As an avid New York Yankees fan, I've come to appreciate the late Yogi Berra's famed "Yogiisms". One of my favorites is the classic line, "You can observe a lot by watching." Over the past few weeks, I've both watched and listened (via the CNBC simulcast on Sirius) to a variety of CNBC's financial programming. In my 2003 book, The Teenage Investor, I was very critical of the financial media and how predisposed they are to hyperbole in an effort to drum up interest and ratings. While I am still very critical of listening to the financial media with any frequency, I began to notice some value in paying attention to the media more - even if it only serves as a reminder of what to ignore on your investing journey.
Case in point: much has been made of the demise of the brick and mortar retailer in the age of Amazon. In June, Moody's put out a report highlighting financially distressed retailers. Among the names were well-known retailers like Sears, Neiman Marcus, Gymboree, and Nine West. Retail stocks have suffered over the past few years as brick and mortar retailers attempt to figure out how to compete with Amazon.com and other trailblazing online retailers. Over the past few months, financial commentators have speculated on which retailer would be the next to file for bankruptcy or otherwise exhibit signs of financial distress. Many of the most well-known retailers who are not yet considered financially distressed have seen steep stock price declines, and financial commentators have also begun to wonder whether the American mall will exist in a few years.
So why am I bringing this up? There is no doubt that Amazon is a force to be reckoned with, not only in retail but in various other areas. However, the same financial press who has declared the death of retail, today questioned whether they had gone too far in that assessment. How did this happen? Amazon.com reported Q2 earnings on Thursday that were weaker than expected, and the stock lost roughly $10 billion in market value. The financial press then began discussing whether their predictions for the "death of retail" were wrong, and if an inflection point had been reached where brick and mortar retailers could happily co-exist with Amazon...all because of a singular weak quarterly earnings report.
I have no thoughts or opinions on the viability of purchasing retail stocks, Amazon stock, or any other individual stock in light of all of this information; that's simply not an area I play in. However, by watching CNBC and other financial media outlets over the past few weeks, my view that it's dangerous to get wrapped up in headlines and financial commentary was reaffirmed. More importantly, I also came to the realization that there is a lot of value in paying occasional attention to the financial media, if only to have it serve as a reminder that everyone has an opinion and a position on any given hot button issue. The only opinions that truly matter in the financial world, however, are from the investors who put their money on the line in support of it - and that's what ultimately moves markets.
Friday, July 28, 2017
Friday, December 9, 2016
The Election Aftermath for Investors
Wednesday marked a month since Donald Trump was elected 45th President of the United States, and if the stock market's performance since then is any indication, much of the concern over a Trump Presidency was overblown. Plenty of policy details remain to be ironed out, many within Trump's first 100 days, but the Dow is up 1,200 points since Election Day and is inching closer to the uncharted territory of 20,000. There is an old Wall Street adage that says "markets climb a wall of worry" which in today's case basically means that the momentum the stock market had prior to the election seems to be continuing, and enhanced by, Trump's investor and business friendly policy positions. Trump's apparent less friendly economic policies (i.e. a 35% tariff on imports) likely won't pass muster with Congress, so Wall Street is taking those with a grain of a salt.
What does all of this mean for investors? For one, the market's performance in the aftermath of the election suggests that to Wall Street, the removal of uncertainty in the marketplace is far more important than almost any other development in the past few weeks. Many investors certainly take comfort in the fact that they can assess the potential impacts of a Trump Presidency on the economy and their own investments and not simply speculate further about what a Trump Presidency means.
My guidance to an individual investor is to avoid any form of market timing; do not attempt to jump into out of investments in order to "ride momentum" or attempt to capture price movement in stocks that some speculate many benefit from a Trump Presidency. If you have any capital losses that you can use to offset gains you may have realized while rebalancing your portfolio as the year winds down, it may be wise to consider doing so. Lastly, consider maxing out your 2016 Roth IRA contributions. The 2016 Roth IRA contribution limit (subject to certain income limitations), is $5,500 or $6,500 if you are 50 or older.
