Category Archives: Mutual Funds

The Three Investments Every New Investor Should Have

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There are a lot of investment choices.  There are stocks, bonds, REITs, Options, Warrants, and convertibles.  Then there are funds that buy and sell these different investments for you, which would make things simpler, except that there are many different funds out there.  In fact, there are actually more mutual funds buying and selling individual stocks than there are individual stocks.  So, how do you choose?

The good news is, there are really only a few things that you should invest your money in.  Once you know these few investments, you can cut through all of the noise and make a wise choice of where to place your money.  I would say that there are three investments you really should make before you get near retirement.  Ignore the rest.  Here are the three:

1.  Total Stock Market Index Mutual Fund

This investment does what it says – it buys stocks in the total US stock market.  Buying just this one mutual fund will mean that you are diversified over the whole stock market.  You’ll want this because it eliminates the risk of picking a bad stock or a bad sector.  It is possible that one company could go out-of-business and you’d lose your whole investment if you try to pick a stock.  But what are the chances that every company in the US stock market will be wiped out?  If that happened, you wouldn’t be too worried about your portfolio.  You would be worried about finding enough ammo to keep the wandering bands of marauders at bay.

You need to have stocks when you are investing for a long time since they are the only investment that will grow over time.  This means that you will make real money, even when inflation is taken into account.  Put your money in the bank for 30 years and you’ll find that you’ll be able to buy maybe 75% of the stuff you could have bought with the money when you put it in.  Put your money in the stock market for the same period of time, and you’ll be able to buy about eight times as much stuff.

You buy an index fund because they are cheap.  The fees are really low, often below 0.25% of the amount of money in your account each year.  If you go out and buy a managed mutual fund where someone, or a team of someones, buys and sells stocks for you, you’ll pay 1% or more per year.  Given that most managers match the indexes at best over long periods of time, you’ll probably make a lower return in a managed fund than an index fund.  So, go for the index.

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2.  A Corporate Bond Index Fund

A bond is a loan to a company.  In exchange for the loan, they pay you interest payments twice a year for a period of time.  At the end of the period, they pay you your money back.  Bonds are good because they give you steady income that quiets down the gyrations caused by a stocks.  If you have an all-stock portfolio, you might be up 30% one year, but then down 30% the next.  Over time you’ll make about 7% after inflation, but it is a wild ride in the mean time.  Add 20-30% bonds, and you’ll see lower swings since the bonds will always be there, paying out interest, which helps offset the swings in stock prices.

You don’t want to have all bonds.  That is even more risky than having a mix of bonds and stocks.  You also don’t want to hold a lot of bonds for thirty years or longer since the returns you’ll get will be lower than they will be from stocks.  Over shorter periods of time, however, bonds will sometimes outperform stocks, particularly if there is a big downswing like we saw in 2008 and early 2009.  In that period, while stocks lost 40%, bonds actually went up a few percent.  They did a lot worse than stocks in late 2009 and 2010 as the markets recovered, but people who were holding bonds during 2008 and 2009 felt a lot better than those holding stocks.  Again, buy an index fund that holds a lot of different types of bonds for low cost and diversification.

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3.  An International Stock Fund

US stocks are often the place to be since the economy is stable and often growing, but it is not always the best place.  You’ll always want to have some of your money in whatever segment of the market is doing the best at any given time.  You should therefore put some of your money, maybe 20-25%, into an international stock fund.  Here you want to look for inexpensive index funds that invest all over the world, rather than picking a niche fund that invests only in Asia, for example.

So there you have it.  A total stock market fund, a bond fund, and an international fund.  Find cheap index funds, send in a check, and never look back.  Happy investing!

Have a burning investing question you’d like answered?  Please send to vtsioriginal@yahoo.com or leave in a comment.

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Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Investing a Coverdell ESA/Educational IRA during the Last Few Years

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Clingdome2It is pretty easy to plug a few numbers into an investment calculator and expect a return from your stock portfolio in a certain number of years.  The issue is that returns are hard to determine over relatively short periods of time.  If you’re investing for retirement and you’re starting at age 18, you can reasonably plug in a 12 or 15% return into an investment calculator and probably come fairly close to makign that return over 40 or 50 years.  If you’re investing for shorter periods of time, like ten to twenty years, you’re almost guaranteed a positive return over the period, and that you’ll do better than you will in a savings account, but the return you’ll get is more difficult to judge.

The issue is that those 12% to 15% returns include some really fantastic periods like the 1980’s and 1990’s.  Go without them, and your returns can be a lot less.  The 2000’s were pretty rotten, starting with the dot com bust in 2000 and including the housing bubble burst in 2008.  Luckily, we’ve had some good years, such as in 2003 and 2004 after taxes were cut, 2009 and 2010 after the housing bust when investors rushed in to buy cheap stocks, and even 2013 and 2014 thanks to historically easy monetary policy.  This has helped reduce the sting.  Still, it hasn’t been the roaring eighties or the roaring twenties.

