pay back when you have income come in. Secondly, even if you find yourself stuck with some bills, be sure to keep contributing to your 401(k) for the tax and compounding benefits and save a set percentage of every paycheck for an emergency fund. Ultimately, the 401(k) and emergency fund contributions are two cash "outflows" that shouldn't make you feel bad because by making them, you're only helping yourself. 

By not "segmenting" (outside of the 401(k) and emergency fund contributions) your money before your actual paycheck is deposited, you will immediately begin to see substantial savings. After all, it's much harder to spend money when you can actually see your account balances declining with each purchase, rather than simply thinking about it and accounting for it later at which point you'll likely realize that most of your paycheck is gone before it's even arrived!

Monday, September 12, 2011

The Benefits of the High-Yield Index Fund

Many people are often faced with the seemingly difficult situation of trying to maximize their income due to lack of sufficient cash flow. This becomes even more of a problem as economic growth slows and employers lay off workers and cut salaries in order to help manage their cost structures during a downturn. Luckily, there are some investments that offer regular distributions that can help add a few extra dollars to your household balance sheet every month.

One such investment is a high yield bond index fund. High yield bonds - also known as "junk bonds" - are the debt of corporations and other entities that may be experiencing financial distress. As a result, investors receive a higher interest rate as compensation for the greater risk to their invested cash. As Rob Williams, director of Income Planning at Schwab notes, "Defaults on investment-grade bonds have historically been low, though the frequency increases as credit quality declines."   

Better still, the diversification of a high yield bond index fund ensures that if one issuer were to default, the likelihood of a significant impact on the rest of the portfolio is minimum. How do such funds help maximize current income? The funds pay out their distributions monthly and in the case of the Vanguard High-Yield Corporate Investor Shares (VWEHX), currently yields 6.91%. Thus, even though the numbers might appear small in the beginning - only $30 or so extra a month on a $5,000 investment - you have the choice of taking that cash every month to maximize current income or reinvesting it to help your stake compound which will lead to even higher passive income amounts in the future. 

Overall, high-yield bond funds are a much better avenue for investing in high yield securities due to their overall lower risk profile, low fees and impressive long-run returns

Monday, September 5, 2011

Helping Kids Understand Credit

A recent WSJ article regarding kids and credit cards piqued my interest and led me to think more about the role that parents play in shaping their child's view of money and finances. The old saying goes "the apple doesn't fall far from the tree" and in the world of financial learning, that is indeed correct. Much of what children learn about spending in their formative years comes via observation. If they observe their parents engaging in profligate spending, they are more apt to believe that is OK behavior because they have little understanding of cause and effect. After all, if they are still living in a comfortable home with nice clothes, food on the table and toys to enjoy, they will likely take that as a confirmation that their parents' spendthrift ways are rational behavior. Similarly, if a family carefully watches its budget while still providing the same nice clothes, food and toys in a household, a child will take this as confirmation that their parents' budget consciousness is important. 

Children are very impressionable. If they see you reaching for a credit card every time you go out to shop, they will begin to think that credit cards are an instant source of money (they are) but it's up to you to set the example and teach them that when the time comes for them to get a credit card, its balance should be paid off in full every month. 

This is a problem that confronts Gen Y parents in particular because we are gradually moving away from a monetary system based on physical dollar bills. Instead, the majority of consumers are more likely to use electronic payment methods such as a debit or credit card to pay for a store purchase. This has its pros and cons but there is one key thing I would recommend all parents do: before exploring credit cards with children, teach them about saving and spending the old fashioned way - with cash. There is much greater regret among children when the $10 bill they were given is spent than if it were simply accounted for via swiping a card. It may be old fashioned, but it certainly worked for me when I was a child!

Tuesday, August 30, 2011

Debunking Financial Myths

I came across an interesting and informative article the other day - "10 Financial Myths Debunked". An especially relevant myth is assuming long-term average stock market rates of return of 8 percent as are certain rules of thumb when planning for retirement. 

Point 4 is relevant because most people are way too optimistic when it comes to calculating potential rates of return during retirement planning. From a young age, it pays to err on the side of caution and assume anywhere from a 5-7% long-term rate of return on your portfolio. If you have the time, use a financial calculator to plug in your current investments, time horizon and potential rates of return from 5-7% and see where you end up during the year you plan to retire. By assuming a smaller potential return, you will be able to set up the best possible plan to reach your goals and ensure that your investments don't overpromise and underdeliver.

It's also worth noting that "rules of thumb" in the investment world are rarely worth the paper they're printed on because each person is different and the world is not static. Since the world we live in today will be drastically different than the world we will live in 40 years from now, it's not worth prescribing to certain rules that simply can't change with the times. For example, it's impossible to tell what type of health we will be in, what our family situation will be like and how the world will really be so far into the future. Thus, we should plan our investments out based on our own goals and risk tolerances, while avoiding "catch all" rules of thumb that don't accomplish much.

Saturday, August 20, 2011

Navigating Your 401(k)

As a new entrant into the working world, I was recently faced with the task of figuring out what my 401(k) options were and deciding on an asset allocation appropriate for my age. Asset allocation decisions are such that if you ask 50 different experts for opinions on what an appropriate asset allocation is for a 22 year old, you are going to receive 50 different answers. The key in deciding on an appropriate allocation in your 401(k) is to take advantage of the opportunities you have as a young investor. 

First and foremost, I cannot stress enough the importance of maxing out your 401(k) contributions each paycheck while you are young. While preparing a monthly budget, you should decide on a pre-tax contribution percentage that will enable you to achieve maximum savings while at the same time ensuring you are not cash poor when all is said and done. For example, if you earn roughly $2,000 a paycheck and contribute 10% of your pre-tax pay to your 401(k) then that's an automatic $200 investment every paycheck. If you get paid twice a month, this adds up to $4,800 a year. The beauty of this is that the percentage is taken from your pre-tax pay so that you achieve maximum savings benefit and as a result, pay less taxes because you are no longer taxed on the $2,000 you would have earned, but on $1,800 instead. I encourage you to calculate what percentage you can afford to contribute and then maximize that - the benefits of the long-term time horizon you have are many.

