Consider the 60/40 – stock/bond asset allocation (AA) plan of my comments from March 6, 2009, “Fundamental Asset Class Definitions and Asset Allocation. First, it is important to understand that a simple 60/40 asset allocation plan is a very good plan that is very easy to implement. Historically, it will beat the performance of most other investors provided you use low fee investment instruments to construct the portfolio (ie low cost index funds or Exchange Traded Funds) and you consider a time frame of about a decade or more. Many investors would like to improve on the simple two asset class allocation by including a more sophisticated allocation analysis. There is no guarantee that consideration of additional asset classes will improve performance, so there is no optimum way to construct a more sophisticated asset allocation plan. But historical analysis can help to produce plans that would have performed better under certain economic conditions in the past. What follows are two examples of how to develop a more complex asset allocation plan.
An investor might start by observing that many broad stock market indexes are overweighted with large-cap and underweighted with small-cap stocks. That means that large companies are over-represented in the index as compared to smaller companies. By splitting the stock allocation in half, a second order allocation plan with three components is achieved. The new allocation includes 30% large cap stock, 30% small-cap index, and 40% bond. Introduction of small cap stocks in the allocation historically provides greater long-term returns but also introduces greater volatility (based on 130 years of US stock market history). If an investor is nervous and does not feel comfortable with increased volatility, the second order AA plan would not be advised. If the investor is more experienced and able to maintain the plan through small-cap downturns that may last several years, the second order plan is likely to result in greater long-term returns. Notice that additional appropriate funds must be identified and purchased for this more complex asset allocation plan. In fact, with each addition of a new asset class, additional funds must be used.
Another AA alternative would be to partially replace the small-cap fund with a Real Estate Investment Trust (REIT) investment. REIT returns have been weakly correlated to large cap stock returns in recent years, but tend to exhibit less volatility than small-cap funds during most periods of time.
Further sophistication of the allocation plan can be added by differentiating between value and growth funds. Both the large-cap and small-cap portions of the stock investment can be further split to include large-cap value and small-cap value funds to complement the general large-cap fund and general small-cap fund. The additional weighting of value stocks in the stock portion of the portfolio has historically both decreased volatility and increased long-term return (although not in every historical period). The resulting third order allocation plan includes as many as six components: 15% general large-cap stock, 15% large-cap value fund, 10% general small-cap stock, 10% small-cap value fund, 10% REIT, and 40% short-term bond.
Starting again with a first order 60/40 – stock/bond AA, an alternative asset allocation example can be developed. An investor might decide to split the general stock allocation into large-cap domestic stock, international stock, and small-cap domestic. Over some periods, international stocks have shown low correlation to US-based stocks. The inclusion of 15% to 25% international stock in a portfolio has helped produce both greater returns and reduced volatility during these periods. A second order asset allocation plan designed to address this might include 20% large-cap domestic stock, 20% international stock, 20% small-cap stock, 20% short-term bonds, and 20% intermediate term bonds. In this example, the bond asset allocation has also been sub-divided to provide stability over shorter periods of time.
Both of the above second order asset allocation plans can be rationalized and neither can be proven to be “optimal” for the future. Still other plans can be developed based on examination of alternative subdivisions of the general stock/bond asset classes and historical correlation and volatility data. Before subdividing the general stock/bond allocations and adding an asset class, you should understand what that asset is, the cost of owning it (fees), the risk it brings to your portfolio, and how it may correlate with the other assets in your plan. Adding asset classes without this basic understanding can hurt rather than help your investment portfolio. The number of assets in an investment plan is not an indication of sophistication. If you don’t understand an investment, don’t buy it. An investor that maintains the simple first order stock/bond allocation has historically outperformed most other investors. This is often done with as few as two market-tracking index funds. The simple stock/bond allocation plan, when coupled with a reasonable spending model and regular saving, will get you to a comfortable retirement.
More on Asset classes and Investment Options: http://www.golio.net/Chapter5.html
More on Asset Allocation (see Section 6.2): http://www.golio.net/Chapter6.html
Some material is from Golio, Engineering Your Retirement, Wiley, 2006. (see http://www.golio.net//)
Tuesday, August 18, 2009
Tuesday, June 2, 2009
Bond Basics
A bond is a loan for which the investor is the lender. They are like IOUs. When you purchase a bond, you are lending money to the government, a company, or some other organization. Bonds are sold in fixed increments, normally $1000. The organization that sells a bond is known as the issuer. Like other loans, there is an amount borrowed (face value or par value). There is an applicable interest rate (coupon rate), and a specified time when the bond must be paid off (maturity date). Bond maturities can range from days to decades. The bonds that typical individual investors purchase have maturity dates that are years to decades in length. Interest is paid to the bond owner on a schedule specified by the bond – typically every six months, although quarterly or monthly payments are sometimes specified. Because the cash flow from them is fixed, bonds are also known as fixed-income securities. On the maturity date, the face value of the bond is returned to the bondholder.