In bad timing from an investing standpoint, my son was born in 2001.  We started an educational IRA/ Coverdell ESA the year he was born and invested $2,000 in it each year.  We put mostly mutual funds into it with a few individual stocks (probably a 60%/40% ratio).  Some of the individual stocks have done very well, others not so well.  Our best pick was Stryker, up 110% from what we paid back in 2010.  The worst was Pier One Imports, which lost about 50% of its value before we sold it.

Estimating a 12% return, I expected the account to have about $95,000 in it by now.  With the market issues we’ve seen, however, and some iffy stock picks, we have about $40,000, or an annualized return of about 4%, which is just a little better than the return of the S&P500.   That leaves me with a tough decision over the next few years.

With $40,000, I should be able to cover tuition at a four-year instate school.   It is, therefore, tempting to sell most of the stocks and invest in income and cash investments.  That would lock in the gains I have and mean that tuition was covered.  We or our son would just need to come up with living expenses.  That is probably what I would do if this was all of the money I had for college expenses since I couldn’t take a chance of a loss, which is a real possibility with only three years left until our some goes off to school.

Because we do have other money available for school expenses, if need be, I’m thinking of staying mostly in stocks, with a few income elements.  If the market does really well over the next few years, I might be able to raise the balance to $60,000 or even $80,000, which would be enough to pay for most of his college costs.  Also, because I don’t necessarily need to cash it all out his Freshman year, I actually have about six years to invest – not just three years.  I could, therefore, wait and watch, taking an opportunity that arises before he heads off to school or a few years into school to cash out.  If another 2008 crash occurs, I would probably make most of the losses back if I were able to wait a year or two.  Most crashes recover quickly.

Really this is the flexibility that comes with saving and investing so that you have reserves available.  It allows you to take a few more risks that may very well work out well.  Even in retirement, I plan to stay invested mostly in stocks because I expect to have more than enough to generate the income I need to pay for necessities.  I will take a portion of my portfolio and manage it like a retiree – with an appropriate mix of stocks and bonds – producing enough income to provide for expenses.  The rest can be left in stocks and tapped as the opportunity arises to increase the income being generated.

So what are your plans to pay for college for your children?  Are you saving and investing?  Planning the student loan route?

Got an investing question?  Got a great idea to share?  Please leave a comment.

Follow on Twitter to get news about new articles. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Simple Steps to Making 401Ks Better

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Clingdome2My broker feels that 401Ks – the retirement plans that have largely replaced pensions – are a terrible idea and that most people would be better off in a traditional pension.  The main issue with pensions is that they can become a burden on a company since the company may need to add more money from time-to-time, depending on how the markets do.  When companies fail, they can also end up dumping their pension plan on the US Government, which will both cost the taxpayer money and can result in substantial reductions in the payouts the retiree receives.  Another issue is that companies tend to promise a lot in the pension plan when workers start to demand higher salaries and benefits since it is easier to promise to pay money later than it is to actually come up with the cash today.

The issue with 401Ks isn’t the plan itself.  It is the poor level of financial literacy that most people have.  This is surprising, given how important money is to most people (and by money, I mean shelter, food, and clothing, not gold rings and trips to the Riviera).  If people would spend a little bit of time reading and learning (The Smallivy Book of Investing is still on sale), they would find that managing their 401Ks is really not that difficult.

Given that they probably won’t, there are a few things that could be done that would make it a little harder for people to mess up their 401K.  These are:

1.  Make enrollment at the maximum company match opt-out.  Many people fail to enroll at all since they must opt-in to the 401K plan, or they don’t contribute up to the full company match, leaving money on the table.  This could be changed where employees are automatically enrolled at the amount needed to capture the full company match.  If they choose to not participate or reduce their contributions, they would need to go in and opt out.  Given that most people are slow to act, this would cause most people to do the right thing financially and put money away.  Actually, it would be even better if you were enrolled at 10% of your pay regardless of the company match since you need to be putting at least that amount a way to have a secure retirement at your current level of lifestyle.

2.  Make a target date retirement plan the default.  Given the choice, I’d choose my own funds rather than use a target date retirement fund.  For many people, however, a target date retirement fund is better than what they tend to choose.  Many plans drop people into a money market as a default, and many people then just leave it there.  This guarantees that they will lose a lot of their money to inflation and will lead to a dismal retirement unless they sacrifice like crazy and put a lot of money away.  For those who don’t want to mess with it, a target date fund would provide at least the returns that a traditional pension would.

3.  Eliminate the ability to withdraw funds before retirement.  One of the worst things about a 401K is that you can withdraw funds before retirement.  Often this comes with a 10% penalty plus a large tax bill, such that you lose 50% of your money by taking it out early, yet people continue to take the money out on a whim or when they change jobs.  You wouldn’t be able to go to your pension plan manager and say you want to take your money out before you reached retirement age.  You shouldn’t be able to do so in your 401k either.

These three simple changes would totally transform the landscape when it comes to retirement security in the United States.  Are any Congressmen reading?  I’d be happy to discuss them.

