Today, Chuck Jaffe wrote in The Wall Street Journal about a variety of different investment risks and made the case that investors are investing at precisely the wrong times because they don't understand the risks inherent in investing. Ultimately, on average, the riskier an asset, the higher potential return that comes along with it. It's impossible to eliminate all investment risk - even if a portfolio is diversified properly - as you will still face "systematic" risk or the risk that's inherent to the entire market.
Jaffe makes an excellent point in saying that "People will say they can tolerate risk, so long as they don't experience losses. They will settle for a near-zero return in a money-market fund because it is better than posting a loss without recognizing that they are losing buying power—ultimately the same impact as a loss-every day their investments fail to beat inflation."
Yes, investment risks encompass a variety of forms but one of the most important that Jaffe highlights is purchasing-power risk. If an investor is afraid to put any money in the market, they will commonly hoard it away in a seemingly "safe" investment vehicle like a savings account, CD or simply withdraw the cash entirely. This is a bad move for a variety of reasons, but the biggest is because inflation will likely erode the long-term purchasing power of the dollars as the interest earned on any bank deposits won't keep up with the rate of inflation.
In fact, today, 5-year CDs are only averaging 2.40% according to BankRate.com. If inflation is 4% over the next 5 years, you wind up losing 1.60% on an investment that you deemed "safe". Worse still, depending on the policies of your bank, you probably won't be able to withdraw money from your CD without incurring a penalty and you will be locked in at the stated interest rate for the 5-year term. Thus, it's important to understand the risks you face when investing because they can take shape in a variety of different ways.
Monday, October 11, 2010
Friday, October 8, 2010
Economy Sheds More Jobs
The U.S. lost 95,000 jobs in September, much worse than the anticipated drop of 5,000 that was the median estimate of economists surveyed by Bloomberg News. The government continues to cut temporary Census hires and the private sector's employment growth is lagging.
This news tells me that the much-anticipated economic recovery is still faltering. Fiscal support from government stimulus quickly wore off and the unemployment rate, sitting stubbornly at 9.6%, will get worse before it gets better.
Interestingly, while the economy remains deep in the tank, the stock market has performed well. The Dow Jones Industrial Average (DJIA) is nearing 11,000 and stocks' reputation as a leading indicator may indicate a quicker economic recovery than some economists are forecasting. A more likely explanation, however, is that the round of cost cutting that companies initiated in response to the recession has lead to higher earnings all around and subsequently, an expectation for higher profits once these leaner companies start growing again.
Have a great weekend! Enjoy the football games. Geaux Tigers!
This news tells me that the much-anticipated economic recovery is still faltering. Fiscal support from government stimulus quickly wore off and the unemployment rate, sitting stubbornly at 9.6%, will get worse before it gets better.
Interestingly, while the economy remains deep in the tank, the stock market has performed well. The Dow Jones Industrial Average (DJIA) is nearing 11,000 and stocks' reputation as a leading indicator may indicate a quicker economic recovery than some economists are forecasting. A more likely explanation, however, is that the round of cost cutting that companies initiated in response to the recession has lead to higher earnings all around and subsequently, an expectation for higher profits once these leaner companies start growing again.
Have a great weekend! Enjoy the football games. Geaux Tigers!
Thursday, October 7, 2010
ETFs vs. Index Funds: Expenses Matter
The Wall Street Journal recently had an article extolling the virtues of exchange traded funds (ETFs). Basically, ETFs are baskets of stocks that trade openly on an exchange. Most of them are like index funds in that the ETF tracks a specific index by holding the stocks in the benchmark index in proportion to their weight in it. For example, the Vanguard Total Stock Market Index (VTSMX) has an ETF counterpart, the Vanguard Total Stock Market ETF (VTI) which trades all day just like a stock. This can be a good or bad thing. When you send money in to buy a mutual fund, your trade is typically processed at the price at the end of the business day in which your money is received. The constant price changes in an ETF make it appeal to traders who may play the continuous price movements by buying and selling constantly.
However, as a rule, the one time I will recommend an ETF over its index fund counterpart is when the ETF has lower expenses associated with it. For example, the article mentions how "the average ETF expense ratio is 0.6% of assets, compared with an average 0.8% for traditional index funds, according to investment researcher Morningstar." This amount will differ on a firm by firm basis, but the lower the expense ratio, the better. However, make sure that you're not incurring any type of substantial commission by buying the ETF - after all, purchasing an index fund through a firm like Vanguard is free - you will simply incur year end expenses deducted from your fund's assets.