Now comes the part where you need to decide what to invest in. While your plan sponsor may encourage you to invest in an target retirement fund, I would first check the total expense ratio of such a fund and its holdings. If the fund is actively managed, it is likely to have higher costs and may tend to drift away from its stated objectives as the underlying funds ebb and flow with the markets. Your best options are index funds and I would recommend an asset allocation along the lines of: 60% total stock market index fund, 30% total international index fund and 10% total bond market (or high yield) index fund. This asset allocation, while only a suggestion, will give you a broad exposure to the U.S. stock market, international stock markets and provide some bond exposure which you are likely to increase over time.

Saturday, August 13, 2011

The "Experts" Can Be Wrong

I came across an article in the Wall Street Journal earlier in the week detailing the performance of some key hedge funds as they deal with the bumpy ride the stock market has offered up lately. Amidst all of the volatility, some funds have scored impressive gains by having investments in traditional safe havens like gold and Treasuries. 

Meanwhile, John Paulson's firm, Paulson & Co. has dealt with the opposite - severe underperformance to the tune of -31% at his Advantage Plus fund and -21.5% at his Advantage Fund. This serves to demonstrate how difficult it is to beat the markets, even for the experts. After all, Paulson was the fund manager who racked up very impressive gains during the mortgage market meltdown that lead to a person windfall upwards of $5 billion + dollars. 

Thus, this news should give individual investors some comfort because many successful professionals who manage money for a living are having a very difficult time outperforming in such a weak environment. If the experts can't consistently outperform, why should you try to and even more importantly, why even try to pick managers who try to beat the market? Sometimes it takes a volatile market and large gyrations in stock prices to help reinforce key investing principles. 

Sunday, August 7, 2011

Change is Constant

If one thing is certain about the financial markets, it's that change is constant. We are likely to see many changes and new developments over the next few weeks, especially in light of S&P's downgrade of the United States' credit rating from AAA, the safest possible rating, to AA+, one notch below. 

While we can't know of any of the changes that are likely to take place, it helps to have some perspective and take solace in the fact that in 2008, when things were much worse, we were able to recover from many major firms failing, or coming dangerously close to it including: Bear Stearns, Lehman Brothers, AIG, Washington Mutual, Wachovia, Merrill Lynch, Fannie Mae & Freddie Mac and many more. While much of the current crisis is centered on the shortcomings of policymakers in Washington, much of the blame can also be passed along to the Eurozone, whose financially secure members are forced to bear the burden - including potential bailouts - of those nations facing insolvency. 

Going forward, it helps to look back on the 2008 financial crisis and realize that things are much better today than they were then. Ultimately, the United States rebounded strongly and was able to prosper in the wake of such difficulties; hopefully we are able to do much the same now.

Saturday, July 30, 2011

You and the Debt Crisis

By and large, I have told readers that it's important to avoid paying too much attention to the headlines and instead employ a long-term approach when looking at investments and the financial markets. Our collective will in executing that has been shaken lately by dire news reports ticking down the hours and minutes to when the United States may potentially miss its first debt payment and in effect, will be considered in default on its financial obligations to its creditors. 

While this news is indeed scary, it's not something that should shake your confidence too much for two reasons. First, if the market was taking such a prospect as seriously as the media makes it out to be, then the major market indices would have shed much more of their value in the weeks leading up to the August 2nd deadline. I look at it this way: based on the efficient market theory, everything that can be known about an investment or the market in general is already priced into it because of the speed and efficiency of information flow. Even the bond market, while under plenty of pressure given the uncertainty, has not seen the types of wholesale declines that would indicate a default was imminent. 

Secondly, we must not kid ourselves. Lawmakers in Washington know how much is on the line and how disastrous a default would be, and while there has been much political grandstanding and theatre throughout the process, at the end of the day, a deal will be cut, especially if it means preserving re-election chances for many of the incumbents. Unfortunately, this is how Washington works and the media likes to capitalize on the uncertainty. Don't fall victim to the circumstances which don't seem that dire after all. 

Saturday, July 16, 2011

Weekend Reading: Gen Y's Conundrum

A July 11th blog post at the WSJ's "Real Time Economics" blog caught my eye as it noted that most of the income growth in the United States from 1975-2009 was achieved not through wage increases, but through overtime (i.e. working longer). This conclusion was reached by the Brookings Institution's Hamilton Project which noted the following:

"Although median wages for two-parent families have increased 23 percent since 1975, the evidence suggests that this is not the result of higher wages. Rather, these families are just working more. In 2009, for instance, the typical two-parent family worked 26 percent longer than the typical family in 1975."

This news is especially sobering for Generation Y for two reasons. First, since the data was taken from 1975-2009, it does not include the last year and a half of dismal unemployment data which further suggests that a recovery might take awhile to form. Since an extra year and a half of work data was not included, the results are likely even slightly worse than the 1975-2009 data indicates. Secondly, Michael Greenstone, the MIT economist who runs the Hamilton Project notes that, "The long-run decline in wage opportunities has put lots of pressure on families. People are adjusting, but they’re adjusting in ways that we might not like very much. All of that points away from a vision of the American dream where each generation is doing better than the last." 

Unfortunately, that last line should serve as a wakeup call to Generation Y. While it's common to see each successive generation better off financially than the last - this new data suggests that such progress may skip our generation entirely. 

As scary as that sounds, it simply means that as a generation, we need to alter our expectations, especially from an investing perspective.  On this front, my number one recommendation to Gen Y investors is to use a 7% long-term average rate of a return in all investment calculations so as to avoid any type of unreasonable optimism and to build a cushion into all assumptions. The worst feeling in the world is building an investment plan that assumes a rate of return that is much higher than what actually happens. A 7% return is reasonable since the 10-11% long-term average rates of return that we used to see seem to be a thing of the past; now, more than ever, it's better to be safe than sorry!

Friday, July 8, 2011

Building Wealth Can Be a Slow Process

One of the toughest things for many Gen Y investors to accept is that building wealth is exactly what its name implies: a process, sometimes slow, that starts with something small and ultimately grows to something much bigger. Much of the time, we're put out of a touch with reality when we hear stories of instant wealth being "made" either by investors, company founders or the like.