(Example: You buy a bond with $1000 face value, 5% coupon rate, and 5 year maturity date. Purchase of the bond costs you $1000 plus any sales fees. Every six months – as specified by the bond -- you are paid $25 in interest payments. Five years from the date of purchase, you get your $1000 purchase price back.)
Long-term investors include bonds in their portfolio to provide stability, not higher returns. For long-term investment periods (25 years or longer), the stock market has always beat bond performance. For periods of a decade or less, however, stable bond interest can outperform the more volatile stock market. For most investors it makes sense to have part (but not all) of their portfolio invested in bonds.
Bonds are debt while stocks are equity. This distinction means that equity holders are owners of a company while bondholders are creditors. Legally, the creditors (bondholders) have a higher claim on assets. In case of bankruptcy, a bondholder will get paid before a stockholder. An organization’s bonds carry less risk than their stock certificates. Since the bondholder is taking less risk, he or she almost always receives lower returns. The relationship between risk and reward (ie. higher reward requires taking greater risk) is the underlying principle for all investments.
Not all bonds carry the same risk. The more risky the bond investment, the higher the coupon rate of the bond. Companies sometimes default and fail to pay back bonds. Large, stable company bonds tend to pay less than those of small, volatile companies. Government bonds are the least risky and also tend to pay the lowest rate.
Time is also a factor in bond risk. A bond that matures in 30 years is much less predictable, and therefore more risky, than a bond that matures in 1 year. For this reason, longer time to maturity is usually associated with higher interest rates. Bond investors should consider underlying risk before investing in a bond.
How does an investor evaluate bond risk? -- Bond ratings can be useful in evaluating the default risk of bond issuers. Bond ratings are developed and published by two major rating organizations in the United States: Moody’s, and Standard & Poor’s (S&P). These ratings are similar to a report card on the issuer’s stability. The highest grades are awarded to the government since they are the closest thing to a risk-free investment available. Large, blue-chip firms tend to receive fairly high ratings because of corporate stability. Financially unstable companies receive low ratings.
Moody’s Ratings in order from least to most risk are Aaa, Aa, A, Baa, Ba, B, Caa, Ca, C. S&P ratings (low to high risk) are AAA, AA, A, BBB, BB, B, CCC, CC, C, D. Bonds with ratings of higher risk Ba or BB are referred to as junk bonds. These bonds offer high yield, but at greater risk.
A bond can be sold before its maturity date. When bonds are sold like this, it is on the secondary market. The price of such sales can fluctuate from the face value. If a bond is bought at face value, the yield is equivalent to the coupon rate of the bond. If the bond is purchased at a price greater than face value, the payments remain fixed, providing a yield less than the coupon rate. Similarly, a bond purchased at below face value will produce a higher yield than the coupon. The yield to maturity (YTM) is the return an investor will receive from a bond purchased on the secondary market at a price different than the face value. YTM can be larger or smaller than the bond coupon. Bond prices and bond yields are inversely related.
The entire bond market can be categorized along a dual continuum. The classifications that apply to bonds are maturity and credit rating. Conventional maturity classifications are long (greater than 10 years), intermediate (4 to 10 years) and short (less than 4 years). Credit rating is the Moody’s or S&P’s credit rating as discussed above. As an example, a U.S. treasury bond with a 20 year maturity would be classified as a long-term, low-risk bond, while a bond from a financially struggling small company with a 3 year maturity would be a short-term, junk bond.
In addition to the maturity and credit rating, bonds can be divided into US or foreign debt. Non-US bonds can be further classified either as emerging or as developed country debt. Bonds can also be classified by the business sector of the company.
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adapted from Engineering Your Retirement, Golio, Wiley, 2006. http://www.golio.net/EngineeringYourRetirement.html
(Example: You buy a bond with $1000 face value, 5% coupon rate, and 5 year maturity date. Purchase of the bond costs you $1000 plus any sales fees. Every six months – as specified by the bond -- you are paid $25 in interest payments. Five years from the date of purchase, you get your $1000 purchase price back.)
Long-term investors include bonds in their portfolio to provide stability, not higher returns. For long-term investment periods (25 years or longer), the stock market has always beat bond performance. For periods of a decade or less, however, stable bond interest can outperform the more volatile stock market. For most investors it makes sense to have part (but not all) of their portfolio invested in bonds.
Bonds are debt while stocks are equity. This distinction means that equity holders are owners of a company while bondholders are creditors. Legally, the creditors (bondholders) have a higher claim on assets. In case of bankruptcy, a bondholder will get paid before a stockholder. An organization’s bonds carry less risk than their stock certificates. Since the bondholder is taking less risk, he or she almost always receives lower returns. The relationship between risk and reward (ie. higher reward requires taking greater risk) is the underlying principle for all investments.
Not all bonds carry the same risk. The more risky the bond investment, the higher the coupon rate of the bond. Companies sometimes default and fail to pay back bonds. Large, stable company bonds tend to pay less than those of small, volatile companies. Government bonds are the least risky and also tend to pay the lowest rate.