I wish everyone a healthy and prosperous 2017.
What does all of this mean for investors? For one, the market's performance in the aftermath of the election suggests that to Wall Street, the removal of uncertainty in the marketplace is far more important than almost any other development in the past few weeks. Many investors certainly take comfort in the fact that they can assess the potential impacts of a Trump Presidency on the economy and their own investments and not simply speculate further about what a Trump Presidency means.
My guidance to an individual investor is to avoid any form of market timing; do not attempt to jump into out of investments in order to "ride momentum" or attempt to capture price movement in stocks that some speculate many benefit from a Trump Presidency. If you have any capital losses that you can use to offset gains you may have realized while rebalancing your portfolio as the year winds down, it may be wise to consider doing so. Lastly, consider maxing out your 2016 Roth IRA contributions. The 2016 Roth IRA contribution limit (subject to certain income limitations), is $5,500 or $6,500 if you are 50 or older.
I wish everyone a healthy and prosperous 2017.
Saturday, October 29, 2016
Don't Let Election Jitters Cloud Long-Term Focus
With the U.S. Presidential election only 10 days away, much uncertainty lingers amongst investors, especially in light of yesterday's FBI announcement regarding the investigation into Hillary Clinton's emails. Such October surprises are common in Presidential politics, but that doesn't mean they rattle investors any less. As soon as the FBI announcement was made public, the Dow dropped substantially and the Mexican peso declined sharply versus the U.S. dollar. Thus, political and economic news can substantially move markets, and also, investor's expectations. Wall Street has differing views on what a Hillary Clinton or Donald Trump Presidency means for stocks and the economy, but the nervousness that Wall Street watchers may exhibit over the Presidential outcome shouldn't cloud individual investor's judgement.
A key argument in favor of staying calm despite highly uncertain times comes from the recent decision by British citizens to vote in favor of the United Kingdom exiting the European Union (EU). While public opinion polls up until the day of the vote seemed to indicate that British citizens would vote to remain in the EU, the news of Brexit was met with dire predictions of economic calamity and misfortune (i.e. reduced free trade, labor and people movements, etc.) that would befall the U.K. should it choose to leave the economic and trade connections with the EU. While we are dealing with a relatively small sample size, the U.K. economy actually grew more than expected (+0.5%) post-Brexit. While much could change in the future, this is one recent example of the doom and gloom that pundits and media often predict failing to come to fruition.
The Brexit discussion, in turn, brings me back to the jitters investors are exhibiting regarding our Presidential election. While emerging economies like China and India will no doubt play a larger and more important role in the world in the coming decades, the United States still remains the world's pre-eminent economic superpower. Many analysts argue that we could lose that role to China or some other emerging players in the future, but we must focus on the here and now and improving American economic competitiveness on the world stage. The media likes to use loaded, attention grabbing headlines to influence public opinion and drive viewership. A key consequence of this is that the editorializing that we see from both political viewpoints leads to uncertainty. This uncertainty often manifests itself in spikes in the VIX, a key indicator of volatility in the marketplace. If there is one thing investors hate, it is uncertainty. Markets tend to perform better when the future is easily mapped out and understood. If I could make one recommendation for the next few weeks, it would be to avoid focusing too much on the electoral headlines and the doom and gloom that the media may push regarding either outcome. Despite what many pundits would have you believe, we will likely be just fine either way. Remember, the United States has endured two World Wars, depressions, recessions, terror attacks, and countless other calamities that we recovered from economically. Stay invested in the market, dollar cost average into your positions, and keep your eyes on the prize: building wealth over the long-term, slowly but surely.
A key argument in favor of staying calm despite highly uncertain times comes from the recent decision by British citizens to vote in favor of the United Kingdom exiting the European Union (EU). While public opinion polls up until the day of the vote seemed to indicate that British citizens would vote to remain in the EU, the news of Brexit was met with dire predictions of economic calamity and misfortune (i.e. reduced free trade, labor and people movements, etc.) that would befall the U.K. should it choose to leave the economic and trade connections with the EU. While we are dealing with a relatively small sample size, the U.K. economy actually grew more than expected (+0.5%) post-Brexit. While much could change in the future, this is one recent example of the doom and gloom that pundits and media often predict failing to come to fruition.