However, as a rule, the one time I will recommend an ETF over its index fund counterpart is when the ETF has lower expenses associated with it. For example, the article mentions how "the average ETF expense ratio is 0.6% of assets, compared with an average 0.8% for traditional index funds, according to investment researcher Morningstar." This amount will differ on a firm by firm basis, but the lower the expense ratio, the better. However, make sure that you're not incurring any type of substantial commission by buying the ETF - after all, purchasing an index fund through a firm like Vanguard is free - you will simply incur year end expenses deducted from your fund's assets.
Wednesday, October 6, 2010
Vanguard Cuts Fund Fees Further
There's some great news out there today for individual investors: Vanguard, the index fund giant, has announced that they are cutting fees further on most of their index fund offerings. They are doing this by cutting the minimum investment required for their Admiral shares. Before the cut, it required $100,000 to invest in the Admiral shares but now it will only be $10,000. Amazingly, the AP report states:
"For example, Admiral shares of Vanguard's Total Stock Market Index Fund will charge $7 in annual expenses for every $1,000 invested, provided an investor has at least $10,000 in the fund. That's down from $18 in annual expenses for Investor shares in the $138 billion fund, which requires a minimum of $3,000."
Yes, that's only $7 in annual expenses for every $1,000 invested or about 0.007%! It's important to remember that these fees are deducted directly from the fund's assets and are not charged so that you have to write a check to cover the expense amount. Overall, this is fantastic news for retail investors who have seen fees and expenses skyrocket in recent years. It's clear that Vanguard "gets it"!
"For example, Admiral shares of Vanguard's Total Stock Market Index Fund will charge $7 in annual expenses for every $1,000 invested, provided an investor has at least $10,000 in the fund. That's down from $18 in annual expenses for Investor shares in the $138 billion fund, which requires a minimum of $3,000."
Yes, that's only $7 in annual expenses for every $1,000 invested or about 0.007%! It's important to remember that these fees are deducted directly from the fund's assets and are not charged so that you have to write a check to cover the expense amount. Overall, this is fantastic news for retail investors who have seen fees and expenses skyrocket in recent years. It's clear that Vanguard "gets it"!
Tuesday, October 5, 2010
More Parents Raiding Retirement Accounts for College
A study released today by student loan provider Sallie Mae and the Gallup Organization shows that 25% of the nation's parents are now raiding their retirement accounts to pay for their children's education, regardless of the tax consequences. This news is disconcerting on a number of levels, namely that parents don't have enough money saved up elsewhere for college but also because of the large tax burdens that can arise from tapping a 401(k) or IRA prematurely.
Even worse, parents are using investment vehicles that have a dubious track record when it comes to producing the returns needed when college comes calling. CNNMoney reports that "the most common way that parents reported saving for college was with CDs or general savings accounts. Some 50% used those more traditional forms of saving, according to the survey." Adjusted for inflation, these savings accounts aren't going to produce the returns necessary for a tuition payment. Thus, that means that parents using them will have to save that much more, just to be in the ballpark of a tuition payment. The moral of the story? Save early and often for whatever goal you would like to achieve so that you're not stuck tapping funds that should be used only for retirement.
Even worse, parents are using investment vehicles that have a dubious track record when it comes to producing the returns needed when college comes calling. CNNMoney reports that "the most common way that parents reported saving for college was with CDs or general savings accounts. Some 50% used those more traditional forms of saving, according to the survey." Adjusted for inflation, these savings accounts aren't going to produce the returns necessary for a tuition payment. Thus, that means that parents using them will have to save that much more, just to be in the ballpark of a tuition payment. The moral of the story? Save early and often for whatever goal you would like to achieve so that you're not stuck tapping funds that should be used only for retirement.
Monday, October 4, 2010
The Difficulty of Decision Making
Shirley Wang at The Wall Street Journal has an interesting article on a psychological issue - the difficult nature of decision making. A lot of the information in the article pertains to investing, as well. Generation Y may find that it's very difficult to make the tough decisions about financial issues because so much seems to be at stake. After all, if you plan incorrectly, have a mix of the wrong investments or the like, you risk financial ruin at a very young age. However, high stakes do not have to mean that decision making should be difficult.
