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Age Based Investing for Retirement

Miranda — Thu, 06 May 2010 18:45:09 +0000

Source: sxc.hu Photo: lumix2004

There are a number of strategies that you can follow as you attempt to reach your retirement goal. One of these strategies is investing based on your age. This is especially popular for those planning retirement. By creating an investment plan based on age, it is possible for many to shift their asset allocation in an orderly manner as they approach retirement. However, it is important to realize that age based investing for retirement should not rely entirely on lifecycle funds that are so popular today, in part because so many 401k plans offer it. Creating a retirement investment plan based on your age is not the same thing as handing your financial well-being over to a lifecylce fund that claims to allow you to “set it and forget it.”

Principles of Age Based Investing for Retirement

Creating an investment plan is one of the basic activities that is likely to help you chart a course to a successful retirement. You can base this plan on your age, and how many years you have until retirement, transitioning your investment portfolio to more conservative investments as you near your retirement age.

Conventional wisdom says that you should invest more in stocks and other growth investments when you are younger so that you have time to make up for short-term losses with long-term gains. The idea is to build as big a nest egg as you can during your younger years, and slowly shift your assets into investment with less risk (like bonds) as you near retirement and become more interested in preserving what you have while attempting to keep pace with inflation. One of the basic rules of thumb for this scenario is to subtract your age from 100. The answer is how much of your portfolio should be in growth investments like stocks. For example, I’m 30. 100 – 30 = 70, so conventional wisdom says that I should have 70% of my investments in stocks.

However, you shouldn’t rely completely on conventional wisdom when investing for retirement, nor should you blindly follow some rule of thumb. Instead, you need to build a road map to your desired retirement outcome by considering the following factors:

Risk tolerance (financial and emotional)
How much money you want
The income you need to cover expenses in retirement
Possible income streams you can cultivate
How many years you have until your desired retirement age
Likely returns on your investments, depending on asset class

You should also consider what could happen if we see a stock market crash just before you retire. This is one of the reasons that people slowly move their assets into bonds and cash as they get closer to retirement. That way, if the stock market crashes or the economy gets too volatile just before retirement is reached, the damage is limited to a smaller portion of the portfolio. It is important, though, to realize that you will still need to keep some of your assets in growth investments, even in retirement. You don’t have to follow the conventional age rule if you are not comfortable with it, but a portion of your portfolio should still be growing at a solid rate in order to help you maintain a nest egg that won’t run out.

Lifecycle Funds

One of the more popular investment products these days is the lifecycle fund. A lifecycle fund is a managed mutual fund that automatically adjusts your assets for you, depending on your age. The fund manager chooses a higher concentration of growth investments while you are younger, and then shifts the allocation as you near retirement. You can choose lifecycle funds built around different goals, and different lengths of time.

As tempting as it might be to “set it and forget it” with a lifecycle fund, you need to be careful. Numerous studies have shown that many managed funds don’t fare any better than their less-pricey counterparts. Additionally, you have to consider that the costs associated with lifecycle funds can eat into your returns, leaving less money in your pocket. In many cases, you can do just as well – or better – by creating your own plan, and using index funds and/or ETFs to invest in a wide range of asset classes, tweaking your allocation as you age.

In the end, age based investing works best when done for retirement. It can be a good way to build your nest egg and then manage it as you get older. But you are probably better off creating your own plan, based around your individual goals and situation, rather than relying on a lifecycle fund.

Disclaimer: I am not an investment professional. Nothing in this piece or on this Web site should be construed as investment advice. Before making investment decisions, do your own research and/or consult with an investment professional. All investment comes with the risk of loss. You are responsible for your own investment decisions and any loss that may result from your decisions.

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Age Based Investing for Retirement

Is Investing Internationally A Good Inflation Hedge?

Arohan — Tue, 04 May 2010 18:33:01 +0000

Source: sxc.hu Photo: svilen001

Simple answer is No.

But maybe not for the reason you think.

Inflation can be neutral to stocks and other real assets

Inflation means rising costs and prices. It also means rising asset values. It means that the currency has lost its buying power and it now takes more of it to buy the same amount of benefit. If you are worried about US inflation and are looking at US assets than keep in mind that as inflation takes hold, the nominal value of these US assets will be repriced upwards. Which means if you buy some of these assets today, than the future value of the asset will keep pace with inflation, all other factors being equal. Real Estate, Stocks and Commodity investments have traditionally kept pace with inflation and this is likely to be the case for the future.