Time is also a factor in bond risk. A bond that matures in 30 years is much less predictable, and therefore more risky, than a bond that matures in 1 year. For this reason, longer time to maturity is usually associated with higher interest rates. Bond investors should consider underlying risk before investing in a bond.
How does an investor evaluate bond risk? -- Bond ratings can be useful in evaluating the default risk of bond issuers. Bond ratings are developed and published by two major rating organizations in the United States: Moody’s, and Standard & Poor’s (S&P). These ratings are similar to a report card on the issuer’s stability. The highest grades are awarded to the government since they are the closest thing to a risk-free investment available. Large, blue-chip firms tend to receive fairly high ratings because of corporate stability. Financially unstable companies receive low ratings.
Moody’s Ratings in order from least to most risk are Aaa, Aa, A, Baa, Ba, B, Caa, Ca, C. S&P ratings (low to high risk) are AAA, AA, A, BBB, BB, B, CCC, CC, C, D. Bonds with ratings of higher risk Ba or BB are referred to as junk bonds. These bonds offer high yield, but at greater risk.
A bond can be sold before its maturity date. When bonds are sold like this, it is on the secondary market. The price of such sales can fluctuate from the face value. If a bond is bought at face value, the yield is equivalent to the coupon rate of the bond. If the bond is purchased at a price greater than face value, the payments remain fixed, providing a yield less than the coupon rate. Similarly, a bond purchased at below face value will produce a higher yield than the coupon. The yield to maturity (YTM) is the return an investor will receive from a bond purchased on the secondary market at a price different than the face value. YTM can be larger or smaller than the bond coupon. Bond prices and bond yields are inversely related.
The entire bond market can be categorized along a dual continuum. The classifications that apply to bonds are maturity and credit rating. Conventional maturity classifications are long (greater than 10 years), intermediate (4 to 10 years) and short (less than 4 years). Credit rating is the Moody’s or S&P’s credit rating as discussed above. As an example, a U.S. treasury bond with a 20 year maturity would be classified as a long-term, low-risk bond, while a bond from a financially struggling small company with a 3 year maturity would be a short-term, junk bond.
In addition to the maturity and credit rating, bonds can be divided into US or foreign debt. Non-US bonds can be further classified either as emerging or as developed country debt. Bonds can also be classified by the business sector of the company.
===============
adapted from Engineering Your Retirement, Golio, Wiley, 2006. http://www.golio.net/EngineeringYourRetirement.html
Friday, March 6, 2009
Fundamental Asset Class Definitions and Asset Allocation
Asset allocation (AA) focuses on managing investment risk while accepting that an investor is not likely to be able to predict what will happen next in the markets. An asset allocation plan involves choosing the asset classes that will comprise the plan and setting target percentages of the overall portfolio that should be invested in each class. Studies show that the asset class choices for an investor are the primary indicator of both performance and risk when considered over long periods of time. The actual specific investments within those asset classes are far less important. An AA plan requires periodically (typically once per year) rebalancing the portfolio as one asset class outperforms another. Rebalancing maintains the portfolio risk at a fairly constant level.
What is an asset class? The most fundamental distinction of asset classes is stocks vs. bonds.
A bond is a loan for which the investor is the lender. They are like IOUs. When a bond is purchased, the buyer is lending money to a government, company, or other organization. Interest is paid to the bond owner on a schedule specified by the bond – typically every six months. The interest rate is fixed by the terms of the bond. If the company performs astronomically well, the bond still only pays according to those terms. It does not pay more. On the other hand, bonds pay the terms of the bonds regardless of poorer than expected company performance (unless the company goes bankrupt). Investors include bonds in their portfolio to provide stability, not higher returns. For long-term investment periods, the stock market has always beaten bond performance. For periods of a decade or less, however, stable bond interest can outperform the more volatile stock market. For most investors it makes sense to have at least part of their portfolio invested in bonds. Bonds can be subdivided into multiple asset classes. A bond is classified by it’s duration, it’s risk (as determined by Moody’s or Standard and Poor’s rating system) and by country of origin. For example one bond might be an international, long-term, Moody’s Baa bond while another is a US, short-term, Moody’s Aaa bond. You can learn details about bond rating systems in Section 5.1: Wikipedia Bond Credit Rating: http://www.golio.net/Chapter5.html An asset class can also be defined using any or all of these distinctions.
Stocks are a certificate of ownership in a company. As a stockholder, you are not personally liable for company debts or mismanagement -- even if you are a shareholder of a company that goes bankrupt. On the other hand, your participation in earnings has no limit. While you can lose no more than 100% of your investment, you can earn more than 10,000% on your stock if the company is very successful. For the greater risk of owning stocks, the investor demands greater returns. This is the reason that throughout history stocks have outperformed other investments over the long term. Stocks can be further distinguished by the size of the company selling the stock. Large companies are large-cap stocks. Small companies are small-cap stocks and medium sized companies are mid-cap stocks. Stocks can be classified along a second continuum as either growth or value stocks. Using these two classifications subdivides the stock asset class into 6 other possible asset classes. When a distinction between US companies and international companies is added, we end up with 12 possible asset classes. For example a company’s stock might be an international, large-cap, value stock while another stock is a US, small-cap growth stock, etc.
