Getting Income from Your Retirement Portfolio


This is part of a series of posts for an online class on how to use your investments to fund your retirement.  To find other posts in the series, select the category  “Retirement Investment Class” under “Retirement Investing” at the top.  The posts will appear in reverse order, with the newest post first. 

A portion of your retirement portfolio should be dedicated to generating current income.  This means that you want assets in your portfolio to be sending you a check regularly so that you can pay for food, utilities, and other expenses you’ll have in retirement.  For example, if you own bonds they will send you an interest check twice per year.  Likewise, many stocks will send you a dividend check four times per year.  REITs (Real estate portfolios) will send you money from rents that they receive from properties in the portfolio.  All three of these types of investments will also send you capital gains distributions periodically from when they sell a security at a profit.  While you can also sell off shares to generate cash, it is better to have interest and dividend payments coming into your account so that you don’t generate brokerage commissions and other costs by selling.  Once you have things set up, it also means that you don’t need to do much of anything.

To show how the process works, let’s assume that I have a two million dollar portfolio, of which I’m using $1.5 M to generate income.  The other half-million I am leaving in growth stocks to keep up with inflation and get better returns than I can from income generating assets.  I’ll use a combination of bonds, dividend-paying stocks, and REITs to generate income.  Let’s say that I want to generate about $50,000 per year in current income from the portfolio.

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Looking through the Vanguard funds, I find the following:

Bond Funds:

Long-Term Bond Index – Yield 3.78%

Total Bond Market Index – Yield 2.96%

Long-Term Corporate Bond Index – Yield 4.42%

High-Yield Stock Funds:

High-Dividend Yield Corporate – Yield 2.89%

REIT Funds:

Real-Estate Index Fund – Yield 4.03 %

I’ll use these funds as building blocks to generate the income I want.  Bond funds tend to pay the most cash, but the higher-paying bonds funds are also riskier.  The amount they pay (in dollars) will also stay relatively fixed with time, while the value of a dollar will decrease due to inflation, so over many years my spending power will be reduced if I only buy bond funds.

The dividend-paying stocks don’t pay as much as the bond funds, but the amount that they pay will increase with time.  I may only get $5,000 from a dividend fund this year, but in ten years I may be getting $10,000.  An equal investment in a bond fund may pay $7500 this year, but in ten years it will still be paying $7500.  The dividend part of the portfolio will help me keep up with inflation.  The growth stock portion will do this as well.

The REIT fund will pay as well as some of the bond funds, but also will have some capital appreciation, helping to keep up with inflation as well.  It is also in a different sector of the economy than stocks or bonds, so the price of the fund may stay up when the stock and bond funds go down and vice-versa.  This adds stability to the value of my portfolio.

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The strategy is to utilize the higher-yielding bond funds to increase my returns, but also buy some lower-yield funds for security and to reduce volatility.  I’ll add dividend-producing stocks for growth of income.  I’ll add REITs to help provide income, stability, and some capital appreciation.

Let’s say that I invested as follows:

Long-Term Bond Index – $200,000, yearly income $7560

Total Bond Market Index – $200,000, yearly income $5920

Long-Term Corporate Bond Index – $300,000, yearly income $13,260

High-Dividend Yield Corporate – $300,000, yearly income $8670

Real-Estate Index Fund – $500,000, yearly income $20,150

My total income would be $55,560, which is $5560 above my goal.  This is fairly close to my goal, so I may say this is good enough and go with it.  The portfolio is nicely balanced, with 47% in bonds, 20% in bonds, and 33% in real-estate.  If I really didn’t need more than $50,000, I would probably shift more money into the high-yield stock fund, which would reduce my current income but increase my future income and get a little better overall return on the portfolio over time.

So there you have it – the strategy for setting up the income portion of your portfolio.  Develop a list of funds with their yields, allocate money to each fund, trying to spread the money out among bonds, dividend-paying stocks, and real estate, and then adjust the allocations until you reach your needed income needs.

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.

Is a Buy-Write Fund Right for Your Retirement Account?


This is part of a series of posts for an online class on how to use your investments to fund your retirement.  To find other posts in the series, select the category  “Retirement Investment Class” under “Retirement Investing” at the top.  The posts will appear in reverse order, with the newest post first. 