But maybe not so much for the bonds and other debt instruments

This time around we are faced with higher inflation in the future and rising interest rates at the same time. The US debt quality is under strain and it will take an increase in interest rates to keep the foreign governments and institutions to continue their buying of US debt. As the interest rate goes up, the bond values will decline. If you are investing in domestic bonds today, not only are you getting lower yields but you will also see your principal decline as the interest rates rise. If your asset allocation calls for investing in bonds, you should look outside US. I am pretty partial to Canada and Australia as these economies are relatively stable, well developed and would be able to perform well due to the fact that they are resource rich and will benefit from the continued demand for commodities.

There are other things to consider

Let’s say that the predictions of higher inflation and higher interest rates come to pass. Which means that the economic climate in the country is not as business friendly as it used to. Businesses will find raising money with debt (which is a cheaper way to raise money) more expensive. Fed would have likely started to act to contain inflation by soaking up the excess money supply, which means that credit will be in short supply as well. This would likely lead to the prospect of reduced economic growth. When this happens, it would be more advantageous to invest in emerging markets and economies internationally which are growing much more robustly. Alternatively, you could invest in US based companies that have a large international presence and would be able to adapt and benefit from international growth.

There are many companies that you can invest in today that are not too expensive, will hold up well during inflation and have large international operations such as Johnson and Johnson, Pepsi/Coke, Boeing, Proctor and Gamble, Unilever, and so on. Some of the banks and financial companies with global franchises may also be a good investment.

As a stock and real estate investor, inflation is not necessarily an enemy. If you are looking to invest internationally, and you should, the reasons to do so should be diversification and exposure to high growth and emerging markets. International investing is not necessarily a good inflation hedge.

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Is Investing Internationally A Good Inflation Hedge?

Commission Free ETFs May Not be Such a Great Deal

Arohan — Mon, 08 Feb 2010 19:11:01 +0000

Source: sxc.hu

Shortly after Schwab started offering transaction fee free trading in it’s proprietary line of Exchange Traded Funds, Fidelity has now rolled out free trading in iShares ETFs to its retail and advisor accounts. For an ETF investor, these appear to be a great news and no doubt in the coming months more brokerages will likely follow suit.

But just because you can trade some ETFs without paying any commissions, are you really getting a sweet deal?

Maybe not. Depends on the ETFs that you are using to construct your portfolio. If you are a Fidelity investor and use iShares ETFs, than yes, the ability to buy and sell without paying a commission is a great deal. But remember, you are still paying a fee in the form of the expense ratio of the ETF. It is quite possible that your commission free ETF carries a higher expense ratio compared to a similar ETF (with commissions) and over your holding period the extra percentage points in the expense ratio add up to more than what you save in commissions. Take for example, the iShares ETF EEM (Emerging Markets Index). The expense ratio on this ETF is 0.72% while the expense ratio of a similar ETF from Vanguard, VWO (Vanguard Emerging Market Stock ETF) only costs 0.27% in expense ratio. For most accounts, buying the Vanguard ETF would be substantially cheaper in the long run even if you have to pay a commission to buy it.

And then there is the question of discipline in investing

Maybe you are immune to the temptation. If you are, congratulations, but I would wager that most investors are not. Just that fact that you can trade some ETFs without incurring a transaction cost, can drive up trading activity of most investors since the short term pain of paying commissions is now absent. This can lead to excessive trading, tax inefficient portfolio and a dilution of asset allocation strategy that can mean lower investment results over the long term.

Do a periodic review of your investment strategy and stick to it

As an investor, you need to stay on the course that you have charted for your portfolio. These short term temptations should not affect your long term portfolio strategy. If you are in a position to take advantage of these commission free ETFs while staying within your long term strategy, do it. I am all for saving money where we can. But, please, do not change your strategy just to take advantage of fee free trading.

Sounds pretty obvious as I write this but you would be surprised at how many investors stray with temptations like this.

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Commission Free ETFs May Not be Such a Great Deal

How to Invest Now With Little Money to Start

MoneyEnergy — Wed, 20 Jan 2010 19:59:33 +0000

Beginning investing

Let’s assume you have no more credit card debts; you make regular student loan payments and you’ve already got your emergency fund in place.

In fact, you’ve been ready to invest for the last six months or so, but you’ve hesitated – perhaps wisely – because you know the market’s already gone up 60% since March of 2009. You’ve also been hearing talk of a double-dip recession and you’re worried about the escalating federal debts.

But you’re supposed to get started investing as soon as possible, right? Time is on your side. And you know you shouldn’t market time, so what’s the matter with just jumping in? Aunt Sally’s doing well with her PowerShares China fund – maybe you should just put some money in that and ride it out while you figure out what you should really be doing with you money?

There will always be mixed messages in market news. This is how markets function – one party thinks it’s the right time to sell a stock, while another party thinks it’s the right time to buy. The important thing is to focus on what you need and what value you can get for your money today.