The Brexit discussion, in turn, brings me back to the jitters investors are exhibiting regarding our Presidential election. While emerging economies like China and India will no doubt play a larger and more important role in the world in the coming decades, the United States still remains the world's pre-eminent economic superpower. Many analysts argue that we could lose that role to China or some other emerging players in the future, but we must focus on the here and now and improving American economic competitiveness on the world stage. The media likes to use loaded, attention grabbing headlines to influence public opinion and drive viewership. A key consequence of this is that the editorializing that we see from both political viewpoints leads to uncertainty. This uncertainty often manifests itself in spikes in the VIX, a key indicator of volatility in the marketplace. If there is one thing investors hate, it is uncertainty. Markets tend to perform better when the future is easily mapped out and understood. If I could make one recommendation for the next few weeks, it would be to avoid focusing too much on the electoral headlines and the doom and gloom that the media may push regarding either outcome. Despite what many pundits would have you believe, we will likely be just fine either way. Remember, the United States has endured two World Wars, depressions, recessions, terror attacks, and countless other calamities that we recovered from economically. Stay invested in the market, dollar cost average into your positions, and keep your eyes on the prize: building wealth over the long-term, slowly but surely.
Saturday, October 22, 2016
The Hidden 401(k) Fee Trap: Administration Fees
My employer offers a 401(k) plan through Fidelity which offers different tiers of investment options. I can choose from a variety of actively and passively managed mutual funds, "target retirement" funds, as well as individual stocks if I choose. Most millennial investors hear the same story from the financial press about 401(k)'s: contribute up until your employer match. It is indeed good advice because it's never a good idea to leave free money on the table. After all, if you earn $50,000 in a year and contribute 5% to your 401(k) with a dollar for dollar employer match, you will have $5,000 in your 401(k) at year end instead of $2,500; nothing beats doubling your money without any additional work! However, I wanted to take some time to focus on something that many millennial investors may overlook but can be equally dangerous as passing up free money: hidden fees in the 401(k) plan.
The U.S. Department of Labor has published a good guide that examines the variety of fees and expenses within 401(k) plans. Remember, all fees and expenses reduce investment returns, and therefore the long-term returns your 401(k) may earn. The Dept. of Labor guide discusses a scenario where a 1% increase in fees reduces a retirement account balance by 28% at retirement...that's a huge hit!
The hidden 401(k) fee trap that I mention in the post title refers to the fact that while many people are familiar with the fees and expenses charged by mutual funds (i.e. sales charges and management fees), your 401(k) plan administrator may actually charge a plan administration fee, among other fees. Generally these fees are charged at the plan level and some percentage may also get passed on to individual employees. This blog post will be the first in a series of posts discussing these different fees.
A plan administration fee may be taken directly from your investment returns (a silent killer!), or you may pay it yearly, sometimes as a flat fee deducted from your account at the end of the year. There are multiple arrangements, but this fee is levied to pay for administrative services such as accounting, records keeping, and possibly even for additional service and support that your employer may have contracted for. Some employers automatically enroll employees in financial advice/planning programs, or offer other services that you ultimately pay for. Since many large corporations have so many employees enrolled in 401(k)'s, the overall administration fee burden on employees may be smaller, and in turn, larger for employees who work for smaller businesses.
In July 2012, the Dept. of Labor enacted a rule to ensure that plan administrators mail you a fee disclosure so you can see exactly what fees and expenses you may be subjected to while enrolled in your 401(k). Most investors likely just discard this notice, but you should pay special attention to it. You can also log into your 401(k) account, or request this information from your HR or Benefits Dept. where you work.