Today’s topic is a bit advanced, so I’ll begin by boiling the lesson down to the key points, then elaborate for those who want to know the details.  The key things you need to know about buy-write funds are:

  1.  They can generate a good amount of cash income regardless of current interest rates (with option writing, you can basically turn any stock into a dividend-paying stock).
  2. They are more volatile than bond funds but less volatile than stock funds.
  3. They won’t go up as fast as stock funds, but also won’t go down as much.
  4. You have the potential to make on the order of 25% per year from buy-write funds, but you will rarely do this.
  5. They will perform the best of anything when markets are stagnant.

So there’s the minimal you need to know.  For those who want more explanation, please read on.

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What are call and put options?

You have probably heard the term, “stock options,” when hearing about a CEO who made a fortune because he received stock options from the company.  An option is a legal contract between two people.  This contract allows one person, the option buyer, 1) to purchase (or sell) 2) a fixed number of shares 3)at a specified price, 4) before a specified date.  An option to purchase is called a call option, where the option to sell is called a put option.  It is called an option because the purchase or sale is optional, purely at the discretion of the option buyer.  The option buyer would buy (or sell) shares from (to) the option seller, also known as the option writer.

Option writers can be covered, meaning they own the shares in the case of a call or have the cash in the case of a put, or naked, meaning they don’t.  A naked option writer hopes that the person who holds the contract never executes it, otherwise he’d need to somehow go out and buy the shares at whatever price they were trading so that he could turn around and sell them to the option buyer (in the case of a put, he’d need to find the cash to buy the shares at the specified price, regardless of where they were selling for now).  As you can imagine, being a naked option writer is insanely stupid and a great way to lose lots of money.  Really, it was naked option writers (who didn’t know they were naked because they bought offsetting options from other naked option writers) who caused the housing market crash in 2008 to almost take out several US financial firms.

To make things easy, most option contracts are standardized, meaning they all are for the same number of shares (typically 100 per contract), have regularly spaced prices at which the shares are bought or sold (called the strike price), and all expire in monthly groups on the same date (the date at which the contract expires is called the expiration date).  For example, this month all of the options expire on Friday, March 16th.

 

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Why would someone buy options?

Options were originally meant as little insurance policies, whether letting someone buy or sell a stock at a certain price.  They have become much more popular as speculating tools, however, since they provide something called leverage, which is when you use a little money to control a lot of money.  Most readers are probably most familiar with leverage when it comes to home buying, where you can put $10,000 down on a $500,000 house.  If the home price goes up 1o% over the next year, you could then sell it for $550,000, making $50,000, or 500% profit.  This is really good for a one-year speculation.  If you had put down the full $500,000 for the home, you would have still made $50,000, but now it would have only been a 10% profit.  Leverage magnifies potential gains.

Options do the same thing.  You might buy a set of 10 calls on a $100 stock for $500, meaning that with $500 you now control $10,000 worth of stock.  If the stock goes up $10 per share to $110, you might be able to execute the options and sell the stock, making a quick $1000, or 100% profit.  (You might also be able to just sell the options to someone else for $1000 since the price of the options would go up when the stock price went up.)  If you had bought the shares for $10,000 instead of buying options, you would have only made a 10% profit, plus you would need to find the $10,000 somewhere to buy the stock.  This is why people use options, the potential to make a fast profit without putting too much money down.  This potential return comes with great risk, however, since your options expire worthless on the expiration date if you don’t use them.  You therefore need to be right about both the direction and the timing.

What about writing options?

The person on the other side of the trade described above, the option writer, would get money from the option buyer called a premium.  The premium in the example above was the $500 the option buyer paid for the calls, which went to the option writer.  The value of the premium varies constantly, based upon the price of the stock relative to the strike price, how volatile the stock is, and how long it is until the expiration date.  Basically it is whatever the person who is writing the option is willing to accept from the person buying it at any given time.  While the option buyer has the potential to make a lot of money, most of the time he doesn’t.  Some thing like 9 out of 10 options expire worthless, meaning the option writer pockets the premium and the buyer limps away with nothing.

For this reason, while the potential profit is less, it is still better to be the option writer because the odds are so much on your side.  You might only collect $800 when you write a set of calls on $20,000 worth of stock you own, but if you can do that six times a year, that’s $4800 per year, or a 24% return.  Compare that with the historical 10-15% return you can get from buying and holding stocks, and you can see why it is attractive.  It is like being able to make any stock into a dividend-paying stock.