Got an investing question? Please send it to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

The Good and Bad of Adding Fiduciary Duty

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Lost Cave1I was talking to my broker the other day about the changes that are coming for individual retirement accounts.  The biggest change is that brokers and others who manage or advise people on individual retirement accounts will need to take on a fiduciary duty.  This means that they will be required to work in the best interest of the client,rather than their own best interest or the best interest of the firm.  Currently, they are required to recommend “suitable” investments, but not necessarily the lowest priced investments.

In many ways this is a good thing since it will help to prevent the common practice of selling things like annuities and proprietary funds that perform poorly relative to other investments but pay the salesman and their firm a big sales commission.  Unfortunately, there are many who take advantage of the lack of knowledge of their clients to make money for themselves.  We don’t need people with the stereotypical used-car salesmen approach selling financial instruments.

The downside is that there will be a lot more paperwork, particularly if you do have knowledge of what you’re doing and want to go against the conventional wisdom.  For example, I see no reason to own bonds at my stage of life (although I do own some REITs) since I have more than 20 years until retirement.  I know that stocks will return several percentage points more than bonds over that period and I don’t want to give up that additional return.  I take the chance in any given year of seeing 40-50% of my portfolio value evaporate because of this position, but I also feel that stocks will recover from any such drops before I need the money because I have 20 years.  As I get closer to retirement, as long as I have at least 2-3 times what I really need to make it through retirement, I’ll probably stay heavily invested in stocks since I’ll be able to take a 50% drop without it really affecting me. I’ll have excess funds, so if I lose some money I can still eat.

The conventional wisdom for someone my age would be to have about 35% invested in bonds by this point.  This would help shelter me from market downturns since bonds usually fall less than stocks since the interest they pay helps prop their prices up.  The issue with this strategy is that it doesn’t take the effect of time in reducing risk into account.  It uses diversification – spreading out investments into more than one type of asset – to reduce risk, but holding the investments for a couple of decades also reduces the risk.  Having 35% of my portfolio invested in bonds would mean that I would get about a 6-8% return on that money instead of the 12-15% I can get in stocks over the same period of time.  That can add up to be a lot of money.  The new laws, however, will certainly require me to sign a lot of documents saying that I understand the risks of doing so.  Perhaps in the future I won’t even have the choice.

The reason these laws were enacted, however, was that most people aren’t financially literate (and generally proud of it, for some reason), and the people taking care of their money for them were lining their own pockets.  Generally, this was not by offering them investments that were too risky, but investments that we’re risky enough, such that they lost a lot of the return they would have gotten if they had invested properly, but have high fees.  These are things like annuities, which almost no one under age 65 or maybe 70 should have.

So in summary, because most people don’t even get the preliminary education in investing and money management that they could get through reading a couple of books (The SmallIvy Book of Investing, Book 1 on sale now!) or reading blogs like this one, they need to rely on “experts.” Many of these “experts” have little financial education other than on how to sell the high-fee annuities and funds their firm is pushing.  Because of this, we’re going to see a lot more controls on the people who manage money and sell financial instruments.  Unfortunately, people are ignorant enough about finances and some advisors are unscrupulous enough that this is needed.  I’m just hoping that the rest of us who do know what we’re doing will be able to still make the choices we feel are right for our situation.

Got an investing question? Please send it to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Start an IRA Today (If Not Sooner)

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Clingdome2How would you like to retire a millionaire?  Well, if you’re a teen working a summer job and you put $1000 away into an IRA (Individual Retirement Account) today, you have a shot at reaching that goal even if you do nothing else.  That’s if you earn a 15% return between now and about 50 years later when you’re ready to retire.  If you earn only 12%, you’ll only end up with about $300,000, but still that’s not bad for a $1000 investment.

Now I know that $1,000 is a lot of money when you’re working for $7.25 per hour, especially after taxes are taken out and you factor in expenses like gas to get to work, so you really only earn about $6.00 per hour.  Still, that 170 hours worth of income you give up now could help set you up for retirement.  And it doesn’t even need to be your $1000.  As long as you earn at least $1000 from working, your parents or a nice uncle could give you another $1,000 to invest while you spend the $1,000 you earned.  Maybe you can work out a deal with your parents where they match your contribution, so you actually only need to contribute the earnings from about 80 hours ($500) yourself.

So what is an IRA?

An IRA is an account included in the tax code where contributions are allowed to grow either tax deferred – where you take the money out and then pay taxes, or tax-free – where you pay no taxes.  This means that your money will be able to compound without taxes being taken out all of the time as you go.  The more money you have to earn interest on, the faster your money grows.  If you use a traditional IRA, you don’t pay taxes on the money you contribute, which means Uncle Sam will be putting something like $100 of the $10000 you are investing in for you.  Whatever money you pull out when you retire, however, will be taxed at that point, so your Uncle Sam will take back about $200,000 of your $1 M.  If you do a Roth IRA, you’ll need to pay all of the taxes now, meaning you’ll need to come up with the full $1,000, but when you pull it out the money is all yours.

How do I setup an IRA?