This all highlights an important principle: it's easier to make money when you already have it. However, do not fret! Just because you're not starting off with a billion dollars does not mean that it's impossible to become wealth; just the opposite, in fact. Just because building wealth can be a slow process does not mean it's the wrong process. Being cautious but at the same time well-calculated, meaning you have an asset allocation that fits your tolerance for risk but also allows you enough flexibility to enjoy the here and now, will ultimately make you a better person and investor.

Many readers know that I like to use examples to illustrate why even though building wealth may seem "slow" it ultimately pays off. Consider an investor who begins with $5,000 at at age 22 and is able to earn a 7% return without adding any additional capital. Of course, 99.9% of investors reading this blog will actively add to their nest egg over time, but this example proves that even if our investor doesn't, the magic of compounding still works. After 40 years, our investor would have $74,872. Now, some people might ask what the point of investing and saving is if we can't enjoy today. My response is simple: give yourself enough flexibility to enjoy today - set aside a comfortable amount of discretionary income per month so you can go away on a trip, buy a new TV or do whatever else you'd like to do - and by investing the rest today, you'll ultimately ensure a much earlier retirement than age 62.

Thursday, June 30, 2011

The "Best of Both Worlds"? - There's No Such Thing!

Every once in awhile I come across a personal finance article that offers up shockingly bad advice which, if followed, would do much greater harm to an investor’s situation than it would to help them. A recent Forbes article does just that in claiming that there is a way to have “the best of both worlds” between actively and passively managed investment strategies.

As a passionate indexing advocate, my interest was piqued. The strategy is presented as follows: rather than invest in international stock funds, simply buy 10-30 foreign stocks according to the weightings of your favorite international mutual fund. The writer sums up the strategy’s “benefits” - “by avoiding the high fees of an actively managed fund, investors who buy a diversified portfolio of individual stocks are getting much of the same low cost advantage as index fund investors.” In reading that, I was speechless. Why recommend a much more difficult and costly strategy when it’s already been stated that your goal is to replicate the low-cost strategy of the index fund? Why not just buy an index fund?

Not only is this bad advice for obvious reasons – assets are being spread too thin and high transaction costs eat away at returns (the strategy is by no means low cost), it goes completely against the tenet that investors should keep investing
simple. How is this strategy “the best of both worlds” when it so obviously involves actively managing your portfolio? After all, the investor is picking both the fund to replicate and the stocks to own when managing their money.

The writer even notes “owners of individual stocks also get the added advantage of being able to reduce their taxes by controlling when and how they sell individual shares. They can sell shares that have dropped in value, buy them back after 30 days, and then use the losses to offset other taxes.” Most of the individual investors I know have neither the time nor the patience to pull off such a bad strategy. Besides, indexing is inherently tax efficient which would negate any positive effect the above tax loss selling strategy would have over the low costs of indexing. Here’s a better idea then the one offered up in the article: buy an index fund and forget about everything else!

Ultimately, the article offers up no rational argument against indexing – the simplest and most efficient way to long-term wealth. Indeed, the article opens up explaining how indexers think:

Since you have no way of knowing which lucky manager will outperform, you're better off just buying the whole market and minimizing your fees with passive index funds. The evidence seems to largely bear this out as studies show that up to 80% of actively managed mutual funds underperform the market and that those that did outperform didn't tend to continue doing so over subsequent periods of time.

The facts are all laid out for the reader. I’m at a loss for why people still try to justify owning actively managed funds – or an investor’s replication of an actively managed fund - provided there’s a passively managed fund that is considered an equal or greater representation of a specific area of the market as compared to the actively managed fund.

Thursday, June 16, 2011

A World Without Soothsayers

Dictionary.com defines a soothsayer as "a person who professes to foretell events." Another name for this type of person is a prognosticator or clairvoyant, and I can't help but think that Wall Street is becoming populated more and more with these types of people and less and less with people who actually know something. In short, Wall Street is trying to sell you something that they shouldn't: their predictive power.

The problem with Wall Street analysts and strategists making predictions and claims is that they're never held accountable. They are free to predict Dow 36,000, economic malaise, food lines and the like without any system of checks and balances. After all, why should they have one? The people making these predictions get paid to make them and for the most part, get to keep their jobs even if they're wrong. Just like your local weatherman may think but never openly admit, "we have met the enemy and he is us".

All of this leads me to the question - what would a world without market soothsayers be like? If Wall Street's hype and prediction machine collectively ceased to exist, would things run more efficiently? For one, dissemination of facts and true information could be acted upon without the potential for personal judgment to be clouded by the opinions of others. It may sound like a perfect world, one in which Wall Street and the media have no ability to impact your investments. Indeed, it is a perfect world for all investors - it is the world in which we simply ignore what Wall Street's prognosticators are saying and enjoy our lives.

Thursday, June 2, 2011

The More Things Change...

An old adage goes, "the more things change, the more they stay the same" and nowhere is this more applicable than on Wall Street. Many readers, especially those who came of age during the Internet era and subsequent dot com bubble, will remember vividly the days of dot com IPOs skyrocketing 1,000% or more in their public debut and frenzied day traders trying to get their hands on said shares. It's been over 10 years since we emerged from the dot com bubble and it appears as if a fresh bubble may be brewing...in Internet names. On May 18, LinkedIn, the business networking site, debuted and skyrocketed more than 80% during the trading day. Fresh on the heels of LinkedIn's debut, other Internet names like Groupon, Twitter, Facebook and Zynga are filing or expected to file for IPOs in the coming months. Some estimates peg Facebook's value upwards of $65 billion, larger than many major American companies. 

Is the Internet bubble back? Time will tell. The only constant is that the more things change on Wall Street, the more they stay the same.

Thursday, May 26, 2011

Saving is Easy

It never ceases to amaze me how difficult some people find it to save money when such an activity should be a fact of life. I believe many people assume that the only people who are able to achieve financial independence, and ultimately, a comfortable retirement, are those that are already wealthy or who have extremely high paying jobs. Nothing could be further from the truth!

Saving and investing money is inherently easy on any income and here's why: If you really want to save your money, you will. This boils down to psychology because some people simply do not want to save, even though they should to ensure a comfortable future.