An asset allocation plan can be developed based simply on the stock/bond distinction. An AA could establish a target allocation of 60% stock and 40% bond for their portfolio. A reasonable rule-of-thumb for determining stock allocation is to compute (100 – [your age]) as a target stock percentage. Thus a 40 year old would choose a 60/40 stock/bond allocation. An investor who is comfortable with more risk might use (110 – age) while a conservative investor might choose (90 – age) to compute a stock target. Such a plan isn’t complete until the investor decides how he/she will own stocks and bonds. An investor can choose to pick individual stocks and bonds through a brokerage house, or buy them through mutual funds. For an individual, diversification is most easily achieved by choosing mutual funds. A very good first order asset allocation plan could be based on only two mutual funds: 1) A broad stock market index fund, and 2) a broad bond market index fund. Historically, for periods of at least two decades, an investor with an asset allocation plan with only these two, low cost index funds would have outperformed over 80% of all other investors.
Investors may be able to improve on the above fundamental asset allocation plan by using the more refined divisions of stocks and bonds as asset class definitions. The 60% stock allocation, for example, might be broken down into 40% US stocks and 20% international stocks. Further subdivisions that consider the growth-value and/or size continuum can also be applied. Bond class definitions can similarly be applied. In addition, real estate and/or commodities can be added to the target asset classes.
Not all asset class distinctions are useful to an investor. Adding more asset classes without understanding correlations between those assets does not help a portfolio in terms of risk or reward. In other words, more asset classes is not necessarily an indicator of a more sophisticated investor.
For more on asset allocations, refer to http://www.golio.net/Chapter6.html Section 6.2.
Visit my site at: http://www.golio.net/
What is an asset class? The most fundamental distinction of asset classes is stocks vs. bonds.
A bond is a loan for which the investor is the lender. They are like IOUs. When a bond is purchased, the buyer is lending money to a government, company, or other organization. Interest is paid to the bond owner on a schedule specified by the bond – typically every six months. The interest rate is fixed by the terms of the bond. If the company performs astronomically well, the bond still only pays according to those terms. It does not pay more. On the other hand, bonds pay the terms of the bonds regardless of poorer than expected company performance (unless the company goes bankrupt). Investors include bonds in their portfolio to provide stability, not higher returns. For long-term investment periods, the stock market has always beaten bond performance. For periods of a decade or less, however, stable bond interest can outperform the more volatile stock market. For most investors it makes sense to have at least part of their portfolio invested in bonds. Bonds can be subdivided into multiple asset classes. A bond is classified by it’s duration, it’s risk (as determined by Moody’s or Standard and Poor’s rating system) and by country of origin. For example one bond might be an international, long-term, Moody’s Baa bond while another is a US, short-term, Moody’s Aaa bond. You can learn details about bond rating systems in Section 5.1: Wikipedia Bond Credit Rating: http://www.golio.net/Chapter5.html An asset class can also be defined using any or all of these distinctions.
Stocks are a certificate of ownership in a company. As a stockholder, you are not personally liable for company debts or mismanagement -- even if you are a shareholder of a company that goes bankrupt. On the other hand, your participation in earnings has no limit. While you can lose no more than 100% of your investment, you can earn more than 10,000% on your stock if the company is very successful. For the greater risk of owning stocks, the investor demands greater returns. This is the reason that throughout history stocks have outperformed other investments over the long term. Stocks can be further distinguished by the size of the company selling the stock. Large companies are large-cap stocks. Small companies are small-cap stocks and medium sized companies are mid-cap stocks. Stocks can be classified along a second continuum as either growth or value stocks. Using these two classifications subdivides the stock asset class into 6 other possible asset classes. When a distinction between US companies and international companies is added, we end up with 12 possible asset classes. For example a company’s stock might be an international, large-cap, value stock while another stock is a US, small-cap growth stock, etc.
An asset allocation plan can be developed based simply on the stock/bond distinction. An AA could establish a target allocation of 60% stock and 40% bond for their portfolio. A reasonable rule-of-thumb for determining stock allocation is to compute (100 – [your age]) as a target stock percentage. Thus a 40 year old would choose a 60/40 stock/bond allocation. An investor who is comfortable with more risk might use (110 – age) while a conservative investor might choose (90 – age) to compute a stock target. Such a plan isn’t complete until the investor decides how he/she will own stocks and bonds. An investor can choose to pick individual stocks and bonds through a brokerage house, or buy them through mutual funds. For an individual, diversification is most easily achieved by choosing mutual funds. A very good first order asset allocation plan could be based on only two mutual funds: 1) A broad stock market index fund, and 2) a broad bond market index fund. Historically, for periods of at least two decades, an investor with an asset allocation plan with only these two, low cost index funds would have outperformed over 80% of all other investors.