The easiest way with $1,000 is to go to Vanguard, open an IRA (it takes about 15 minutes online), and buy into their Vanguard Target Retirement 2060 Fund.  I choose this fund because it has only a $1,000 minimum investment and because it has mainly stocks, which is what you want for the next 40 years or so.  You then just have your parents send in a check for you or transfer money from a bank account and you’re an investor.  Simple.

What do I do then?

Well, you don’t need to do anything, really, at least for while.  Once you reach the account minimums for Vanguard’s other funds, which currently are at $3,000, you should switch to the Vanguard Total Stock Market Index Fund because that will increase your returns over time since you’ll then get rid of the bonds that are in the 2060 fund and be invested in all stocks.  It will take you until about 2039 to reach that point, however, if you only invest the original $1,000.  (Compounding starts slowly and then accelerates at the end.)

I would rather you become a regular investor, sending in $50 whenever you can through college.  Once you’re working a regular job, see if you can contribute the maximum ($5,500 per year, plus another $5,500 into a spouse’s IRA if you get married).  Also get into the 401k plan at work if there is one.  While $1 M may seem like a lot today, the truth is you’ll need like $10M or $20 M by the time you’re ready to retire since $1 M won’t buy what it does today.  If you invest regularly through your twenties, however, you’ll have it easily.  In fact, if you do a good job of sending in money between 16 and 35, you really won’t need to contribute at all after you reach about 40 since you’ll already be set.

The other thing to do is something not to do:  Do not touch the money for any reason until retirement.  If you take the money out early, you’ll pay extra fines and taxes.  Plus, you’ll be undermining yourself.  Right when you were going to start earning really money from your investments, you’ll take it out.  If you try to start over in your forties or fifties, it will be much more difficult.

What if I wait?

I know, money is tight and you’re busy doing other things.  If you wait until you’re 25 to start investing, however, that $1,000 will only make you $300,000 ($100,000 at a 12% rate-of-return).  Wait until your 40, and it will only net you $33,000.  That means you’ll need to work a lot harder and sacrifice a lot more to retire comfortably.  The other choice would be to retire uncomfortably and be scrounging for food and heat.

So see if you can set aside $1,000 and a half hour to start an account.  Maybe take one extra hours or spend some time with friends doing things that don’t cost money.  Your future self will thank you.

Got an investing question? Please send it to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Managing your 401k Like an Investing Ninja

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Clingdome2Many people manage their 401k accounts poorly.  The majority manage them adequately.  A few manage them well.  Then there are the investing ninjas.  Investing ninjas do everything right to ensure themselves the maximum return and a more than comfortable retirement.  Being an investing ninja takes a little more time than just being an adequate or a good investor, but not that much more time.  Here are the secrets of the investing ninja:

1. An investing ninja  researches investing choices.  A ninja takes some time on the website of its 401k management company and learns his choices.  He finds what types of assets the funds invest in, including stocks, bonds, real estate, and commodities.  He finds what kind of stocks each stock fund invests in, including whether they invest in growth or value, and whether they invest in small or large companies.  He sees if he has an international fund.  He finds all of his choices and lists them by groups since he wants to make use of the choices he has available.

2.  An investing ninja minimizes fees.  While finding out her choices, the investing ninja finds out the fees for each of the funds in each of the different categories.  She then zeros in on the fund in each category that has the lowest fees.  She knows that over long periods of time high fees mean lower returns.

3.  An investing ninja maximizes growth while he is young.  An investing ninja knows that he can have more stability – meaning that the value of his 401k account will fluctuate less – if he includes 20-30% bonds, but he also knows that those bonds will return 6-8% over long periods of time while stocks will return 10-15%.  Not wanting to give up return, while he is young he invests only in stocks, knowing that it will be a wild ride at times but that he can tolerate the fluctuations for the superior returns.

4.  An investing ninja diversifies.  An investing ninja may concentrate in stocks while she is young, but she knows that different sectors of the market do well at different times.  She therefore spreads her money out among large and small stocks.  She may also add some international stocks in case US stocks suffer a rough patch or currency exchange rates cause international stocks to do better.  She knows that she cannot predict which sector of the market will be doing well at any given time, so she buys into all of them.

5.  An investing ninja stays the course.  An investing ninja knows that most people lag market returns significantly because they buy after stocks have risen and sell after they drop.  He knows that he cannot time the market, so he sticks to his plan, knowing that over long periods of time things will work out fine.  He adds money each month, every month, regardless of what the market is doing.  He doesn’t move money around due to market circumstances.  If the market fluctuations bother him, he only looks at his account balance a few times per year.

6.  An investing ninja rebalances.  While he doesn’t let market circumstances dictate his moves, an investing ninja checks the ratios of her portfolio that she has in each sector of the market and rebalances periodically.  If she plans to have 30% in small stocks but they do so well that she has 40%, she sells shares and buys more shares of other funds in her 401k.  Most fund providers have tools to allow the investor to do this very easily.  She only balances about once per year, perhaps in December or perhaps on a memorable date like her birthday.