How can this be accomplished? Try cutting out unnecessary discretionary purchases and using that money instead to fund a retirement account that owns a basket of index funds. At this point, many readers might question this strategy since we most often derive much of our satisfaction from these purchases, but it doesn't have to be difficult. Instead, rotate every week, month, or whatever time interval you've chosen to changing which discretionary purchase you swap out for savings funds. If you go out to eat 5 times in an average month, try going out 2 or 3 times instead. For a family of four, you'll likely save well over $100 a month using this strategy. If your family likes to go out to eat, why not go out to eat 5 times again the next month but drink coffee at home each day instead of going to Starbucks? Scaling back these are the activities are one key way in which you will save a lot of money in the long run.

Of course, all of this goes without saying that you should follow the adage of "paying yourself first" and simply save a set percentage of your paycheck, say 10-20%, if possible and devote that to an investment account. You will be amazed at how much you can earn in 30+ years just by investing $100 a paycheck. This is the magic of compounding at work but it's only possible through disciplined saving. Saving money is inherently easy, it's just that many people don't find it fun because the rewards we realize from it do not satisfy us instantaneously.

Thursday, May 12, 2011

Opening the Door to New Investors

I was excited to hear news out of Vanguard yesterday that they've lowered their minimum initial investments for their Target Retirement funds to $1,000 from $3,000. This is encouraging news as many young investors find it difficult to invest large amounts of cash at one time. This reduction in initial investment will open up some of Vanguard's most interesting offerings to new investors. 

At their core, target retirement funds set a specified retirement year - 2040 for example - and invest the fund's assets for an investor planning to retire in or around that year. Right now, the 2040 fund has 89.96% of assets invested in stocks, 9.98% in bonds and 0.06% in short-term reserves.

Ultimately, as 2040 approaches, the fund's managers will decrease the amount of equities in the portfolio in order to lower the fund's risk profile. Even better, the Target Retirement funds are funds of funds which own index funds and not individual stocks. This news is a welcome development for investors for another reason: as Vanguard attracts more assets, they benefit from economies of scale and will continue to lower fund expense ratios which benefits all investors.

Thursday, May 5, 2011

The Anniversary of the Retail Index Fund

In 1976, Vanguard pioneered the index fund by offering it to retail investors for the first time. The company has not looked back and is now the leading manager of index funds and consistently one of the top 3 investment managers in the world by assets with $1.6 trillion under management as of February 2011. I'd like to take time in this post to reflect on what the availabilty of the index fund has meant to individual investors by posting an interview with two of Vanguard's experts - Sandip Bhagat, head of Vanguard Quantitative Equity Group, and Kenneth Volpert who oversees Vanguard's bond funds.

The whole interview is well worth reading but the best part about the interview is that both experts point out that the rise of new "fundamental" or "intelligent" indexes is not truly passively managed investing. In short, this is just another way for Wall Street to sell us an actively managed product that is likely to fail in its attempt to outperform the true passively managed index fund. As Mr. Bhagat notes, "
The point is that any portfolio configuration that goes beyond the size of a company's market-determined value does not represent a passive approach to investing. It brings with it a belief that the market's prices are incorrect, and that some other factors merit more attention. "

This is key because many retail investors assume that a fundamental index offers a better way to capture the "true" value of a basket of stocks. Therein lies the problem - the true value of a company is really what the stock market dictates it is based on its current trading price. Yes, the future value of a company may be drastically different, but we cannot predict or know the future with certainty. The information that is used to create fundamental indexes is often based on earnings reports or other information that happened in the recent past. By attempting to place a fundamental value on stocks, the fundamental "index" winds up becoming nothing more than an actively managed impostor as stocks are changed based on earnings and other data.

Wouldn't it make more sense to simply take the reflection of the collective knowledge of every investor in the world - the price of a stock in the here and now - and build a true index around that? That's precisely what Vanguard did in 1976 and why they have been so successful. Need more proof? Since its inception in 1976, the Vanguard 500 Index (VFINX) has returned 10.79% on average, annually. What has your actively managed fund done for you lately?

Thursday, April 28, 2011

A Video Intro to Indexing

Things have been pretty hectic around here so I'm going to offer up a quick video for anyone that wants to see how and why passively managed (indexed) investment strategies outperform actively managed strategies over the long-term. This is a video inspired by the Bogleheads - investors who follow Vanguard founder Jack Bogle's investment philosophy - and is right on the money. While it may seem goofy at first, there are plenty of truisms within that are often overlooked by investors.

Thursday, April 21, 2011

Why You Should Turn Off CNBC

Up until yesterday, it had been a long time since I really watched CNBC. The business news network is a ubiquitous presence on trading floors and in the homes of many investors throughout the world. As a younger investor, I was one of those people addicted to the constant flow of information and endless ticker scrolling across the screen. Ultimately, I wised up and turned the channel to something that became more interesting, namely, SportsCenter. The problem with CNBC and other business news networks is that not only do you suffer from information overload, but by being drawn into the constant drone of information, you're more likely to make a rash investment decision as you begin to believe in the madness of crowds and adopt the "herd mentality." You may even think things like, "hey, if everyone is doing it, why am I so late to the party?"

I tried watching yesterday but I felt compelled to turn it off after a half hour. A key afternoon segment focused on gold prices hitting all-time highs and the show highlighted different ways individuals could "profit from rising gold prices". This is precisely the problem with CNBC - where were they when gold prices were at levels much lower than they are now? I fear some investors watching the network may have felt compelled to add a significant gold position to their portfolio at the expense of a more rational thesis (namely, having a plan and sticking to it). Unfortunately, this type of thing happens all the time on business networks. If it's not gold that they're talking about, you can simply insert whatever commodity/market sector/area of the world that's experiencing major out or underperformance and CNBC will have plenty of "experts" on telling you how you can make money off the moves.

This is not to say that I blame CNBC - they're simply catering to an audience who craves business and market news - but therein lies the problem. A financial news network should never dictate what investment decisions you make and the noise that it represents serves as a big distraction when it comes to your overall investment plan. If investors are serious about building wealth, they would realize that you don't build wealth by following what CNBC says. You build wealth by creating an asset allocation plan that works for you and systematically investing in it for the long-term.