With all those caveats out of the way, here are my suggestions for anyone just looking for a smart, sensible way to get started in investing now. We will assume that you are starting with $10,000 to invest. If your capital is different, the advice should still hold.

Starting Investing With $10,000

$10,000 can be a lot of money. Since some Canadian mining stocks (to take one example) rose 100, 200 and 300% (and more) off the March 2009 lows, you can imagine what $10,000 could do if invested in the right vehicles. I’m not suggesting you look at Canadian mining stocks, however. That story’s already finished.

What you need to do is figure out

asset allocation
the sectors to invest in and
the vehicles for investing in them

This means figuring out what portion of your portfolio should be in fixed income vs. growth, whether you will invest in the entire market or just key sectors like healthcare, and whether you will use mutual funds, ETFs, or buy shares directly through a broker.

For simplicity’s sake, and for just getting started, I’d recommend that, for now, you just limit your portfolio to ETFs.

Protect your portfolio

You want some portion of your portfolio in investments that are not very volatile and have little downside risk. Usually this is bonds, but recently there is growing hesitation over bonds since their rally might also be done (it’s called a “crowded trade”). Investments such as Money Markets, GICs or CDs (Certificates of Deposit) aren’t helpful right now either, since they pay next to no interest.

I’d take your age, turn it into a percentage figure, and then use that as a guideline for what % of your $10k to put in this category. It’s not a hard and fast rule, so if you have reason to believe you’re comfortable taking on a bit more risk, you can lower the amount. So if you’re 30 years old, you might think about allocating anywhere from 25-35% of your portfolio here.

My suggestions right now: low-beta (i.e., low volatility) healthcare or pharmaceutical stocks like Johnson & Johnson, that pay good, rising dividends. You might also still consider a corporate bond fund, since these pay higher yields. Don’t put all your money in a “high-yield” bond fund, however, without knowing what it’s made of – it could be largely “junk” bonds (bonds with low credit ratings), or it could include quite a few decent corporate bonds, too.

Buy an ETF focusing on “income” or “fixed income.” It should pay you distributions at least quarterly. Make sure the MER is low, preferably close to 0.5% or lower.

Allocate about $2500 to this portion of your portfolio.

Domestic Growth

Because you know your own country best, you have an advantage over international investors because you are familiar with many of the companies and you might have access to better research about them. It’s also easier to buy companies’ stock listed on domestic exchanges.

Depending on where you live, I’d advise you to have a bit less or more in this category than usual. If you’re in the U.S., you should definitely (in my opinion) be “underweight” (i.e. own much less than usual) American equities. The economic fundamentals just aren’t supporting U.S. growth anytime soon. That said, there are several U.S. companies that do most of their business abroad (think IBM and Coke) and these could be good choices.

If you live in Brazil or Vietnam, however, you can afford to be heavy on your own market because your own domestic economy is experiencing good growth and will be for some time to come.

Buy an ETF that tracks the main index of your country. In Canada, this is the S&P/TSX 60 – so you want the iShares ETF that replicates this index (XIU).

Depending on where you live, I’d allocate about $2000-$4000 to this portion of your portfolio.

International Growth

Right now foreign equities should be the bulk of your portfolio. Pick a mix (say, 50-50) of companies with a history of paying out good dividends and increasing them on a frequent basis and combine these with a handful of companies poised for heavy growth – some tech stocks, telecommunications stocks, health care stocks and pharmaceuticals (all industries that are expected to do well over the next year).

Because you’ll be less familiar with international stocks, I’d buy them through ETFs which help diversify your growth and currency risk. Visit the websites of iShares, Vanguard, Barclay’s and PowerShares to get a sense of the ETFs available. Check their expense ratios and try to get the cheapest ones possible for the ETF class you’re interested in.

Buy one ETF that tracks the “total world index” (Vanguard has one of these), or buy two ETFs – one for international dividends, one for pure international growth.

I’d allocate about $5000, or around 50% of your portfolio here. For Americans, I’d probably go with about $6000.

Everyone Has To Start Somewhere

You won’t get investing “right” your first time around. It takes time to learn everything and you need to allow yourself chances to make mistakes. But I wouldn’t wait on the sidelines until you think you “know enough” to jump in. Put some money in and just start learning. The options mentioned here are all conservative choices that will do you well if you keep a few things in mind:

Buy and hold – the quickest way to start losing money is to start timing and trading. Don’t do this if you’re a beginner.
Keep fees low – go with ETFs that have very low Expense Ratios, like 0.3% or 0.5%
Buy passive ETFs only – don’t buy “actively managed” ETFs, don’t buy leveraged ETFs. The original ETFs were simple and just tracked indexes. This is what you want to do, too.