Ultimately, almost everything in the world of individual investment can be whittled down into investment policy - the act of defining long-term financial goals and the means by which to achieve them. Every investor both young and old needs to have a sound investment policy. So, what does that policy consist of? As investors, we must first develop financial goals. For example, a goal may be that you would like to retire at age 55 with a nest egg of $2 million. Secondly, we should outline the appropriate ways to achieve those goals including the investments that we can use to help us get there. Lastly, we should determine the exact investments to put into our overall asset allocation and evaluate them accordingly.
This is a simplified way of creating a sound investment policy but you will find that if you work hard on it now, the amount of work required in the future on it will simply be a matter of tying up the loose odds and ends. Yes, it may be difficult to make decisions. With a rock-solid investment policy, it doesn't have to be.
Ultimately, almost everything in the world of individual investment can be whittled down into investment policy - the act of defining long-term financial goals and the means by which to achieve them. Every investor both young and old needs to have a sound investment policy. So, what does that policy consist of? As investors, we must first develop financial goals. For example, a goal may be that you would like to retire at age 55 with a nest egg of $2 million. Secondly, we should outline the appropriate ways to achieve those goals including the investments that we can use to help us get there. Lastly, we should determine the exact investments to put into our overall asset allocation and evaluate them accordingly.
This is a simplified way of creating a sound investment policy but you will find that if you work hard on it now, the amount of work required in the future on it will simply be a matter of tying up the loose odds and ends. Yes, it may be difficult to make decisions. With a rock-solid investment policy, it doesn't have to be.
Friday, October 1, 2010
The Moral of the Story Is...
A few days ago, The Wall Street Journal's Brett Arends penned an article entitled, "You Should Have Timed the Market". Arends bases his assertion on the fact that recent research from TrimTabs indicates that regular investors bought into equity mutual funds during the boom and needlessly sold them when everyone was panicking and selling their positions. As a result, investor losses were pegged at $39 billion.
Arends points out that TrimTabs, "calculates that mutual fund investors bought into the Standard & Poor's 500-stock index at an average of 1,434. That's close to its record high of 1,565. If investors had invested at random times instead, their average purchase price would have been 1,171."
The conclusion shouldn't be that we should time the market. Yes, we should buy when everyone else is selling. As was famously said, you should buy stock when "there's blood in the streets". However, by tacitly agreeing to market time, you are setting yourself up to head down a very slippery slope. By engaging in this, you'll soon see that you find yourself jumping into and out of equities at precisely the wrong times because your emotions play such a big role in investing.
For example, suppose you've held a stock for a few years and have done extremely well with it. You have done the appropriate research and realize that the stock is still undervalued and so you continue to add to your position. When the company releases a poor earnings report, should you sell because everyone else is? Of course not! It's almost always a bad bet to follow the herd and to let your emotions get the best of you. You should always have the courage to stick to your convictions until the underlying fundamentals prove otherwise.
Instead, rather than "timing" the market as Arends advocates, it's a better idea to dollar cost average (DCA). With this, you simply buy into your investment (index fund, stock, etc.) without paying any attention to the price. This is helpful because you'll find that over the long-term, your average purchase price will be quite small and it will make up for any of the problems you would have had if you had tried to time your purchases based on the prevailing "wisdom" in the market. Dollar cost averaging beats market timing - always.
Arends points out that TrimTabs, "calculates that mutual fund investors bought into the Standard & Poor's 500-stock index at an average of 1,434. That's close to its record high of 1,565. If investors had invested at random times instead, their average purchase price would have been 1,171."
The conclusion shouldn't be that we should time the market. Yes, we should buy when everyone else is selling. As was famously said, you should buy stock when "there's blood in the streets". However, by tacitly agreeing to market time, you are setting yourself up to head down a very slippery slope. By engaging in this, you'll soon see that you find yourself jumping into and out of equities at precisely the wrong times because your emotions play such a big role in investing.
For example, suppose you've held a stock for a few years and have done extremely well with it. You have done the appropriate research and realize that the stock is still undervalued and so you continue to add to your position. When the company releases a poor earnings report, should you sell because everyone else is? Of course not! It's almost always a bad bet to follow the herd and to let your emotions get the best of you. You should always have the courage to stick to your convictions until the underlying fundamentals prove otherwise.
Instead, rather than "timing" the market as Arends advocates, it's a better idea to dollar cost average (DCA). With this, you simply buy into your investment (index fund, stock, etc.) without paying any attention to the price. This is helpful because you'll find that over the long-term, your average purchase price will be quite small and it will make up for any of the problems you would have had if you had tried to time your purchases based on the prevailing "wisdom" in the market. Dollar cost averaging beats market timing - always.
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