Thursday, April 14, 2011

Proof That Compounding Works

When thinking about investments, it never ceases to amaze me at how effective compounding investment returns are. As they say, the proof is in the pudding, and by using a simple financial calculator, it's easy to show how beneficial saving and compounding actually is.

One of the things I often hear from young investors - Gen Y in particular - is that they feel that investing for retirement is something that can be put off since it's so far away. I don't like this line of thinking at all because it's self defeating: we save and invest not to retire at an old age, but to have enough of a nest egg built up to retire whenever we want!

Even worse, investors tell me that $100 saved here and there or their small $1,000 savings today won't amount to much so it's not worth investing until they start their careers. This is even worse thinking! Here's proof: If you invest $1,000 in an index fund, assuming a 7% average return and never touch it for 40 years you will wind up with $14,974 due to investment compounding. If the market gets cooking and long-term returns average 10%, you will wind up with $45,259.

Now just imagine what would happen with each additional dollar saved!

Thursday, April 7, 2011

Mutual Fund Performance Measures

Much has been made about mutual fund performance figures and how certain pieces of data don't tell the full story when it comes to evaluating a fund. I would advocate not worrying about what a mutual fund's Morningstar Star Rating is because star ratings are assigned based on risk-adjusted past returns which are not indicative of future performance.

Further, it may also be a stretch to compare a fund to a certain benchmark because its mandate and overall investment policy may be drastically different than what the index's is. For example, a bond fund that does not invest in U.S. Treasury securities may be compared to a bond index with a heavy weighting towards Treasury securities. If U.S. Treasuries perform well compared to other global bonds, it may be a stretch to legitimately say the fund "outperformed" the index. On the other hand, a fund investing primarily in small-cap growth stocks may experience style drift and its strategy could begin to include beaten down companies that qualify as small-cap "value" firms.

A recent Wall Street Journal article noted that looking at total returns works best when you understand what a fund's expense ratio is and also when you look at fund returns over longer time periods in order to smooth out the effects of short-term market movements. However, even this approach isn't foolproof as the Journal notes; "even if a fund has outperformed for 10 years, its odds of outperforming over the following three to five years are only about 50-50, research by Vanguard Group suggests."

Overall, investors are best served by focusing on the index rather than on an actively managed fund. If you simply index your money, your index funds will own the entire market rather than cherry-picking certain securities. This strategy is beneficial because not only is it extremely inexpensive, you also won't have to worry about comparing your fund's performance relative to the benchmark because it is the benchmark.

Thursday, March 31, 2011

The Young and Wealthy Don't Trust Advisers

A recent report by Cisco’s Internet Business Solutions Group on young investors with $500,000 or more in investible assets “showed that more than a third of respondents had lost faith in the 'fairness of the market' and believe the individual investor doesn’t have a chance to succeed. Half expect to delay their retirement because of their losses” according to the Wall Street Journal’s Robert Frank.

Further, Frank notes that, “The under-50s also don’t trust their financial advisers as much for financial advice. The survey showed that more than half use social networking for investment advice and two thirds are interested in joining online investor communities. Boomers and silvers were far less interested in the online tools.”

This is very telling to me. It shows that in the recent past, young investors have felt that wealth managers are more concerned with making money for themselves and not their client. While on one hand it’s a bad thing that Gen Y feels as if they have no place to turn to besides the internet for investment advice, it’s also a great thing because one of the first steps to building wealth is understanding that most so-called “experts” in the wealth management business do not have your best interests at heart. 
After all, the goal of many people in wealth management is not to see that you grow your wealth, but rather, that you give it away to them! This is done through their advocating frequent trading for clients, constant sales pitches for new investment "ideas" and "cleaning out the inventory" of securities their company needs sold. Fred Schwed's classic book Where are the Customers' Yachts? explores the issue further with plenty of humor. Remember, you are your own best advocate!

This does not mean that there aren’t good advisers out there. In fact, fee-only advisers with the Certified Financial Planner (CFP) designation are often outstanding sources of planning advice. Unfortunately, some brokers, “vice presidents” and other salesmen in disguise give the business a bad name and no doubt represent one of the biggest issues that Gen Y has with trusting experts on Wall Street.
The image of Bud Fox in the moving Wall Street cold-calling investors can strike a raw nerve.

Interestingly, it’s noted that in many instances, Gen Y trusts internet message boards and financial websites for advice over a human adviser. For one, the cost of consulting the internet for advice is minimal. On the downside, there may certainly be a lag time in having key questions answered and in other instances, the investor may not feel comfortable divulging too many personal financial details. With that said, there are some great online resources available for do it yourself investors. Besides Vanguard.com where you can actually set up an account to begin indexing, the
Bogleheads, those investors following Vanguard founder John Bogle's advice, are an outstanding group with plenty of knowledge to go around. As always, it’s best to seek advice from those people you feel comfortable seeking advice from. If that person happens to be on the internet as opposed to sitting in front of you in an office, so be it!

Thursday, March 24, 2011

Greener Pastures in Rising Dividends

As part of my general investment philosophy, I tend to avoid investing in individual stocks because of my preference for low-cost, highly efficient and diversified index funds. After all, it's been proven that over the long-term, picking stocks is a loser's game and we often resort to market timing - shifting in and out of stocks to capture potential future price movements - which is a costly and ineffective strategy.

However, I do believe in the importance of dividend-paying stocks, particularly those that have a long history of raising dividend payouts and returning excess cash to shareholders. Most of the companies who are able to do this have two things in common: 1). A tremendous amount of brand equity 2). Large amounts of free cash flow

Thus, if a company is borrowing money to meet a quarterly dividend payout, it's likely that financial distress is on the horizon (or is there already). So why do I recommend owning a basket of dividend stocks? In addition to your index fund investments, you can experience the true benefits of compounding if you own 5-10 large dividend payers and simply reinvest their dividends to buy more shares. Ultimately, not only will you receive more and more dividends because you'll have more shares, but if a company has been good about initiating dividend increases consistently, the benefits of compounding become even more apparent because you'll be receiving a higher payout from the company.