7.  An investing ninja plays it safe near retirement.  An investing ninja doesn’t want to work any longer than he has to, so he starts to shift into more bonds and fixed income as he gets into his mid-fifties and early sixties.  He may even sell some shares and hold enough cash to last him for a few years at the start of retirement so that a sudden market downturn doesn’t jeopardize his future returns.  He knows that he can tolerate market fluctuations far less once he is actually living on investment income.  If his portfolio is far larger than he needs for current income, he plays it safe with the portion needed to cover expenses and invests the rest for growth.

So there you have it.  Are you going to be an average investor, or are you going to be an investing ninja with your 401k?  It’s up to you.

Got an investing question? Please send it to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Investing for Income with Rising Interest Rates

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With interest rates set to rise, income investors – those who invest in bonds and dividend paying stocks to generate income for life expenses – are justifiably worried.  The secret for staying calm in such times is to have an effective and consistent investing strategy and to stick with that strategy regardless of what outside forces do.  In the last post I discussed what the effect of rising interest rates is on income investments.  Today let’s look at how to invest if you’re an income investor whee rates are rising.  Let’s first look at the effect changes rising interest rates will have  on bonds and dividend paying stocks and then see what the appropriate investment strategy would be.

Bond and Rising Interest Rates:  If you hold individual bonds, you can be sure that their prices will decline if interest rates increase.  The change in price will be proportional to the increase in rates.  If you hold bonds to maturity, however, you can expect to be paid whatever the bond payoff is when the bond matures regardless of price fluctuations in the interim.  For most bonds, this will be $1000 per bond.  So if you hold a bond right now that is worth $900 per bond (the price is $90) and interest rates increase, the price may drop to $80, or $800 per bond.  If you hold it until it matures, however, you should get $1000 per bond.  The only exception would be if the company defaults on the bond, in which case you would get next to nothing.

If you hold bonds in a mutual fund, the mutual fund will see similar things happen to the bonds they have, which will cause the price of the fund to decline somewhat, but then new bonds they buy will pay a higher interest rate, so that their payouts will increase, possibly leading to the price of the fund to increase again.  The farther out the maturity date of the bonds they hold, the greater the change in price you should expect.  For example, a long-term bond fund may decline quite a bit, but a short-term bond fund may not decline at all.  This is because the long-term fund holds bonds that won’t mature for many years, while the short-term fund has bonds that mature within only a few years, so investors are more focused on the price of the bond relative to its maturity price than they are on the interest rate paid by the bond.  They are almost assured of being paid whatever the maturity price is within a year or two, but won’t collect many interest payments before the bond matures.

In either case, if you are a long-term investor, your main concern should be more about the income you are receiving and the risk of default than you are of about the price of the bonds or of the fund that holds them.  If you are going to hold the bonds until maturity anyway, or hold the fund until the bonds the fund holds mature, it really won’t matter if the price of the bonds decreases for a while.  If you are a regular investor, you should enjoy the opportunity to pick up more bonds cheaply and get a greater interest rate for your investment.

Note that if you are thinking of selling out and then buying in at lower prices, the prices of bonds and their funds already reflect the expected interest rates.  You would just be paying transaction costs and taxes.  You would also be forgoing interest payments while waiting for bond prices to drop and interest rates to rise.

Dividend Stocks and Rising Interest Rates:  The effect of rising rates on stocks is similar to that on bonds, but slightly different.  This is because there is no maturity for a stock – you have no assurance that you will receive any amount for your shares in the future – and because the dividend a stock pays can change over time.  While the price of dividend paying stocks may rise and fall as interest rates fall and rise for the same reason as do bond prices, every high yielding stock will act like a long-term bond since there is no “maturity date” in the future.  The average price of the stock will be based on whatever dividends the company is able to generate in the future with either a premium or a discount depending on what interest rates are doing.

In finding dividend paying stocks, it is therefore important to select those that have stable dividends.  You don’t want to pick one that is paying out so much as a dividend that there is not enough money left over to reinvest in the company.  Note that if a company is paying a much higher dividend than its peers – for example, one utility is paying 10% while all of the others are paying 5%, the dividend is probably not sustainable and therefore will be cut in the future.  Often the reason that the dividend is so high is that the price of the stock has dropped in anticipation of the company making less money and therefore needing to cut the dividend.

Finding stocks that have consistently grown their dividends, such as those that have increased their dividend for ten years or more, is generally a good strategy.  This shows that the company is well run, growing, and is willing to reward investors with a portion of the profits they make.  If you’re holding that kind of stock, while the price may drop in the near-term if interest rates rise, over long periods of time you’ll probably be just fine.  Just focus more on the amount of the dividend being paid and less on the price of the stock.  If you’re not ready to sell soon anyway, the stock price really doesn’t matter much.

When to Start an Income Portfolio

While there is no reason to sell bonds and high yield stocks just because you think interest rates are going to rise, buying such assets when interest rates are at historic lows, as they have been for the last several years, is not a good strategy.  You are effectively locking in your rate, especially when you buy a bond and to a limited degree when you buy a dividend paying stock.  Because rates went so low, many bonds went above their par value, meaning that if you buy them now they’ll drop in price when they mature and you won’t get your full investment back.  You also may be locking in a 4% return when you could get 6% or 8% for the same bonds in a better environment.  In this type of environment, it is better to hold growth stocks and simply sell shares to raise income as needed.  Note that the taxes are often lower on capital gains than on interest income as well, but this varies over time and by state.