Writing covered calls is not without risk.  If the price of the stock drops, you will lose money, or at least need to wait for the price of the stock to recover, which could take weeks, months, or years (or never).  You are also setting a limit on your potential return.  If you have shares of XYZ stock, selling at $95 per share, and you write calls with a strike price of $100, once the stock passes $100 per share you will no longer be making any more money.  Also, because there will be some positions where the stock declines in price and times when you just can’t get a good price when writing a new option, it is unlikely that you’ll actually get 25% returns.  In actuality, I’d say that you would be more likely to make 8-12% per year, but still it is a good return , especially when dividends are like they are today, at 2% or lower.  It is putting cash into your retirement account, so you’ll have cash-flow that you can use without needing to sell stocks to raise cash.

Is there an easier way than writing calls yourself?

Yes.  There are mutual fund companies that create buy-write portfolios for you.  For example, PowerShares has an S&P 500 buy-write ETF that is like an S&P 500 fund with a call option written against the portfolio.  You won’t do as well in this fund if markets are going up as you would be by just buying an S&P 500 fund, but you’ll be doing a lot better if markets are stagnant and a little better if they are dropping.  In both cases, you’ll be making 8-12% in premiums to offset whatever the underlying index is doing.  For example, in 2017 the fund provided about 11% in cash payments.  This is not as good as the 20% percent return you would have had if you were just invested in an S&P 500 index fund, but would provide the cash needed for living expenses.

Note that the price of the buy-write fund will change, meaning that your total return will probably not be 10-12% each year even though you were receiving payments of 10-12% per year.  For example, if you receive a 10% payment but the share price drops by 8%, your total return would only be 2%.  With income investment, however, you should be focused on the cash return you are getting and not the share price.  The fund price may go up or down, but all you need it for the fund to continue providing you the income you need each year.  In many ways this is similar to a rental property, where home prices may change constantly in an active market, but unless you are trying to sell the property, all you care about is getting good tenants in and seeing a steady rent check each month that increases over time.

Have a burning investing question you’d like answered?  Please send 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.

Eight Simple Steps to Start Investing


 

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Maybe you’ve been working on your personal finances for a while.  You’ve got a budget. You’ve paid off all of your debt (or never had any in the first place).  You’ve gotten your emergency fund together and have about $10,000 in cash sitting there.  At this point you’ve got a line in your budget called “Investing” and you’re starting to siphon money out of your income to a bank account that you’ve created to store up your investing funds until you have enough to get into the markets. But now you’re worried about what you should do, where you should invest, and even how you go through the actions needed to buy stocks and bonds.

Luckily, investing is a lot easier today than it was before about the year 2005.  Where in the past you would need to have a fairly large amount of money before brokers would even work with you, the mutual fund industry has answered the need for the common man (and woman) to invest and discovered that there are a lot of people out there needing such services.  At places like Vanguard you can set up an account and start investing with as little as $3,000 ($1,000 if you’re starting a retirement account like a traditional or Roth IRA).  You might be able to invest with even less at places like Charles Schwab and/or if you set up autodraft from your checking account.  With these accounts, you have access to a wide array of mutual funds, and even individual stocks and ETFs, all with a few clicks of a mouse.

Still, there are a lot of options and it is probably fairly intimidating for the new investor.  That is why I’m providing the Simple Steps needed to get started in investing.

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Step 1:  Pay off all credit cards.

Before you even think about investing, get rid of your credit card debt.  During a really good period in the stock market, you’ll get a return of 15% per year.  Long-term returns average around 10% (which is 7% after inflation).  You just can’t compete with a 19 or 25% interest rate on a credit card balance.  Just think of yourself getting a 25% return on the money you use to pay off credit cards.  Then, cut up your cards and get debit cards instead so that you won’t go into credit card debt again.

Step 2:  Start with a retirement account.

Someday you will want to retire, which means that you need to have retirement savings to last you for about thirty years, plus something like $500,000 to $750,000 to pay for healthcare expenses beyond what Medicare covers.  If you have a 401k or 403b at work, start there, putting in at least as much as your company will match.  Putting in less means that you are leaving free money on-the-table.  If your company matches the first 5%, you can effectively increase your salary by 5% by just putting 5% of your pay into your 401k.  If you don’t have a 401k plan at work, sign up for the pension plan if one exists.  Regardless if there is a plan at work, go to Vanguard or Schwab and start a Roth IRA.