Investors may be able to improve on the above fundamental asset allocation plan by using the more refined divisions of stocks and bonds as asset class definitions. The 60% stock allocation, for example, might be broken down into 40% US stocks and 20% international stocks. Further subdivisions that consider the growth-value and/or size continuum can also be applied. Bond class definitions can similarly be applied. In addition, real estate and/or commodities can be added to the target asset classes.
Not all asset class distinctions are useful to an investor. Adding more asset classes without understanding correlations between those assets does not help a portfolio in terms of risk or reward. In other words, more asset classes is not necessarily an indicator of a more sophisticated investor.
For more on asset allocations, refer to http://www.golio.net/Chapter6.html Section 6.2.
Visit my site at: http://www.golio.net/
Sunday, February 15, 2009
Asset Allocation vs Market Timing
The underlying, fundamental principle that describes investments is that greater return comes with greater risk. The underlying cause for this relationship is that investors expect to be compensated for taking on additional risk. A U.S. Treasury bond, for example, provides lower return than a corporate bond. The reason for the difference in returns is that the risk of a corporation going bankrupt is higher than the risk that the government goes bankrupt. The corporation has to pay a higher rate than the government to entice investors to buy their bonds rather than government bonds. The risk-return continuum that applies to government and corporate bonds also applies to stock, mutual fund, real estate and commodity investments. All investment choices need to consider an individual’s comfort level with risk and his/her requirements for reward.
Investment strategies can be classified along a continuum between asset allocation and market timing. Asset allocators are investors who focus first on managing risk by maintaining fixed percentages of their portfolio in various asset classes – each associated with that class’ risk. For example, a simple asset allocation plan might be to keep 30% of investments in US stock market investments, 30% in international stock investments, and 40% in short-term bonds. A pure asset allocation strategy would involve establishing a portfolio with this mix of investments, then periodically (once a year, for example) re-balancing the overall portfolio to maintain the asset classes at the same levels. Asset allocators accept that they cannot predict what the markets will do and choose instead to manage risk.
In contrast, market timers focus first on return. Buy low; sell high is the goal of the market timer. Market timing is a seductive strategy. Engineers who are used to optimizing performance understand that maximizing yield must involve picking equities and bonds when they are underpriced and selling them when they are overpriced. Unfortunately, this is easier said than done. In order to successfully time the market, the investor must 1) identify a bargain correctly before anyone else has done so. Once others identify the bargain, the market will immediately increase the price until it is priced appropriately. 2) buy the bargain at the right time. 3) sell the bargain at the right time. If a market timer misses on any of the above tasks, they can completely eliminate their profit advantage.
Countless studies have looked at various investments strategies and compared the resulting performance. Over periods as short as 5 years, most asset allocators outperform market timers. As the time period gets longer, the performance advantage of asset allocation grows. For periods of 2 or 3 decades, only a small fraction of market timers are comparable to pure asset allocation strategies.
Visit my site at http://www.golio.net/
Investment strategies can be classified along a continuum between asset allocation and market timing. Asset allocators are investors who focus first on managing risk by maintaining fixed percentages of their portfolio in various asset classes – each associated with that class’ risk. For example, a simple asset allocation plan might be to keep 30% of investments in US stock market investments, 30% in international stock investments, and 40% in short-term bonds. A pure asset allocation strategy would involve establishing a portfolio with this mix of investments, then periodically (once a year, for example) re-balancing the overall portfolio to maintain the asset classes at the same levels. Asset allocators accept that they cannot predict what the markets will do and choose instead to manage risk.
In contrast, market timers focus first on return. Buy low; sell high is the goal of the market timer. Market timing is a seductive strategy. Engineers who are used to optimizing performance understand that maximizing yield must involve picking equities and bonds when they are underpriced and selling them when they are overpriced. Unfortunately, this is easier said than done. In order to successfully time the market, the investor must 1) identify a bargain correctly before anyone else has done so. Once others identify the bargain, the market will immediately increase the price until it is priced appropriately. 2) buy the bargain at the right time. 3) sell the bargain at the right time. If a market timer misses on any of the above tasks, they can completely eliminate their profit advantage.
Countless studies have looked at various investments strategies and compared the resulting performance. Over periods as short as 5 years, most asset allocators outperform market timers. As the time period gets longer, the performance advantage of asset allocation grows. For periods of 2 or 3 decades, only a small fraction of market timers are comparable to pure asset allocation strategies.
Visit my site at http://www.golio.net/
Saturday, January 31, 2009
Investing Basics
When it comes to investing, people don’t agree on anything. Investors disagree on what to buy, when to buy it, and how long to hold it. Some trade individual stocks or bonds, others only invest in mutual funds. There are disciples of real estate, commodity traders . . . you name it. Some investors believe in using a pure asset allocation strategy. They maintain specific target percentages of their portfolio in specific asset classes (X% stock, Y% bond, Z% real estate,. . .) regardless of what the markets do. Other investors try to time the market (buy low, sell high). Regardless of what method they use, most investors believe that their method is best and every other investment style is inferior.