Another option, for someone who really just wants to cautiously dip their toes in the water, would be to pick a stock you know well and think should do well – and just open up a brokerage account and buy a few shares of it. This allows you to learn about the process of using a brokerage and tracking your stocks/ETFs without laying a lot of money on the table yet. You can get comfortable with the feeling of having some money in the markets without yet putting it all in.

Once you’re comfortable that you know what you need to know, then invest your $10,000 in two or three stages. For example, on February 1 you might put $5000 into two ETFs. On March 1, you might put in the other $5000. This will also allow you to benefit (or take advantage of) from changes in the direction of the market (if the market drops in February, you can buy it cheaper in March; if the market rises in February, at least you got half of your portfolio in at the lower price).

If you have any questions about getting started, feel free to ask me here or email me through my blog. There are some other options for you, too. I look forward to hearing from you! I am not a registered investment advisor so make sure you consult your financial advisor and conduct your own diligence.

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How to Invest Now With Little Money to Start

Age-Based Investment Strategy Can Hurt You

Retirement Savior — Thu, 10 Sep 2009 18:39:08 +0000

Adapted from Source: sxc.hu Photo: wax115

You have heard that you should invest more aggressively when you are young, and become gradually more conservative as you age. Fund companies help with the conventional wisdom by creating target retirement date, or “lifecycle” funds. These funds shift the asset allocation from almost all stocks for younger workers to mostly bonds for older employee portfolios with target retirement dates like 2015. Another investment rule of thumb for the same idea is to subtract your age from 100, and that should be your percentage allocation to stocks in your portfolio.

The basis for this investment strategy is that bonds are a safe, secure investment during all time frames. For instance, during the period from 1973-2008, bonds returned almost 8% per year, with less than half the volatility of stocks. When you reach retirement age, it is believed that they will provide you with steady growth that, while less than stocks, the returns will keep your portfolio funds from running out.

This asset allocation strategy does not always work

There are some major problems with this belief. The vast majority of workers today have experienced one of the largest bull markets for bonds in history. In 1981, interest rates reached 20% and have gradually decreased ever since until they reached 0% in 2008. Bonds are positively affected by decreases in interest rates, and negatively affected by interest rate increases and inflation. The next 30 years will not be a repeat of the last 30. In fact, I believe that the next generation will see a bond bear market.

What has happened historically during bond bear markets? According to Global Financial Data, from 1940 to 1981, investors in bonds lost money in real terms. While the dollar value of their investments increased, the purchasing power declined. This was caused by rising inflation and interest rates. Another example outside of our own country is Britain. After World War II, high sustained inflation hurt their consols (perpetual war debt securities) to the point where in 1979, their was worth the same amount that they were in 1889!

There is a solution to inflation and rising interest rates, though. If you hold bonds and wish to keep them in your portfolio, reinvest them into funds with shorter maturities. So if you hold long-term bonds to gain extra interest income, in funds like Vanguard Long-Term Investment Grade Bond (VWESX), or in exchange traded funds such as TLT or BLV, you should move your funds to shorter maturities. Shorter maturities are helpful because as interest rates rise, their yields rise more quickly with the market, and their prices are hurt less. Examples of these would be Vanguard Short Term Investment Grade Bond (VFSTX) or the corresponding ETF with the ticker symbol BSV.

Another solution, though more volatile, is to increase your allocation to real assets. For example, commodities and real estate prices rise with inflation. Both generally have a modest correlation to stocks, though all have performed similarly since the beginning of the financial crisis. You can easily add these to your portfolio through ETFs, with the commodity fund DBC, and the real estate fund RWR.

Remember, in these times, you need to take charge of your retirement investing and learn as much as you can about your options. This means always questioning the conventional wisdom, because in the end your portfolio performance is up to you.

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Age-Based Investment Strategy Can Hurt You

Planning for a Prosperous Retirement

Miranda — Fri, 07 Aug 2009 15:51:50 +0000

Source: sxc.hu Photo: CraigPJ

Retirement is one of those nebulous goals that we set for the future. Often, we do little beyond think about retirement, and perhaps set money aside through a retirement plan offered by an employer. However, preparing for a prosperous retirement requires active planning and action now. Otherwise, you’ll find yourself, five years away from your target retirement date, wondering how in the world you will ever catch up. Here are a few things worth considering when preparing for a prosperous retirement:

1. Where you are now

Before you can plan for the future, you have to have a pretty good idea of where you are right now. Once you have taken a brutally honest look at your present situation, you can start planning what to do in order to change the path you are on and reach your retirement goals. Look at your debts, expenses and income. Consider what you can do to pay off your debt (including your mortgage, if possible) by the time you retire. Look for ways to boost your income through active or passive means.