You should start an income portfolio when interest rates are high, relative to historic rates, and there are therefore many bonds of quality companies paying a good interest rate and solid dividend paying stocks paying a good yield.  You also want to buy a portion of income stocks and bonds that are appropriate for your stage in life.  If you need regular income because you’re going through college or in retirement, you’ll need more income paying assets than if you are working a regular job and have many years before you’ll need the income.

You might consider putting a portion of your portfolio into income securities even if you don’t really need the income and will just reinvest since that will help add stability.  This means that your portfolio value will hold up better during various recessions and bear markets in stocks.  Over the long-term you’ll be giving up return, however, so if you still have a really long time horizon, you might choose to forgo the income investments.  If you do buy some bonds and dividend stocks and don’t need the income, however, put them in your traditional IRA or 401K so that you won’t be paying taxes on that income each year, allowing your investments to compound and grow.

Got an investing question? Please send it to vtsioriginal@yahoo.com or leave in a comment. 

Follow on Twitter to get news about new articles. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

How Do Interest Rates Affect Bonds?

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After years of keeping rates at 0%, the Federal Reserve is talking about raising rates this year.  Because the economy remains extremely weak, mainly due to uncertainty in things like the effect of Obamacare on health insurance costs and employment rules, no quick change is expected.  Instead, predictions are that the Fed will raise rates by a couple of percentage points over the course of a couple of years.  They will also be looking for signs of weakness and take a pause or drop rates back down if needed.  Note that it is important that rates be raised because there is currently no flexibility to drop rates should the economy get worse since they are at zero (it’s not like banks can start charging you for leaving your money with them).  Plus, it’s really tough on retirees living on CD interest when rates are really low as they have been for many years now.

If you are an income investor, buying bonds and high yield stocks in an effort to generate an income from your investments, interest rate changes can have a big effect on your investments.  Hikes in interest rates tend to drive the prices of bonds and income producing stocks down.  If you’re a long-term investor, this may not really matter to you, but it is certainly unsettling to see your portfolio value drop, especially over a short period of time.  That’s why today I’ll be discussing the effect of interest rates on income investments.  In the next post I’ll discuss the best way to deal with changes ( and expected changes) in interest rates.

So why do changes in interest rates by the Federal Reserve have such an effect on the prices of bonds and income producing stocks?  The Federal Reserve has control of two key interest rates – the rate at which big banks charge each other for overnight loans and the rate they charge banks for loans at what they call the “Discount Window.”  They can also change the amount of cash reserves banks are required to hold in-house, reducing or increasing the amount of money they have available to loan out.  All of these factors have an effect on how easy it is to get a loan, which in turn affects the growth rate of the economy and inflation.
The control of those two interest rates allows the Federal Reserve to (very crudely) control other interest rates, such as savings account, CD, and money market rates.  If the Fed lowers their rates, banks lower the rates they offer to consumers since they can get money from the Fed or other banks without needing to deal with bank customers.  If the Fed raises rates, then banks will raise the amount they will pay in interest to consumers since they are now more eager to borrow from bank customers.
Now bonds and dividend paying stocks are also affected by these rates, although the effect is less direct than is seen with bank interest rates.  When people buy bonds and dividend paying stocks, they’re taking a risk that their money will not be returned (for example, if the company goes through tough financial times and can’t repay the bond or the stock price declines).  In exchange for this risk, investors require a higher rate of return from bonds and dividends than they can get from a bank CD.  If the rates on bank CDs increase, investors will sell bonds and dividend paying stocks and put their money in bank CDs.
New investors in bonds and stock will then offer a lower price for bonds and dividend stocks so that the interest rate that they receive is higher.  You see, a company issuing a bond will pay a fixed amount of money in interest each year through the life of the bond.  Likewise, companies tend to pay about the same amount out in dividends with perhaps small increases or decreases depending on how their business is doing.   Because the amount of money paid out is fixed, the effective percentage rate that a new investor gets depends on the amount he pays for the bond or the stock.  The more he pays, the less his interest rate.  The less he pays, the greater the rate.
The effect of an increase in bank interest rates is therefore to cause bond and income stock prices to decline.  Note that prices can also decline if there are fears that interest rates will rise far enough to cause the economy to slow, reducing future dividend payments and possibly causing some companies to fail and default on their bonds.  This will probably not happen with a small increase, but it certainly could if the Fed raises rates enough to shut-off the supply of money to companies that rely on borrowing to pay their bills.  Note also that if interest rates rise, the interest rates companies must pay on new bonds they issue also increases, so their borrowing costs increase and reduce the amount of money they have available to grow and expand their businesses.
In the next post, I’ll go into what income investors should do (or not do) in the face of a rate increase.