What can you do? Some employers may allow you to opt out of additional services that are paid for by the administration fee, so you may be able to lessen your fee burden that way. As the Dept. of Labor says, "generally the more services provided, the higher the fees." You should question whether you really use or even need the extra services that are being offered. This is particularly relevant when you are charged a yearly fee that is deducted directly from your account balance and not paid out of plan assets, because you will see the fee deduction at the end of every year.
Why is this all important? Consider the following. If you have a $10,000 401(k) account balance and are charged a 1% yearly administration fee, that's $100 that is taken away and won't contribute to long-term compounded investment returns. Assuming your 401(k) balance never changes (it will as the market moves up and down and as you invest more during your career), that yearly $100 charge turns into $3,000 over a 30 year career! With a 7% annual return, that $3,000 alone would become $22,836 over a 30 year career. The silent killer indeed!
The U.S. Department of Labor has published a good guide that examines the variety of fees and expenses within 401(k) plans. Remember, all fees and expenses reduce investment returns, and therefore the long-term returns your 401(k) may earn. The Dept. of Labor guide discusses a scenario where a 1% increase in fees reduces a retirement account balance by 28% at retirement...that's a huge hit!
The hidden 401(k) fee trap that I mention in the post title refers to the fact that while many people are familiar with the fees and expenses charged by mutual funds (i.e. sales charges and management fees), your 401(k) plan administrator may actually charge a plan administration fee, among other fees. Generally these fees are charged at the plan level and some percentage may also get passed on to individual employees. This blog post will be the first in a series of posts discussing these different fees.
A plan administration fee may be taken directly from your investment returns (a silent killer!), or you may pay it yearly, sometimes as a flat fee deducted from your account at the end of the year. There are multiple arrangements, but this fee is levied to pay for administrative services such as accounting, records keeping, and possibly even for additional service and support that your employer may have contracted for. Some employers automatically enroll employees in financial advice/planning programs, or offer other services that you ultimately pay for. Since many large corporations have so many employees enrolled in 401(k)'s, the overall administration fee burden on employees may be smaller, and in turn, larger for employees who work for smaller businesses.
In July 2012, the Dept. of Labor enacted a rule to ensure that plan administrators mail you a fee disclosure so you can see exactly what fees and expenses you may be subjected to while enrolled in your 401(k). Most investors likely just discard this notice, but you should pay special attention to it. You can also log into your 401(k) account, or request this information from your HR or Benefits Dept. where you work.
What can you do? Some employers may allow you to opt out of additional services that are paid for by the administration fee, so you may be able to lessen your fee burden that way. As the Dept. of Labor says, "generally the more services provided, the higher the fees." You should question whether you really use or even need the extra services that are being offered. This is particularly relevant when you are charged a yearly fee that is deducted directly from your account balance and not paid out of plan assets, because you will see the fee deduction at the end of every year.
Why is this all important? Consider the following. If you have a $10,000 401(k) account balance and are charged a 1% yearly administration fee, that's $100 that is taken away and won't contribute to long-term compounded investment returns. Assuming your 401(k) balance never changes (it will as the market moves up and down and as you invest more during your career), that yearly $100 charge turns into $3,000 over a 30 year career! With a 7% annual return, that $3,000 alone would become $22,836 over a 30 year career. The silent killer indeed!
Saturday, October 15, 2016
Dividend Reinvestment for Millennials
It only took 5 years between my last post and the post before it, so a 6 month gap shouldn't be considered too bad! I hope to be able to post more in the coming weeks as time permits, but today I would like to focus on a very important topic that many millennial investors tend to ignore in favor of flashier strategies: income investing through dividend reinvestment.
While readers know I am a big advocate of index funds, I also think high dividend yield stocks can play an important role in millennials' investment portfolios, especially when the dividends are reinvested. I have covered the topic of dividend reinvestment before, but basically it means that whenever a company pays its quarterly dividend, those dividends will go towards purchasing more shares of stock in the company instead of being routed to your account's cash balance. The tax implications are exactly the same whether the dividend is paid out in cash, or if it's reinvested; most millennial investors will pay a 15% tax on qualified dividends.