But here’s the truth. The "best" method to use is one that you understand and can live with. Trying to emulate the success of someone else probably won't work for you unless you have the exact same knowledge and temperament that they have. Here’s another fact: Most investors who think they have the best method are fooling themselves and are almost certainly underperforming the markets.
For the vast majority of successful investors, the key to asset accumulation is to 1) Live Below Your Means (LBYM), 2) Invest regularly, and 3) Let time in the markets work its magic. Obsession about trying to beat the market is more likely to hurt your chances of success than to help you. If you avoid throwing your money at get-rich-quick schemes, invest regularly, and follow a few simple guidelines, the choices of what specifically to invest in are less important than many investors fear.
The simple guidelines:
1) Diversify. Don’t put all your investments in a handful of stocks, for example. Index funds are a great way to do this. They diversify investments across an entire market index.
2) Minimize Fees. If you buy mutual funds you should be looking at the expense ratio (expenses/assets expressed as a percentage). Different mutual funds will have expense ratios that vary from as low as 0.15% to over 4%. Countless studies have shown that over periods of a few decades or longer, fees are the single best predictor of which funds will do best. Higher fees mean poorer performance. It’s that simple. If you buy stocks or bonds directly, look for discount brokers. Fees matter.
3) You don’t have to beat the market to get rich. Timing the market is hard. Despite what your neighbors, colleagues or broker may tell you, the vast majority of people do not beat the market. And the longer the period of time you consider, the fewer the number who actually do. The truth is that your neighbors, colleagues and broker probably spend too much money, have too much debt, and don’t have a clue how their portfolio really did against the market. If you invest in index funds, you will (by definition) match the markets (minus fees). If you put your money in low fee index funds and let time do its magic, you can achieve the nest egg you need to retire. You have better things to do than read corporate 10K forms, study charts and call your broker. If you do choose to try to time the market, you will need to understand your greed/fear levels and control them well as your investments rise and fall. Invest in a good program that will keep track of your returns and be honest with yourself. Studies show that most people who invest this way dramatically overestimate the actual performance of their portfolios.
4) Understand your risk tolerance. Your investments are at risk. Regardless of how you have chosen to save (stocks, bonds, commodities, annuities, houses, or buried in a jar in the back yard) there is a chance you could lose all or part of your investment. The underlying principle that drives investment results is that there is a direct relationship between risk and return. Greater investment risk brings greater potential returns (long term). The underlying cause for this relationship is that investors expect to be compensated for taking on additional risk. It is hard to understand risk and its effect on comfort until an investor actually experiences significant declines in their portfolio. Risk tolerance before a market decline is like courage before a battle. Until it is tested, it is difficult to distinguish someone who is brave from someone merely showing bravado. Establishing your appetite for risk involves gauging the potential impact of a major loss on both your portfolio and psyche. You need to make sure you have balanced your high flying investments with enough less volatile investments to let you sleep at night in the event of a catastrophic market crash.
For more information go to: http://www.golio.net/Chapter6.html
Visit my site: http://www.golio.net/
But here’s the truth. The "best" method to use is one that you understand and can live with. Trying to emulate the success of someone else probably won't work for you unless you have the exact same knowledge and temperament that they have. Here’s another fact: Most investors who think they have the best method are fooling themselves and are almost certainly underperforming the markets.
For the vast majority of successful investors, the key to asset accumulation is to 1) Live Below Your Means (LBYM), 2) Invest regularly, and 3) Let time in the markets work its magic. Obsession about trying to beat the market is more likely to hurt your chances of success than to help you. If you avoid throwing your money at get-rich-quick schemes, invest regularly, and follow a few simple guidelines, the choices of what specifically to invest in are less important than many investors fear.
The simple guidelines:
1) Diversify. Don’t put all your investments in a handful of stocks, for example. Index funds are a great way to do this. They diversify investments across an entire market index.
2) Minimize Fees. If you buy mutual funds you should be looking at the expense ratio (expenses/assets expressed as a percentage). Different mutual funds will have expense ratios that vary from as low as 0.15% to over 4%. Countless studies have shown that over periods of a few decades or longer, fees are the single best predictor of which funds will do best. Higher fees mean poorer performance. It’s that simple. If you buy stocks or bonds directly, look for discount brokers. Fees matter.
3) You don’t have to beat the market to get rich. Timing the market is hard. Despite what your neighbors, colleagues or broker may tell you, the vast majority of people do not beat the market. And the longer the period of time you consider, the fewer the number who actually do. The truth is that your neighbors, colleagues and broker probably spend too much money, have too much debt, and don’t have a clue how their portfolio really did against the market. If you invest in index funds, you will (by definition) match the markets (minus fees). If you put your money in low fee index funds and let time do its magic, you can achieve the nest egg you need to retire. You have better things to do than read corporate 10K forms, study charts and call your broker. If you do choose to try to time the market, you will need to understand your greed/fear levels and control them well as your investments rise and fall. Invest in a good program that will keep track of your returns and be honest with yourself. Studies show that most people who invest this way dramatically overestimate the actual performance of their portfolios.