Even better, this strategy is important for retirement because your income needs grow larger as you get older. What better way to have a large amount of quarterly income come in than to have all of those years of reinvested dividends now take the form of a quarterly check to you? I tend to stick with large companies who have a history of dividend increases in highly defensive industries. This strategy is much better than simply buying a couple of bonds because there are no maturity dates associated with individual stocks and it's less likely than inflation will eat away at returns because companies that have a history of raising dividends will likely do so at a rate higher than inflation.

Thursday, March 17, 2011

How to Become a Millionaire

The title of this blog post may sound cheesy and conjure up images of the slick businessman with greased back hair, preying on the poor and unsuspecting in order to make a quick dollar. In fact, that's not what most millionaires are. Just as the majority of businesses in the United States are "small businesses", the majority of millionaires in the U.S. are average, everyday Americans who built the wealth themselves and/or with spouses. The majority don't inherit boatloads of money and it's usually hard work and ingenuity that pay off in the long run both professionally and monetarily.

In fact, education is typically the main determinant of who will become wealthy. A recent study by Spectrem Group found out that, "Households with over $1 million are more likely to have a graduate degree than those in the $100,000 to $1 million segment. Thirty four percent of Millionaires have an advanced degree and 30% of the ultra-high net worth are similar. Fifteen percent of the UHNW are Doctors, 17% have a MBA and 6% are lawyers."

All of this data leads me to the recent report that the U.S. millionaire population is nearing its 2007 peak of 9.2 million households. Currently, there are roughly 8.4 million millionaire households in the United States. So, how did this number grow 8% in 2010 and 16% in 2009? It's evident that our perception of millionaires as rich, jet-set types who are disconnected from the general public is way off base. Why? Because millionaires are the general public. They're your small business owners, accountants, doctors, lawyers, teachers and firemen...among countless other occupations. Ultimately, the question is - how did they get there? This leads me to my main point - how to become a millionaire.

Becoming a millionaire is easy once you've gotten the education part down (and provided you have a job). You need to do two things: 1). Keep costs low while not sacrificing personal well being 2). Max out Roth IRA contributions and/or 401(k) contributions while receiving an equal employer contribution in the 401(k) 3). Invest systematically in index funds

This may sound too simple but the answer is that simple. First, when you keep costs low, you'll get to keep more of the net income that you bring in via your paycheck and by not sacrificing personal well being (something many cost cutters do), you'll be happier and much more likely to have the drive to work hard and go out and do a good job day after day. Even better, you'll enjoy life! There's no reason to be a miser or a cheapskate because we only live once and we can't take it with us as they say.

Secondly, max out your Roth IRA contributions. Roth IRAs are retirement accounts that allow your current after-tax earnings to compound tax free. Right now, Gen Y can contribute $5,000 to their Roth IRA accounts. This is great for investors because you will not have to pay taxes on any of the earnings when you start withdrawing from the account. Also, take advantage of your employer's 401(k) plan and be sure to max out your contributions to the plan (if feasible) so you receive the biggest employer match - you're basically receiving free money by doing this.

Lastly, systematic investment in index funds is the surest way to build long-term wealth. Consider this: At age 30 you are armed with an MBA and a job that pays $80,000 (roughly the average MBA's salary). You have $35,000 saved already and invest $9,600 a year ($800 a month) for 30 years at a 7% return. Even if you didn't add anything additionally along the way, you would end up with $640,394.62. Talk about the power of compounding!

Through education, hard work and systematic investment, becoming a millionaire is easier than it seems. As long as you stay dedicated and disciplined throughout the process, you will have a great shot at joining the 8.4 million other households who consider themselves millionaires in the United States.

Thursday, March 10, 2011

Hindsight is 20/20

I'm going in a different direction with my post today because I want to highlight a fact of life that all investors will have to deal with at one time or another: hindsight is 20/20. I have a couple of individual stocks - "legacy holdings" - that I've held since I was younger and before I knew about the virtues of index funds. I'm gradually selling them off to move all of my holdings into index funds and one of my holdings is up roughly 30% since I sold it. For a New York minute, I was kicking myself for leaving money on the table but this is precisely why individual stock picking is generally a bad idea: we get greedy and this results in market timing.

Sure, the stock is up 30% but it could just as easily have been down that amount. This brings me to an important point: when you sell a stock, fund, or otherwise make any investment decision, let that be the end of it. It's easy to play games of what if but that won't change the fact that you made the decision you did. Be at peace with your decisions.

Thursday, March 3, 2011

The Case of the Closet Indexer

There's a mysterious character in the world of investment management and he's known as the closet indexer. The mystery surrounding this character is made maddening by the fact that while his actively managed mutual fund may indeed be highly correlated to a benchmark like the S&P 500, he's likely to trail the return of the index after fees and expenses.

Unfortunately, many actively managed funds are now "closet indexing". You may wonder why I am so against this practice when I'm such a strong advocate of index funds but the answer is simple: not only do you get hit with larger fees and expenses for investing in the actively managed fund, you're likely to experience under-performance in certain markets because the funds are still actively managed and may be more conservative or aggressive to capture some upside in falling or rising markets. This is a recipe for disaster because it's not likely that the manager will be perfect all of the time, further hampering returns.

Martijn Cremers, a finance professor at the Yale School of Management points out that the main rationale for this practice is that individual investors are more "benchmark aware" and they are quick to sell funds who underperform a given benchmark. After reading this, it sounds like they just don't know about the virtues of actual index funds!

The Smart Money article linked above highlights the main issue: "of the 514 actively managed funds in Morningstar's large-cap blend category, 79 mimic the index almost exactly . And that means they're almost guaranteed to underperform, because 'you'll get the market return – less the fees,' Shannon Zimmerman, the associate director of fund analysis at Morningstar."

I was more shocked by this quote from the manager of an actively managed fund that the article dubbed a "closet indexer": "Scott Glasser, co-manager of the Legg Mason Clearbridge Appreciation Fund, says that while his fund has been highly correlated to the S&P -- and charges an expense ratio of 1.05% -- it is more conservative than the index and has outperformed its benchmark over the past three-, five- and ten-year periods. 'This fund may have higher fees, but it's earned those fees over time,"

I'm really not too sure how the fund "earned" its higher fees over the long-term and it begs the question - why settle for mediocre performance that's made worse by excess expenses when you can just buy an index fund and be done with it? The article mentions that the Vanguard 500 Index Fund (VFINX) has a 0.18% expense ratio while the SPDR S&P 500 Index ETF (SPY) has a paltry 0.09% expense ratio. To me, the choice is clear: stick with the real index fund and avoid closet indexers.