The reason income investing is enticing is that it can basically set an investor up for a large pot of passive income later in life. For example, if you buy 100 shares of Verizon Communications (VZ), you will receive $56.50 in dividend income every quarter ($0.565 quarterly dividend x 100 shares). As of 10/14/16, Verizon stock was trading at $50.28, so by reinvesting dividends, you are basically acquiring an additional share of stock every quarter - which in turn will earn more dividends - and this acts as an attractive source of compounding. The website buyupside features an easy to use dividend reinvestment calculator which helps to explain how dividend reinvestment increases long-term investment returns. As an example, assuming a 30 year investment horizon and 5% annual dividend and stock price growth rates, a $50 stock paying $2.00/year in dividends will result in 324.34 shares at the end of 30 years, and a total value of $70,088 versus $35,561 without reinvestment. This equates to a 30 year annualized return of 9.2% versus 6.76% without reinvestment. This is particularly beneficial later in life, because once an investor hits retirement, he or she can stop reinvestment and allow the dividends to be paid in cash to be used for whatever the heart desires.
For investors who tend to shy away from individual stocks, the same benefits can be had by reinvesting the dividends paid by your mutual funds. Most bond funds distribute interest payments monthly, and most actively and passively managed funds pay distributions quarterly.
A word of caution, however. Not all high dividend yield stocks are created equal. Many are master limited partnerships (MLP) which have run into trouble lately, others are companies with high yields due to poor financial position (yield goes up as a stock price goes down provided the dividend isn't cut), and some simply don't generate enough free cash flow to fund the dividend. Companies with strong free cash flow and payout ratios (dividend per share/earnings per share) in the 0.50 range may be attractive income investment candidates. Never purchase a stock on yield alone without doing more research into the sustainability of the dividend. It's important to consider the long-term dividend payout track record, as well as the cyclicality of the industry the company is in, among other factors.
While readers know I am a big advocate of index funds, I also think high dividend yield stocks can play an important role in millennials' investment portfolios, especially when the dividends are reinvested. I have covered the topic of dividend reinvestment before, but basically it means that whenever a company pays its quarterly dividend, those dividends will go towards purchasing more shares of stock in the company instead of being routed to your account's cash balance. The tax implications are exactly the same whether the dividend is paid out in cash, or if it's reinvested; most millennial investors will pay a 15% tax on qualified dividends.
The reason income investing is enticing is that it can basically set an investor up for a large pot of passive income later in life. For example, if you buy 100 shares of Verizon Communications (VZ), you will receive $56.50 in dividend income every quarter ($0.565 quarterly dividend x 100 shares). As of 10/14/16, Verizon stock was trading at $50.28, so by reinvesting dividends, you are basically acquiring an additional share of stock every quarter - which in turn will earn more dividends - and this acts as an attractive source of compounding. The website buyupside features an easy to use dividend reinvestment calculator which helps to explain how dividend reinvestment increases long-term investment returns. As an example, assuming a 30 year investment horizon and 5% annual dividend and stock price growth rates, a $50 stock paying $2.00/year in dividends will result in 324.34 shares at the end of 30 years, and a total value of $70,088 versus $35,561 without reinvestment. This equates to a 30 year annualized return of 9.2% versus 6.76% without reinvestment. This is particularly beneficial later in life, because once an investor hits retirement, he or she can stop reinvestment and allow the dividends to be paid in cash to be used for whatever the heart desires.
For investors who tend to shy away from individual stocks, the same benefits can be had by reinvesting the dividends paid by your mutual funds. Most bond funds distribute interest payments monthly, and most actively and passively managed funds pay distributions quarterly.