2. How much you need for a comfortable retirement

Once you know where you are, you need to figure out where you need to be. Figure out how much money you will need to live comfortably during retirement. There is no one way to determine this. In the end, you have to look at what you can expect from Social Security (not much), company retirement plans and pensions, savings, and any passive income you have set up. You will also need to look at your expenses. If you create a plan to help you pay off debt by the time you retire, this will dramatically reduce your outflows. Add up you current expenses, and estimate how much future expenses for things like long-term care, travel, setting up college funds for grandchildren and health care might add to that. Personally, I think that my expenses overall will be very similar to what I have now. My mortgage, car and student loan payments will be replaced by other expenses (hopefully involving lots of travel).

Using the 4% rule to figure out how much of a nest egg you need

After deciding how much you will need to live comfortably, it is time to estimate how much of a nest egg you will require. Most investment and personal finance experts agree that, in order to make your money last indefinitely, you can withdraw no more than 4% of your assets each year. This will help shield you from inflation and years when returns may not be as good. The idea is that you will be living on your returns, without touching the principal. If you think that you will need $60,000 a year to maintain a comfortable lifestyle, take that number and divide it by 0.04. The answer is $1.5 million. That is how much you will need to have saved up in order to live indefinitely on $60,000 a year. If you think that you will only need $40,000, you can perform the same calculation: 40,000 / 0.04 = $1 million.

Naturally, if you don’t mind having the money run out in 20 or 30 years, or if you keep some source of income going, you can adjust your withdrawals to fit your needs.

3. Make a plan

Now that you have a goal to reach, it is time to make a plan to reach it. Look at what you are setting aside, and figure out whether it is enough to grow your money sufficiently. There are a number of investment calculators and asset allocation models that can help you figure out how much you need to be setting aside now to help reach your target later. Once you have a plan, you need to start following it in order to increase the chances that you will reach your goals. Of course, the earlier you start, the more success you are likely to have. You may even need to see a financial planner or adviser to help you map out a way to save, invest and spend in a way that will lead to later prosperity.

4. Other things

There are plenty of other things that are worth looking into as you prepare for a prosperous retirement. Here some questions to ask and avenues to explore as retirement draws near:

Open as many tax-advantaged retirement accounts between you and your spouse as possible.
Question your company retirement plan, and find out if you can change the allocation in your account, or self-direct some of the investments.
Find out about the tax implications of moves you make now, and when you withdraw funds during retirement.
Remember that inflation is always waiting to erode your earnings.
Think about down-sizing as retirement nears. Consider a smaller, less expensive home, fewer cars and getting rid of stuff you do not normally use.
Consider income investing and other passive income streams.

In the end, it is possible to plan for a prosperous retirement. But you have to take an active role in its accomplishment. It may seem like a lot of work to figure out how much you need and put together a plan, but it is worth the time and effort. After all, the earlier you start, the longer compound interest will have to work wonders in your favor.

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Planning for a Prosperous Retirement

Investing in Emerging Markets

Miranda — Thu, 16 Jul 2009 20:01:19 +0000

Shanghai Skyline Source: sxc.hu Photo: henryy

Now that things are looking a little better for the economy, and now that investors are showing a little more appetite for risk, you might be hearing more about emerging markets. Emerging markets are those countries that are developing economically, and preparing to become major players on the world’s economic stage. The two most well-known emerging markets are China and India. With Brazil and Russia, they make up the BRIC nations, considered the leaders of the up-and-comers in the global economy. However, there are other emerging market economies, such as those in Mexico, South Africa and countries in Southeast Asia, South America, Eastern Europe and the Middle East. For those who have a little more risk tolerance, emerging markets can make intriguing — and profitable — investment options.

Characteristics of emerging markets

Emerging markets present interesting sets of challenges, based largely on the characteristics that they seem to share. Some of the characteristics of many emerging markets include:

Rapid growth: This is perhaps one of the main reasons that some investors are so interested in emerging markets. Their economies are growing rapidly. Even China’s “slowed” GDP growth was close to 8% for quarter two of 2009. The rapid economic growth presents investment opportunities.
Producers: Nearly all of the emerging market economies are producer economies. They create products that other countries buy. Often, people in emerging market economies produce more than they buy, which is part of the reason economic growth is so explosive during the good times. Rich, developed nations buy what is produced, tipping the flow of money in favor of producer nations.
A degree of political instability: Even in emerging market countries where the politics are reasonably stable, there are still issues. Some of the countries have government that are at odds with U.S. foreign policy. Also, in many emerging markets, politics and events have a much larger and immediate influence on the economy than in more developed countries.
Fragmentation: Often, there is a relatively high degree of fragmentation in emerging market economies. In some cases, it is necessary to deal with a local economy instead of trying to take advantage of an entire country as though it is a single monolithic market.
Volatility: Emerging markets are volatile. The situation can change quickly, due to any number of factors that may or may not seem related to the economy. While it is possible to make large gains in a short amount of time, it is also equally likely that you could lose a great deal of money.