Fund your retirement plans with 15% of your salary.  Start by putting whatever the company matches into your work plan (or whatever is required by your pension plan), then fund your IRA up to the yearly maximum.  If there is anything left over, put it into your work retirement plan.  Still have money left over?  Start a standard, taxable account at Schwab or Vanguard and fund that account.

Step 3:  Determine your retirement fund asset allocations.

Assets are things like stocks and bonds.  They are things that pay you money, adding to your income.  Standard asset types for investing include stocks, bonds, and real estate.  To determine you asset allocation:

  1.  If you’re less than age 40, start with 100% stocks.
  2. If you’re over age 40, start with your age minus 20% in bonds, 110% minus your age in stocks, and 10% in real estate.   For example, if you’re 45, you would start with 25% bonds, 65% stocks, and 10% in real estate.
  3. If you’ve worried about losing money and are very nervous, increase your bond allocation by 10% and reduce your stock allocation by 10%.  This will smooth things out somewhat.  For example, someone who was 45 would increase their bond allocation to 35%, reduce their stock allocation to 55%, and still have 10% in real estate.  Someone who was 20 would reduce their stock allocation to 90% and add 10% bonds.

 

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Step 4:  Select your retirement account stock funds.

Go through the funds you have available and try to find index funds.  If you can, select a total stock market index fund.  If that is not available, try to find a large-cap (like an S&P500 fund) and a small-cap (like a Russell 2000 fund) fund.  If index funds are not available (for example, in a 401k plan without the best choices), find the lowest cost stock funds available (try to find funds that charge less than 1% of assets invested) and select one that invests in all sectors of the market or one that invests in growth and one that invests in value.  Also find a fund that invests in international stocks, hopefully something like a total international stock fund.  Read the fund descriptions to find what the fund invests in and manager’s style, as well as total fees.  

Step 5:  Find your retirement account Bond and Real Estate Funds

Go through the same process in selecting your bond and real estate funds.  Try to find a total bond index fund and an REIT index fund.  If you don’t have an REIT fund available, just add 10% to your bond allocation.

Step 6: Buy your retirement account funds.

You should be able to buy your funds using the website for your 401k or IRA.  Many sites will allow you to specify specific percentages of the account to put into each fund.  If that is the case, go ahead and set those percentages based upon the asset allocations you determined in Step 3.  If not, you’ll need to pull out a calculator or spreadsheet, do the math, then enter the dollar amounts.  Note that you will want to set your investment percentages in two different places, one for how to allocate the money you have in the account already, and the other for how to invest new funds.  Set both of these the same and matching the allocations you determined.

Divide the money within an asset category (stocks, bonds, real estate) equally to each of the funds in that category.  The exception is international stocks, which should be 20% of your stock allocation (so if you are investing 80% stocks, you would put 16 % of your account (80% x 20% = 16%) into international stocks and then 64% into US stocks and 10% into bonds and 10% into real estate.

Step 7:  Setup taxable brokerage accounts with Vanguard or Schwab if you have more money to invest.

Hopefully, after you are through putting money away for retirement, you’ll still have more money to invest.  Unlike your retirement funds, which you won’t be able to touch until retirement, money you invest in taxable accounts can generate additional income to enhance your life and hopefully make you financially independent before retirement.  Put 100% of your taxable investing accounts into stocks and only sell when you want to generate cash for something since you’ll be taxed each time that you do. As long as you don’t sell the shares, you won’t be taxed on the increases in value of your account due to increases in price of the funds in the account.  You will be taxed on the dividends and capital gains that the stocks in your funds are generating, but these should be small amounts if you buy index funds investing in the whole stock market.

If you want to, you can set these accounts up to spin off cash when the stocks in the funds pay dividends or there are capital gains.  You’ll then just magically see money appearing in your money market account with the fund company, with a larger amount n December (fund companies tend to move money around and realize capital gains at the end of the year.  This money will be taxable, but then can be used as you wish.  This is a great way to get extra cash without needing to sell shares.

Step 8: Wait until January 15th, then rebalance.

You should rebalance your accounts – set them back to your desired asset allocations – about once a year.  You should also adjust your allocations for changes in your age at this time (as you get older, you should be shifting more into bonds).  Luckily, most mutual fund companies also have tools to let you rebalance.  Just set the percentages you want into the tool and press the button.  Do this again every January 15th (or a date somewhere near then).