A word of caution, however. Not all high dividend yield stocks are created equal. Many are master limited partnerships (MLP) which have run into trouble lately, others are companies with high yields due to poor financial position (yield goes up as a stock price goes down provided the dividend isn't cut), and some simply don't generate enough free cash flow to fund the dividend. Companies with strong free cash flow and payout ratios (dividend per share/earnings per share) in the 0.50 range may be attractive income investment candidates. Never purchase a stock on yield alone without doing more research into the sustainability of the dividend. It's important to consider the long-term dividend payout track record, as well as the cyclicality of the industry the company is in, among other factors.
Friday, April 1, 2016
After a Brief Hiatus, I'm Back
The old saying goes that "life is what happens while you're busy making other plans." So here I write this post, nearly 5 years removed from my last. As you may imagine, a lot has certainly happened since then. My last post was made on October 4, 2011 when I had just graduated from college and began my first job. Since then, I have gotten married to the love of my life, been a member of the workforce for 4 1/2 years, and went to business school at nights while working full-time in order to earn an MBA. The cliche that time flies couldn't be more accurate.
What those 5 years have given me is valuable perspective (life experience, anyone?) that accompany entering adulthood. It's one thing to write about financial management and investing for those just entering the real world, but it's another to actually live it on a daily basis. I'm happy to note that the very investing ideas that I was discussing nearly 5 years ago are the same ones that I implement in my life now. My 401(k) asset allocation is balanced yearly between 3 funds and it's a basic allocation that should work for most young investors:
55% - broad, total stock market index fund
35% - total international index fund
10% - bond index fund of choice
The last option - the bond fund - is not a necessity for most investors under 30, and it may very well be your preference to remain 100% invested in equities. After all, as interest rates rise, the price of bonds go down in an inverse relationship. Since the Federal Reserve raised its target fed funds rate (i.e. 'raised interest rates') in December 2015 for the first time since 2008, many economists expect a pattern of tightening may continue over the next year or so depending upon economic conditions. As the Fed continues to raise rates, bond prices are likely to fall which may hurt bond investor's returns. This doesn't matter much to the long-term Generation WI$E investor, but it's important to note. However, having some exposure to bonds gives you the added benefit of extra income and diversification. If you own the bond fund in your 401(k), you will receive tax-deferred monthly income from the bond fund that can be reinvested to buy more shares in order to leverage the benefits of compounding.
There will certainly be much more to discuss over the coming weeks and months as both the world and financial information flow has changed dramatically in the 5 years since I last posted. I'm looking forward to sharing more of my real world financial journey with you as I continue my goal to make us all members of Generation WI$E.
What those 5 years have given me is valuable perspective (life experience, anyone?) that accompany entering adulthood. It's one thing to write about financial management and investing for those just entering the real world, but it's another to actually live it on a daily basis. I'm happy to note that the very investing ideas that I was discussing nearly 5 years ago are the same ones that I implement in my life now. My 401(k) asset allocation is balanced yearly between 3 funds and it's a basic allocation that should work for most young investors:
55% - broad, total stock market index fund
35% - total international index fund
10% - bond index fund of choice
The last option - the bond fund - is not a necessity for most investors under 30, and it may very well be your preference to remain 100% invested in equities. After all, as interest rates rise, the price of bonds go down in an inverse relationship. Since the Federal Reserve raised its target fed funds rate (i.e. 'raised interest rates') in December 2015 for the first time since 2008, many economists expect a pattern of tightening may continue over the next year or so depending upon economic conditions. As the Fed continues to raise rates, bond prices are likely to fall which may hurt bond investor's returns. This doesn't matter much to the long-term Generation WI$E investor, but it's important to note. However, having some exposure to bonds gives you the added benefit of extra income and diversification. If you own the bond fund in your 401(k), you will receive tax-deferred monthly income from the bond fund that can be reinvested to buy more shares in order to leverage the benefits of compounding.
There will certainly be much more to discuss over the coming weeks and months as both the world and financial information flow has changed dramatically in the 5 years since I last posted. I'm looking forward to sharing more of my real world financial journey with you as I continue my goal to make us all members of Generation WI$E.
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."
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?
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!
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.
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.
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.
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.
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.
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.
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!
"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.
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.
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.
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.
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.
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