Investing in emerging markets

It is important to be careful when investing in emerging markets. Commodities and currencies are rather risky, but offer the highest chance of returns. You can also invest in individual stocks in some emerging markets. Understand that when investing in any foreign country, you are taking an additional risk of the currency exchange rates fluctuating. Make sure you understand the laws and regulations surrounding these actions. Accounting in other countries may not closely follow GAAP so it is important to understand the differences. US tax law also treats income derived from foreign investments differently depending on whether the country has a tax treaty with US or not. Also, consult with a knowledgeable tax professional about those kinds of implications. When considering emerging markets, it is also good to remember that bonds may not be much less risky than stocks. U.S. Treasury bonds are backed by the most stable tax-payer base in the world. Emerging markets can’t make that claim.

Investing directly in an emerging market stock listed on that country’s exchanges can be difficult and not many discount brokers can execute such orders. It can be done through some of the full service brokers but can become very expensive. Several companies from emerging markets have listed their stock on US exchanges in the form of an ADR (American Depository Receipts) or ADS (American Depository Shares). As a requirement for this listing, these companies issue US GAAP equivalent of their financial statements (in addition to their traditional statements). Investing in these companies may be easier in terms of transparency and transactional ease.

Most people, however, prefer to limit their risks by investing in emerging markets funds. There are stock indexes that follow emerging market investments. There are also ETFs that include stocks, commodities, bonds and/or currencies from emerging markets. These types of investments can help reduce your risk (returns might be smaller as well), while still giving you access to the opportunities afforded by emerging market investments. When investing in these funds, you should read the prospectus carefully as some of these funds try to hedge out the risk of currency fluctuations, while some others are totally vulnerable to them.

While emerging market investments can add some growth and diversity to your portfolio, it is important to be careful when including them in your asset allocation. William Bernstein (author of The Four Pillars of Investing) recommends in Money Magazine that you limit your emerging market holds to between 5% and 10% of your holdings. And that’s high end. Carefully and honestly evaluate your risk tolerance before risking even that much of your portfolio in emerging market investments that could result in large losses.

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Investing in Emerging Markets

Mutual Fund Investing with Style

Arohan — Thu, 04 Jun 2009 17:43:02 +0000

When deciding to invest in a mutual fund (or any other investment), it is generally accepted that a diversified portfolio reduces risk over the long term. The readers would have also come across findings and assertions along the lines that stocks do better than bonds over the long term, small cap stocks can be more rewarding than large cap stocks, junk bonds are riskier than treasuries, etc. What do all these terms mean? In this article, we will review the concept of a mutual fund stylebox, that was originally introduced by Morningstar, that can help visually illustrate these concepts and aid in developing a diversification strategy.

There are two basic styleboxes that we need to understand. One is for the stocks and the other is for the bonds. The key attributes that a stock stylebox reflects is the size of the stocks (in the fund) and the valuation of the stocks (in the fund). The bond (or fixed income) stylebox on the other hand reflects the credit quality of the bond and the duration of the bond (maturity). Each of the styleboxes are separated into 9 different quadrants that determine the style of the investment.

Stock or Equity Stylebox

Domestic Equity Stylebox

A stock or equity stylebox consists of the market capitalization of the stock on the vertical axis. The classification of market capitalization of a stock in Large/Mid/Small cap normally vary but a general rule of thumb is any company above $10 Billion in market cap is a large cap company and any company below $2 Billion in market cap is a small cap company, with $2 B – $10 B range classified as mid-cap. Small caps could be further broken down into ultra-small-cap and micro-cap stocks.

Valuation of the stock is represented on the horizontal axis. Traditional industry measures of valuation such as Price-Earnings ratio and Price-Book ratio are used to determine valuation for a domestic equity. For international equity, Price-Cash Flow measure may be used as the Earnings measurement differs across the globe due to differences in accounting standards.

From a risk perspective, small cap stocks are generally considered the riskiest with large cap stocks considered the safest. Additionally, the value stocks are perceived to have less risk than the growth stocks while offering higher potential returns.