Got an investing question? Please send it to vtsioriginal@yahoo.com or leave in a comment. 

Follow on Twitter to get news about new articles. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Should You Buy Individual Stocks or Mutual Funds

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Many people say you should not buy individual stocks, and maybe they are right.  Buying individual stocks is radically different from buying mutual funds.  It takes a different mindset and it carries a completely different set of risks.  So what is the difference?

When you buy into a mutual fund, you are buying a large number of different stocks.  One of the most concentrated mutual funds you can buy is one that tracks the Dow Jones Industrial average (such as the DIA, or “diamonds”). which trades on the American Exchange.  In this case you are only buying into the Dow Jones Industrial Average, which includes 30 large, household-name companies.  There is also the Janus Twenty Fund that invests in just 20 stocks that the managers pick.  Otherwise, you’ll probably find that a listing of the holdings in your mutual fund will cover a few pages in the prospectus (a booklet that describes a mutual fund).   

Because you are buying so many stocks, your return over long periods of time will essentially equal that of the market in general, minus expenses, regardless of the mutual fund you pick.  Your return will be between 8-20% before expenses if you hold for ten or more years, and if you hold for more than  fifteen years, your return will narrow to between about 10-15%.  There will be years when you make 30 or 40% returns, and others where you’ll lose 20 or 30%.  On really bad years, you might lose 50% or more.  On great years, you might make 100%.

With a mutual fund, you’re protected against a single CEO making a big mistake and causing the company stock to lose 90% of its value.  You’re protected against choosing the wrong company and seeing your investment tread water while others are charging ahead.  You don’t need to spend a huge amount of time pouring over annual reports or earnings sheets.

Individual stocks are different.  Individual stocks routinely double in value or drop 50% in a year.  If you have only a few stocks, you may see your portfolio value change by  ten or twenty percent in a day.  There are also times when your stocks will fall in price even though everything seems fine at the company, or continue to rise for days on end without a clear reason why.  You might also see a company take on too much debt, misread the customers, or just become no longer needed and disappear entirely.  This doesn’t happen with mutual funds.

So why would someone buy individual stocks?  Again, most people shouldn’t.  Most people who try to trade individual stocks end up making much lower returns than the markets.  They buy too late, chasing the latest fads after the run-up has occurred, then hold on way to long as their stocks crash back down to earth.  Then they sell out, right at the bottom, when they should have been buying. 

Look at average returns, and you may see 3-4% when the market was making 15%.  For most people, if they would just buy index mutual funds (funds with low fees since they just buy whatever is in a particular stock index) and forget they own them, they would do much better.  In fact, everyone should do this for a portion of their portfolio if they have a portfolio of reasonable size (greater than $20,000, say).

There is a way to use individual stocks, however, for a portion of your investing that can allow you to beat the markets.  This is the way that Warren Buffett and Bill Gates made their billions.  You do it buy buying companies, rather than trading stocks.  Rather than worrying about the price of the shares and trying to time buys and sales to make a small profit, you find great companies and buy in for the long-term.  You plan to own them for the good times and the bad times as they grow and mature.  Twenty years down the road, they may be paying out as much in dividends each year as you paid for the shares.

This type of investing is very simple mechanically, but very difficult emotionally.  You need to be willing to sit there as your shares lose half of their value, perhaps buying more at the bottom.  There may be years when the markets go up 30%, but your company’s stock sits and does nothing.  The big gains are made in short bursts, with a lot of waiting in between.

Individual stock investing isn’t for everyone.  But for some, it can be the path to life-changing gains.  The secrets are patience, stock selection, and proper risk management.  Plus control of your emotions and a willingness to buy when everyone else is selling.  

Got an investing question?  Write to me at VTSIoriginal@yahoo.com or leave a comment.

Follow on Twitter to get news about new articles. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

I Just Can’t Buy Bonds

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Bonds and income stocks are an important part of a portfolio.  While bonds won’t provide the returns that stocks will over long periods of time, when there are falls and crashes in the stock market like in 2008, bonds will usually hold up in price while stocks will fall.  Indeed, in 2008, those who were 50% in bonds, say, might only have seen their portfolio’s decline by 5% or 10%, while those 100% in stocks were looking at 40% drops.  Some bond holders even made money while everyone else was seeing their portfolios decimated. 

A rule of thumb is that you should invest a percentage of your portfolio equal to your age in bonds.  If you are 20, you should be 20% in bonds and 80% in stocks.  If you are 80, you should be 80% in bonds and 20% in stocks.  If you are 100, you should be thankful you’re alive and be 100% invested in bonds.  If you’re 110, I guess you need to short 10% of your portfolio and invest the proceeds in bonds or something.  This is the conventional wisdom and we should never doubt the wisdom, right?

Except I do.  I am in my 40’s, so I should be 40% in bonds, but instead I’m 100% in equities.  (OK, maybe 97% in equities and maybe 3% in cash.)  I plan to be the same way when I’m in my 50’s, and I hope that I can be the same way when I’m in my 60’s and 70’s, although I may diversify into real estate at some point by buying some vacation homes, just for the fun of it.