Friday, February 25, 2011

Costs Matter - Stick With Index Funds!

Mutual fund giant Vanguard announced that they're slashing some of their industry-low expense ratios on several index funds, including many of their international offerings. This is welcome news for Gen Y investors because it means that those of us who invest in index funds (and we all should!) get to keep more of the return that our funds generate.

Consider this: You invest in an actively managed mutual fund that charges a total of 7%; a 5% front end load is paid upon purchase of the fund and an additional 2% in management/other fees get tacked on as well. To make up for that immediate hit, your fund has to return 7% just to break even. Even worse, it's quite difficult for portfolio managers to consistently beat the market and even harder for investors to pick those managers who will!

Alas, it's not all bad news. Index fund purveyors like low-cost leader Vanguard, Fidelity and TIAA-CREF all offer index funds that passively track a market index and earn the return of the market, minus a very small fee. Whereas an actively managed fund may charge you 5%+, an arm and a leg indeed, index funds typically charge very minimal fees. In Vanguard's case, the expense ratio on their Total Stock Market Index (VTSMX) is only 0.17% - now that's cheap!

Thursday, February 17, 2011

The Power of Compounding

It's amazing to me that the simplest principles in the world of finance are often the most overlooked. Granted, I don't expect CNBC and other financial news outlets to offer lessons on the basic concepts of finance but I can dream!

Vanguard, the massive mutual fund management firm that pioneered the index fund for individual investors, has a great article on the power of compounding on its website. Basically, compounding is the effect that you get when your earnings grow on top of prior earnings. These earnings can be in the form of interest, dividends, capital gains distributions or the like.

For example, if you have 1,000 shares of an index fund with a NAV of $10 which pays out a quarterly dividend of 0.25 in the 1st quarter, you will have $250 in dividend income. If you decide to reinvest that, come the next quarter, you will have 1,025 shares (holding the price of the fund constant). As the fund pays out its dividend of 0.25 in the 2nd quarter, you will subsequently receive $256.25 in dividend income. Imagine the results if you keep adding to this by investing systematically. All of this highlights a key principle that is proved true due to compounding: its easier to make money when you already have it.

That adage shouldn't discourage you - in fact, it should inspire you. After all, by starting at a age young like I hope members of Generation WISE are, you will begin to realize the full benefits of compounding investment returns. As your investments and savings grow from a young age, compounding will work its magic. Vanguard says that for compounding to work, you need to "start now, invest regularly and be patient." I couldn't have said it better myself.

Thursday, February 10, 2011

"There's Plenty of Time To Save"

Perhaps you're like me, 22 years old and excited about graduating from college and starting in the proverbial "real world". The prospect can be exciting and frightening at the same time, but also full of misconceptions. A recent article on FOXBusiness.com highlights "8 Misconceptions College Students Have About Money". These misconceptions run the gamut from fear over credit, seeing no need to budget and other general financial pitfalls. Yet, the worst misconception to me is the idea that there's "plenty of time to save."

While retirement may seem far away - 40+ years is likely for a worker just getting into the workforce - the day where you will begin to seriously consider it will come faster than you think. As a result, the planning and saving that we do today will affect both when we retire and how we retire. By that, I mean that how much money we have saved and invested will dictate the terms of our retirement - will we retire at 62, collect Social Security (if it's still around) and live comfortably off a lifetime of savings - or will we "retire" at 70, collect Social Security yet be forced to take a part-time job to cover rising living expenses? The former should be our goal, yet the latter is an unfortunate reality for many people.

By saving and investing more money early on, you will have less of a return differential to make up for as you get closer to retirement age. Ideally, your portfolio will grow and compound enough with the additional contributions that you make during your working years to negate the need for any makeup return as you get closer to retirement. The FOX article quotes a 2009 Vanguard report which states, "
only 31% of employees under age 25 save for retirement, compared to 61% for those between 25 and 34.”

Those are harrowing statistics because it means that we are forgoing the best years of our life to save - when we have limited obligations such as a house payment or raising a family - and wasting precious time. Sure, a dollar today is worth more than a dollar in the future. However, a dollar today is not worth more than a dollar invested today for 40 years earning a 7% average annual return.

Thursday, February 3, 2011

Brokerage Advice Can Be Hazardous to Your Wealth

I have a confession to make. As a young investor in the late 1990s, I was naive and quite taken by the Internet euphoria. At the time, I owned a single stock - PepsiCo (PEP) - which I still own to this day. However, I couldn't help but watch stock prices explode without feeling like I should be a part of the game. Granted, I didn't have much spare cash to work with, but when I did, I was advised by my broker to buy Munder NetNet - one of the pioneering Internet-focused funds that grew to a whopping $8.5 billion in asset size in April of 2000. I should have been smarter, but as an 11 year old investor, I believed in the transformative power of technology and the "new paradigm". Didn't you?

When all was said and done, my small investment in Munder was wiped out to the tune of 90% or so. And while our broker was confident that it would rebound all the way down, it was only then that I realized investing works best when you:

1). Keep it simple and index
2). Buy what you know

Contrary to what Wall Street tells you, it's OK to be conservative as a young investor. And by conservative, I mean that it's OK to invest in index funds. Interestingly, former bond trader and famous author Michael Lewis of Liar's Poker, Money Ball and The Blind Side fame, notes in a recent interview that he took advice from a broker and in 2008 purchased Lehman Bros. preferred stock and auction-rate securities - both investments were wiped out by the financial crisis and Lehman's bankruptcy. So, after this gut-check experience, what does Lewis advocate for individual investors? Surprise, surprise! He says, "
be conservative, don’t listen to brokerage advice, and index."

I couldn't agree more. Ultimately, Wall Street is all about sales and brokers are at the forefront of making sure products - investments in this case - get sold. Unfortunately, the first place they often look to unload their worst products are to unwitting individual investors. It's best to keep it simple by indexing and to avoid listening to brokerage advice!