Bond or Fixed Income Stylebox

Bond Stylebox

Similar to Equities, the Bond stylebox has 2 axis displaying 9 different styles. The emphasis here is on the credit quality of the bond as well as the time to maturity or the duration of the bond. Vertical axis shows the credit quality, with High (AAA-AA), Medium (A-BBB), Low classifications. Typically government/municipal bonds and very stable corporate bonds are classified as High quality while junk bonds are Low quality bonds. Horizontal axis reflects the time to maturity of the bond. The shorter the time to maturity of the bond, safer it is as the company and economic risks are minimized. Similarly, highly rated bonds are deemed to be safer, although it should be noted that sometimes the rating agencies fall behind and do not completely reflect all the known information in their ratings (one of the main reasons for the mortgage crisis was the AAA ratings issued by the rating agencies on questionable mortgage debt securities).

While we have discussed the styles above in the context of stocks and bonds, mutual funds are classified using this style boxes using weighted averages over all their holdings. Therefore it is possible to find a short term high quality bond fund that has a portion of its portfolio invested in junk bonds.

Style drift: When investing in mutual funds, one should keep in mind that the reported style of a mutual fund may drift over time. For example, a small cap value fund can over time become a mid-cap blend fund if its holdings value increases and the fund did not replace the holdings that ran up in price. Generally this is not a problem if the fund manager sticks to his/her stated objective of the fund and the new investments are aligned with the objective. One should be wary of the funds where the style keeps changing randomly without any reason and not in line with the fund objective. This may be an indication of exessive trading (churn) and/or incompetence of the manager.

Caveat: While the styleboxes provide an easy way to classify one’s investments and develop an asset allocation strategy, they should not be the sole criteria for picking an investment. One needs to consider additional factors such as manager experience, past performance, fees and expenses, portfolio turnover, diversification, etc. There are a few well respected managers that run highly concentrated portfolios with little regard for styleboxes and have generated outstanding returns for the investors. You can analyze the horse and the weather and other things all you want but if you do not have the right jockey than your bet is still going to be very risky.

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Mutual Fund Investing with Style

Asset Allocation using 10-5-3 Rule

Miranda — Thu, 16 Apr 2009 15:27:59 +0000

Asset Allocation Source: stck.xchng Image: arinas74

There are any number of rules for investing out there. Many of them have to do with asset allocation. One of those rules that can help you determine what asset allocation could work for you is the 10-5-3 rule. The rule comes from a book by James O’Donnell, called The Shortest Investment Book Ever: Wall Street Secrets for Making Every Dollar Count. This rule is simple, providing an overall average annual return for three different investment classes: stocks, bonds and cash. According to the 10-5-3 rule, stocks are likely to get an annual return of 10%, bonds 5% and cash (as well as liquid cash-like investments) 3%. It is important to recognize that this rule is used for long-term investments. And by long-term, I mean over a period of at least 15-20 years. So we’re talking about a rule of thumb that can help you determine your asset allocation for the long haul; consider applying this rule to your retirement portfolio.

How you can use 10-5-3 to help you with asset allocation

10-5-3 is most helpful in terms of asset allocation when used in conjunction with the Rule of 72 (a lot of rules, eh?). This is a very basic rule that says if you divide the interest yield of your investment into 72, that will give you an approximation of how long it will take your money to double — if you leave it sitting there and do nothing. In the case of 10-5-3, here is how long it would take each of your types of investments to double:

Stocks: 72/10 = 7.2 years
Bonds: 72/5 = 14.4 years
Cash: 72/3 = 24 years

You can see where it becomes necessary to take long-range planning into account. Decide what your target goal is in terms of amount of money. If you want to retire with $1.2 million in 30 years (that’s actually my goal — I’m reasonably young), you can use the 10-5-3 rule to approximate an asset allocation that will put that money to work for you to help you reach your goals. In my case, my stocks can be expected to double four times, my bonds twice and my cash investments once. I’m going to start doing some more math here, but it’s going to be very simplistic. It’s just meant to give an overall idea of how this might work. It doesn’t account for the fact that I will add more money to my accounts every year, rather than letting them stagnate. Let’s say that I’ve got $60,000 in investments (which I would have, if I set aside $334 a month every year for the past 15 years — since I was about 15 and working). Here is one scenario:

$40,000 in stocks. This money will double four times in 30 years. After the first double, there would be $80,000, that $80,000 would double to $160,000, which would double to $320,000, which would double to $640,000.
$10,000 in bonds. This money doubles only twice: first to $20,000 and second to $40,000.
$10,000 in cash. This money doubles only once, to $20,00.

My total is around $700,000, after 30 years. But what if I change my asset allocation to something like this:

$50,000 in stocks. Doubles to $100,000, then to $200,000, then to $400,000, then to $800,000.
$8,000 in bonds. Doubles to $16,000, then to $32,000.
$2,000 in cash. Doubles once to $4,000.