4) Understand your risk tolerance. Your investments are at risk. Regardless of how you have chosen to save (stocks, bonds, commodities, annuities, houses, or buried in a jar in the back yard) there is a chance you could lose all or part of your investment. The underlying principle that drives investment results is that there is a direct relationship between risk and return. Greater investment risk brings greater potential returns (long term). The underlying cause for this relationship is that investors expect to be compensated for taking on additional risk. It is hard to understand risk and its effect on comfort until an investor actually experiences significant declines in their portfolio. Risk tolerance before a market decline is like courage before a battle. Until it is tested, it is difficult to distinguish someone who is brave from someone merely showing bravado. Establishing your appetite for risk involves gauging the potential impact of a major loss on both your portfolio and psyche. You need to make sure you have balanced your high flying investments with enough less volatile investments to let you sleep at night in the event of a catastrophic market crash.
For more information go to: http://www.golio.net/Chapter6.html
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Saturday, May 3, 2008
How much do I need to retire?
Asking this question is a little bit like asking, “How much gain does an amplifier need?” or, “How much gas does it take to get to Tucson?” Without defining many other details, the questions can’t be discussed intelligently. But if enough other information is specified, you can come up with a reasonable estimate.
For retirement, people can use historical simulations or monte carlo simulations and examine how various investment portfolios (stock/bond allocations) would have performed over time. Such simulations include spending habits and inflation and can look at history and performance distributions in the US since 1871. (If you try to go back further than 1871, it’s hard to find useful and complete data.)
The short answer to the retirement question is that you will need investments (or present net worth of your investments if you have pensions, etc.) equal to about 25 times your current annual spending in order to survive the worst 30 year period in retirement history in the US. If you retired at the worst time in US history but withdrew only 1/25th of your investment portfolio that first year, then increased that withdrawal each year by the annual inflation rate, you would have been able to survive for 30 years without ever decreasing your lifestyle. There are a lot of assumptions about stock/bond allocations, rebalancing your investments, the future being no worse than the worst case past, etc. in that answer. But the answer gives a good first guess at your retirement needs. Notice that (1/25) is 4%. This general rule of thumb is sometimes referred to as the 4% Safe Withdrawal Rate (SWR) or the 4% rule.
If you are interested in running historical or Monte Carlo simulations to analyze your own situation, go to: http://www.golio.net/Chapter2.html
Visit my site: http://www.golio.net/
For retirement, people can use historical simulations or monte carlo simulations and examine how various investment portfolios (stock/bond allocations) would have performed over time. Such simulations include spending habits and inflation and can look at history and performance distributions in the US since 1871. (If you try to go back further than 1871, it’s hard to find useful and complete data.)
The short answer to the retirement question is that you will need investments (or present net worth of your investments if you have pensions, etc.) equal to about 25 times your current annual spending in order to survive the worst 30 year period in retirement history in the US. If you retired at the worst time in US history but withdrew only 1/25th of your investment portfolio that first year, then increased that withdrawal each year by the annual inflation rate, you would have been able to survive for 30 years without ever decreasing your lifestyle. There are a lot of assumptions about stock/bond allocations, rebalancing your investments, the future being no worse than the worst case past, etc. in that answer. But the answer gives a good first guess at your retirement needs. Notice that (1/25) is 4%. This general rule of thumb is sometimes referred to as the 4% Safe Withdrawal Rate (SWR) or the 4% rule.
If you are interested in running historical or Monte Carlo simulations to analyze your own situation, go to: http://www.golio.net/Chapter2.html
Visit my site: http://www.golio.net/
Sunday, April 13, 2008
Fees and 401(k) or 457(b) Accounts
Common advice offered to investors is that they should contribute to available tax-deferred plans (like 401ks and 457bs) before investing in after tax accounts. In most cases, this is good advice. It is especially advantageous when company matching contributions are available. If your employer is providing matching funds to your tax deferred accounts, then when you fail to contribute, it is like voluntarily giving up salary. Make sure you get all the matching funds you can get or you are effectively taking a cut in wages.
Even if matching funds are not involved, tax-deferred plans are often better investments than contributions to an after tax account. Consider the following cases:
CASE #1 (After tax contributions):
Contribute $3000 per year to an after tax account for 30 years.
Then withdraw $3000 per year from the account for 30 years.
(net contribution after 60 years =$0)
Assume the account earns 7% per year return with an expense ratio of 0.2% (typical of low-cost index funds)
Assume the pre-retirement tax rate is 28% and the post-retirement tax rate is 18%.
Withdrawals are tax free (since youve already paid tax on the money when you invested).
CASE #2 (Tax deferred account):
As in case 1, contribute $3000 per year to a tax-deferred account for 30 years.
Then, identical to case 1, withdraw the $3000 per year from the account for 30 years.
(net contribution after 60 years =$0)
Assume the account earns at a rate identical to case 1 -- 7% per year return with an identical expense ratio of 0.2% (typical of index funds)
Assume the pre-retirement tax rate is 0% and the post-retirement tax rate is 0% (Consistent with 401(k) and 457(b) regulations).