I know that buying bonds (and income producing stocks) reduces risk, and I know that the additional reward that I can get for being 100% in stocks is just a little better than it is for being 70% in stocks and 30% in bonds, say.  But that’s just it.  By putting money into bonds that could be in stocks, I’m giving up a few percentage points of return that I could be getting from a 100% equity portfolio.  I know that over a long period of time, like 20 years, the difference between making a 12% return or a 15% return and a 10% return is huge.  You see, at a 15% return, by portfolio value will double every 4.6 years, while at 10% it will double every 7.1 years.  In 20 years, 100,000 will be worth about $400,000.  At a 15% return, the same $100,000 will be worth more than $800,000.

Now what is the consequence of not owning bonds?  Well, in years like 2000 and 2008, I’ll see a big drop in portfolio value compared to a portfolio with more bonds.  A portfolio with about 70% bonds and 30% stocks will be lowest risk of all, meaning swings in portfolio value will be substantially less than a portfolio that is 100% stocks or even 100% bonds.  During years like 2008, people who had 60% bond/40% stock portfolios may have even seen an increase in their portfolio values while those with 100% stock portfolios saw 40% declines.  During the next year, however, the 100% stock portfolio saw a 30-40% increase, and another 20-30% increase the year after that.   You risk having big drops in the value of your portfolio, but you’ll also see recovery if you can just stick it out or, better yet, invest more while prices are low.

Having a 100% stock portfolio when you are a few years away from  retirement can definitely be a bad idea.  Certainly there are a lot of people who were ready to retire in 2007 after seeing the value of their 401k’s increase from 2003-2007, only to see their plans of spending time on the beach put on hold after suffering substantial losses in 2008.  In 2008 they were still heavily invested in stocks, hoping to get one more great year to feather their retirement nest.  Instead they saw a bear market for the record books.  

Many advisers propose being very conservative going into retirement, having maybe a 60% bond and 40% stock portfolio, and then actually getting more aggressive as time passes.  There are studies that show starting very conservative right when you retire but then being more aggressive later in retirement increase your chances of outliving your money.  The idea is that when you are just starting out in retirement, a big loss would be devastating, but it becomes less significant as you get older and no longer looking at as many years of life.  Someone who is 70 might be 70% stocks and 30% bonds again. 

Despite the risk of suffering a big setback, I would still like to be mainly invested in stocks even going into retirement, however.  I know that I’ll enjoy much better returns in equities, and therefore have more cash flow to enjoy life, if I’m in stocks instead of being heavily in bonds.  Even at age 65, I still have about 20 years to invest and I know that for periods of 10 years or longer, I’ll have returns on the order of 12% in stocks before inflation.  

Staying fully invested in stocks is not an option, however, if you have just enough money for retirement, which today is somewhere in the $1M to $3M range.  In that case, if you had a large, 50% portfolio loss, you would run the risk of running out of money,  This is because, after a large drop, you’ll need to take more money out of your portfolio for expenses than it can withstand.  Once you reduce the balance of the portfolio enough that it no longer produces enough to regenerate itself for the amount you extract, it becomes a vicious cycle.  Each time you take more out, you reduce the amount of income it can generate.  Next thing you know, you’re moving in with your kids.

I’m hoping (and planning) to have more that I need for expenses, however.  If I have a $6 M portfolio, I can set aside a relatively small portion in bonds (or even just put five years’ worth of expenses in cash) and keep the rest invested in stocks.  If the market takes a tumble, I can just wait for it to rebound since I’ll have expenses covered.  When the market does well, I can sell some shares and build up my cash position.  When it does poorly, I can sit pat and use the cash I have.

The other advantage of building up a bigger portfolio than the bare minimum is that I can stay mostly fully invested even as I approach retirement.  When you are just starting to invest, the return on my account was relatively small (maybe a few hundred dollars a year.  When I get to the point where I have a few million dollars in my account, however, I would be making a million dollars or even two million dollars during years where the market goes up 20 or 30%.  Most people miss out on these big gains because they need to start transitioning to bonds just as their portfolios start to get large because they can’t withstand a big downturn.  They cross a million dollars when they reach 60 years old or so, then transition half of the portfolio to bonds and limit themselves to maybe a $50,000 gain in a given year.  If I have two to three times the minimum needed, I can stay invested in stocks because I know even if I lose 50% in a given year, I’ll still be set for retirement.  I can then take advantage of the opportunity to have really big gains.

If you want to stay fully invested in stocks and get that extra return like me, you don’t start when you’re in your fifties or even your forties.  You need to be putting money away regularly when you are in your twenties.  If you can find a way to put $5000-$10,000 per year into investments when you’re in your twenties, by maybe buying a smaller home when everyone else is buying big homes, or buying older used cars when others are buying new, you can set yourself up to have much more than the minimum to retire.  Then you won’t need to give up return by putting a bunch of your portfolio in bonds either.

Got something to say?  Have a question?  Please leave a comment or contact me at vtsioriginal@yahoo.com.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.