Now the total is $836,000. Obviously, $60,000 just sitting in an account for 30 years isn’t going to get me to $1.2 million. However, you can see that using 10-5-3 helped me get $136,000 closer to my goal in the same amount of time. I would have to keep adding to my accounts in order to make my desired retirement, and that extra money, added in over the next 30 years, would be part of the doubling formula. 10-5-3 just offers an outline you can follow for a reasonably conservative long-term investment plan.

Drawbacks to the 10-5-3 investing rule

Any rule of thumb is merely a guideline. There are no hard and fast investing rules. And there is always the risk of loss. The 10-5-3 rule is no exception. First of all, these are long-term averages. This year, almost no investments are going to conform to the 10-5-3 rule. Market crashes are not reflected in the 10-5-3 rule, and if the market crashes again just before retirement, being heavily invested in stocks will wipe our your portfolio (which is why you should adjust asset allocation as you age). Additionally, the 10-5-3 rule doesn’t take into account the erosion of the value of your dollar due to inflation. And taxes aren’t considered here, either. Another issue about the future was brought to my attention by Arohan:

While the past historical return averages may hold in the future, it is also true that the past 100 years of US stock market returns reflect a nation with increasing productivity and young demographic. The future may indeed look very different as the country ages and productivity increases are not as significant any more (inventions of telegraphy, radio, internet, etc cut days from communication cycle, cars and highways saved significant amounts of time, while microwaves and washing machines enabled women the ability to participate in the work force and the men to help in the household chores. While we do not yet know what new ideas and products will come in the future, it is likely that the low hanging fruit of productivity increases has already been picked).

Going forward, the economy may not see the same level of production and growth that it has seen in the past. 10% annual returns for stocks (which seemed absurdly conservative in the late 1990s) may end up being wildly optimistic going forward. The 10-5-3 rule isn’t meant to be the final word. But it can be a useful tool to use when making long term investing plans.

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Asset Allocation using 10-5-3 Rule

Retirement Plans – Managing Risk with Safe Investments

briskycapital — Thu, 12 Mar 2009 18:58:20 +0000

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The chaos in the market and overall economy has left a lot of people worried and confused. People are extremely eager for information and advice. I can’t tell you how many people have asked me “what should I do with my retirement accounts?” Sell? Hold? Buy More? To that, I’d say take step back and think for a bit. If you’re still holding most of your investments, there isn’t the downside risk that existed a year ago. So the good news is you have some time. You can still take control of your retirement plans by adding some safe investments to your asset allocation and that will help in managing risk in your portfolio.

Managing risk in your retirement plans

The answer to the question will lie in your personal situation and where you’re at in your life. If you have a low risk tolerance, its important that you don’t own things that will keep you up at night. You are best served to sit in cash or low risk investments or at least make some of these cash equivalents a part of your asset allocation to aid in managing risk in your portfolio. Although cash isn’t yielding a whole lot, the good news is that it is easier than ever to invest in bonds. Bond funds, and specifically exchange-traded funds (ETFs) have made the process very easy. Vanguard has a great group of ETFs with very low costs which I would recommend. The Vanguard Total Bond Market ETF (Symbol BND) is an excellent fund if you’re looking for a simple, diversified bond investment. The fund pays monthly dividends, yields 4.64%, and has an expense ratio of 0.11%. You can buy this fund right through your brokerage, for the same price as any stock. Also, if its inflation you are worried about, you can take a look at Inflation-Protected Securities, or TIPS. Their yield is determined by the CPI, and pays out corresponding to increases in that. ishares has an ETF to buy these securities (Symbol TIP).

Manage Risk with Diversification

If you have a little higher appetite for risk, or have awhile until you retire, you’re probably best served getting into some stocks. Quality blue-chip stocks historically have outpaced inflation, and have provided the best overall return. This doesn’t mean you have to buy Citigroup stock and watch CNBC 24/7 to make sure the company is still afloat. Here, diversification is the key to managing risk in your stock investments. The easiest way to do this is again through funds. For example Vanguard’s Total Stock Market ETF (Symbol VTI) will do the trick. It owns the largest 1,300 in the U.S., and yields 4.26%. The expense ratio is 0.07%. Don’t overlook the value of low costs when looking to funds, and Vanguard does the best job of that. Holding investments like this for the long term is one of the best, most stable ways to save for retirement.

With the market experiencing unprecedented volatility, these types of investments can offer stability to the average investor who doesn’t need to be concerned with daily market fluctuations. If you’re looking to get your retirement plans back on track, I’d take a look at these funds.

Disclosure: Author owns BND.

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Retirement Plans – Managing Risk with Safe Investments