Thursday, January 27, 2011

Dow 12,000? So what!

The financial media has been growing increasingly giddy over the prospect of the Dow Jones Industrial Average (DJIA) eclipsing 12,000. Now you're probably thinking "haven't I heard this already?". Indeed, you have. On Monday, Tuesday, Wednesday and now today, the Dow hit an intraday high of just over 12,000 - a level considered to be a key level of "resistance" for the overall market. The Wall Street Journal's homepage has a headline boldly proclaiming: "Dow Regains 12,000"

Not to be outdone, similar headlines can be found all throughout the financial press, detailing the minute-by-minute moves in the Dow as it approaches, reaches, and surpasses 12,000. In the case of the last 3 days, this type of reporting held little relevance because the Dow didn't close above 12,000. The last time that the Dow closed above 12,000 was during the height of the financial crisis - on June 19, 2008 - when the index closed at 12,063. Thus, given all that's happened in the financial markets the past few years and the way that stocks have rallied since their bottoming out in the beginning of 2009, 12,000 may seem like a significant level for the Dow.

Alas, it's not. The constant reminder that the Dow is "regaining" 12,000 serves more as a testament to the resilience of U.S. markets than anything else. It holds little educational or predictive value. After all, the Dow only includes 30 companies and the true driver of stock prices - expected future earnings - have not changed all that much in the past few days.

From a psychological perspective, Dow 12,000 is a good sign because it means that investors have renewed optimism in stocks and are pushing prices higher. On the other hand, what do investors gain by reading news headlines detailing tick by tick moves in the Dow as it approaches a level that holds little relative importance? Not too much, especially since the fundamentals of Dow 12,000 are pretty much the same as Dow 11,999.

Thursday, January 20, 2011

Gen Y Home Preferences & Investing

The Wall Street Journal noted interesting findings from a recent panel regarding Gen Y's housing preferences. Last week's National Association of Homebuilder's conference broke out a few panels that discussed how millennials differ from their Baby Boomer parents in what they look for in a house. The article noted that Gen Y's "want to walk everywhere" Further, "surveys show that 13% carpool to work, while 7% walk" and Gen Y still much prefers city living as opposed to settling down in the suburbs. In fact, 88% of the survey respondents reported the desire to live in a city.

This should not be surprising as Gen Y's are known to crave action and excitement, traits that are no doubt due in large part to our growing reliance on technology and socializing. The hustle and bustle that comes along with our rapid socialization also leads to our interest in city living as cities are key population centers where we can be exposed to as many people and as much activity as possible.

Interestingly, much of what we know from these surveys about Gen Y's housing preferences can tell us a lot about Gen Y's investing habits. Indeed, Gen Y's tend to be more interested in active trading and other strategies centered on high activity rates. Unfortunately, this is also a very costly endeavor that can quickly eat away at any investment returns that are actually generated (and odds are, they won't be).

The old axiom "don't just stand there, do something" applies to Gen Y investors as they stand now but it shouldn't. In fact, as John Bogle notes, all investors should heed the following instead - "don't just do something, stand there". In the end, passive investment pays off for all investors.

Thursday, January 13, 2011

Erasing the Gen Y Debt Burden

Unfortunately, much of my recent posts have been regarding things that millennials are "doing wrong" when it comes to saving and investing. I've noticed that most Gen Y's who have poor saving and investing habits are in such a predicament because their parents may not be great savers. The old saying "the apple doesn't fall too far from the tree" is quite true when it comes to successful saving and investing habits. After all, young people are quite impressionable and even leading up into our college years when we crave independence, many of us still look to our parents for signs of successful money management.

With that said, if you have manageable credit card debt - and 38% of Gen Y does - start paying it off! The time to do it is now, while you're still young. The worst thing in the world you can do when it comes to paying off your debts is to wait.

Even better, pay off your debts in full, if you can. While that may seem unrealistic and come at the sacrifice of immediate savings and investing goals, remember that you have plenty of time to work towards your investing goals and you will be much better off having gotten the debt burden off of your back.

After all, interest costs will ultimately grow exponentially if credit card debts go unpaid or if you continue to just pay the minimum payment each month and then any future earnings you have will likely go towards paying off your creditors. This is a sad situation that many millennials face but it shouldn't dishearten you from an investing perspective. Once the debt burden is erased, begin to focus on investing your money and you will feel so much better knowing the specter of a credit card company is no longer in your rear-view mirror.

Thursday, January 6, 2011

Gen Y's Risk Aversion

A recent Kiplinger's article points out that Gen Y investors are typically more risk averse than other generations were when they were the same age. This risk aversion means just what it says - Gen Y investors are less comfortable with risk - and in turn have put more than half of their savings in relatively safe investment vehicles like "bonds, money market accounts or cash" as the article points out.

The article also goes on to examine the reason for this risk aversion, pointing out the following:

"They've seen little or nothing of the upside of long-term investing in stocks. In the decade since the oldest Gen Yers entered the workforce, the stock market has languished. Worse, many saw their parents' savings evaporate in recent years. If that reluctance to invest in the stock market lasts, many will come up short in their golden years."

While I'm sure the roller coaster ride that the stock market has taken investors on in the wake of the financial crisis was unsettling for many investors, I believe Gen Y's risk aversion boils down more to their temperament and personality. After all, Gen Y tends to have a shorter attention span and a burning want for instant gratification. Maybe they simply don't understand the benefits of investing the stock market and don't have a desire to learn. As a result, they park their cash in relatively risk-free vehicles like CDs and money markets, earning a meager return that can be eroded by inflation.

If Gen Y investors aren't motivated to learn about the importance of taking on at least some risk for higher potential investment returns over the long-term, it will be very difficult to change that mindset since it's probably ingrained in their psyche already. It can be done, however, and I remind readers that while risk aversion can be important, it's simply not practical for Gen Y investors.

We have the most to gain when investing because we have time on our side. However, in order to utilize that time we need to take some risk so that we can be compensated for bearing that risk. A time-tested investment principle continues to hold true, all else being equal: greater risk equals greater potential reward.