Withdrawals are taxed at 18%.
CASE #1 describes typical numbers for a taxable index fund account while CASE #2 describes numbers that might apply for a 401(k) or 457(b). Of course every individuals experience and tax situation is different.
At the end of 30 years, the tax-deferred account of CASE #2 would be worth ~$295,000 while the after tax account of CASE #1 would be worth ~$208,000. Tax deferred treatment is worth ~$87,000.
Once the withdrawal phase is started (years 31 to 60), the taxable account has an advantage since withdrawals do not count as income and so are not taxed. Despite this advantage, at the end of year 60, the tax-deferred account is valued at ~$1.8M while the taxable account is valued at only ~$1.2M a $600,000 advantage to tax-deferred accounts.
But what happens if the 401k account is burdened with high fees? Using identical assumptions for the two cases except assuming the CASE #2 tax-deferred account expense ratio is 1% rather than 0.2% results in the complete annihilation of the tax-deferred advantage. With a 1% expense ratio, the tax-deferred account grows only to ~$256,000 in 30 years (an advantage over after tax saving of only $48,000). But even that slight advantage is lost entirely during the withdrawal phase. For higher expense ratios, a tax-deferred account is actually a bad investment when compared to the low-fee, equivalent returning fund in a taxable account.
Fund expense ratios as high as 1%, or even 4% to 5%, are not unusual. With only a 2.1% expense ratio on the tax-deferred mutual fund, all advantage is lost even in the 30 years of the contribution phase. During the withdrawal phase, this tax-deferred account would lose over $500,000 compared to after tax saving of CASE #1. It pays for investors to keep their eye on expenses. If your employer isnt offering matching funds and offers no low-fee mutual funds in their plan, you might be better off investing your money in a taxable account.
Tax efficient withdrawal tools: Use the ORP Distribution Planner link in Section 8.3 at http://www.golio.net/Chapter8.html
Visit my site: http://www.golio.net/
Even if matching funds are not involved, tax-deferred plans are often better investments than contributions to an after tax account. Consider the following cases:
CASE #1 (After tax contributions):
Contribute $3000 per year to an after tax account for 30 years.
Then withdraw $3000 per year from the account for 30 years.
(net contribution after 60 years =$0)
Assume the account earns 7% per year return with an expense ratio of 0.2% (typical of low-cost index funds)
Assume the pre-retirement tax rate is 28% and the post-retirement tax rate is 18%.
Withdrawals are tax free (since youve already paid tax on the money when you invested).
CASE #2 (Tax deferred account):
As in case 1, contribute $3000 per year to a tax-deferred account for 30 years.
Then, identical to case 1, withdraw the $3000 per year from the account for 30 years.
(net contribution after 60 years =$0)
Assume the account earns at a rate identical to case 1 -- 7% per year return with an identical expense ratio of 0.2% (typical of index funds)
Assume the pre-retirement tax rate is 0% and the post-retirement tax rate is 0% (Consistent with 401(k) and 457(b) regulations).
Withdrawals are taxed at 18%.
CASE #1 describes typical numbers for a taxable index fund account while CASE #2 describes numbers that might apply for a 401(k) or 457(b). Of course every individuals experience and tax situation is different.
At the end of 30 years, the tax-deferred account of CASE #2 would be worth ~$295,000 while the after tax account of CASE #1 would be worth ~$208,000. Tax deferred treatment is worth ~$87,000.
Once the withdrawal phase is started (years 31 to 60), the taxable account has an advantage since withdrawals do not count as income and so are not taxed. Despite this advantage, at the end of year 60, the tax-deferred account is valued at ~$1.8M while the taxable account is valued at only ~$1.2M a $600,000 advantage to tax-deferred accounts.
But what happens if the 401k account is burdened with high fees? Using identical assumptions for the two cases except assuming the CASE #2 tax-deferred account expense ratio is 1% rather than 0.2% results in the complete annihilation of the tax-deferred advantage. With a 1% expense ratio, the tax-deferred account grows only to ~$256,000 in 30 years (an advantage over after tax saving of only $48,000). But even that slight advantage is lost entirely during the withdrawal phase. For higher expense ratios, a tax-deferred account is actually a bad investment when compared to the low-fee, equivalent returning fund in a taxable account.
Fund expense ratios as high as 1%, or even 4% to 5%, are not unusual. With only a 2.1% expense ratio on the tax-deferred mutual fund, all advantage is lost even in the 30 years of the contribution phase. During the withdrawal phase, this tax-deferred account would lose over $500,000 compared to after tax saving of CASE #1. It pays for investors to keep their eye on expenses. If your employer isnt offering matching funds and offers no low-fee mutual funds in their plan, you might be better off investing your money in a taxable account.
Tax efficient withdrawal tools: Use the ORP Distribution Planner link in Section 8.3 at http://www.golio.net/Chapter8.html
Visit my site: http://www.golio.net/
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