Have a burning investing question you’d like answered?  Please send 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 I Learned to Love the Bond


In case you haven’t figured this out yet, I spend a lot of time thinking about financial things and how money works.  I think about the effects that raising the minimum wage would have on low-wage workers (they aren’t good).  I think about why our healthcare payment system is so messed up (you don’t have clear prices, plus everyone is trying to get more than they pay for, so you don’t have an efficient, competitive market).  I also think about things like when using an annuity would be good (normally when you don’t really have enough to live on in retirement through investing).

One conviction I’ve had for a long time is that you should always be 100% invested in stocks (with maybe a little invested in REITs) unless you cannot afford a 50% loss or bonds are paying really high interest rates.  I reasoned that the return on bonds is always a few percentage points less than the return from stocks, so why should you give up a 10% return for a 6 or 8% return?  Having a 50-50 stock/bond portfolio when you’re 60-years-old will help protect you should the stock market decide to drop 40% like it did in 2008, but if you were worth $10M and could live perfectly well with $5 M, why would you want to own 50% bonds?

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And then I kept thinking and started to realize an issue with my convictions: While it is very unlikely that you will lose money in stocks if you hold them for more than 5 years, and very, very unlikely that you will lose money if you hold stocks for more than 10 years, that does not mean that stocks will always do better than bonds over a given five or ten-year period.  While the average return from a stock portfolio is 10-15% per year, that includes some great periods like the 1940’s-1950’s and the 1980’s-1990’s that really goosed the averages up.

A chart showing the annualized returns (the kind of return you would need to get each year at a fixed rate to end up with the same return) for the stock market (the Dow Jones Industrial Average – DJIA) during different decades is given below.  If you held the DJIA stocks from 2000 through 2009, sure you would be up, but your average rate of return would only be 1.07%.  If you held the DJIA stocks through the 1930’s, you would have actually seen a negative average return of -0.63% per year.

(Source of data:  http://www.stockpickssystem.com/historical-rate-of-return/)

During most 20-year periods, you would have been better off in the DJIA stocks than you would have been in bonds, assume a rate-of-return of 6%.  This is only true for seven of the twelve 10-year periods shown.  Of course, during periods like the 1930’s, many of your bonds would have defaulted, so being in bonds during that period would not necessarily have saved you either.  During the 2000’s, however, bonds returned about 6% annualized.  You would have therefore fared better in bonds from 2000 to 2010, but not as well as you would have in DJIA stocks from 1990 through 2010. For the period from 2000 through 2018 so far, you would be about even, but we’re seeing extraordinary returns right now, so the next few years may well cause stocks to outperform bonds again for the 20-year period from 2000 through 2020.

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So what does this mean?  If you have at least 20 years until you need the money, I would stay 100% invested in stocks.  A twenty-year-old who is just starting a 401k account should therefore be 100% in stocks, assuming she can handle the market fluctuations that such a portfolio would provide.  (If you can’t handle the fluctuations, consider adding 20-30% bonds, which will help to stabilize things a bit but not hurt long-term returns too badly.)  If you’re sixty-years-old and planning to start living off of your portfolio over the next few years, you might want to consider a 60-40 stock-bond portfolio even if you have a lot more money than you need in your portfolio and therefore could stand a big decline in the stock market without falling short of spending cash.  If you make it to eighty, you will probably get a better return from being entirely in stocks,  but you might very well do better with a stock-bond portfolio between now and age seventy than you will if you are entirely in stocks.

What would this look like?  Let’s say that you were invested 50% in Vanguard S&P 500 Fund and 50% in Vanguard Small Cap Fund with a $4 M portfolio at the start of 2017.  If you were to have shifted $800,000 from each fund into the Vanguard Total Bond Market Fund you would then have had $1.2 M in the S&P 500 Fund, $1.2 M in the Small Cap Fund, and $1.6 M in the Total Bond Fund.  In 2017 you would have received $24,400 and $18,350 in dividends from the S&P 500 and the Small Cap Funds, respectively, and $41,000 from the bond fund.  This means you’d have about $84,000 in income from your funds each year.  You would also make substantial capital gains in the stock fund during 2017, making $316,000 from the S&P 500 Fund and $213,000 from the Small Cap Fund.  This would mean that your total return for 2017 would have been about $613,000, or about 14% for 2017.

You would have done better during 2017 if you had been entirely invested in stocks, but if stocks had declined a bit during the year, you would still have $84,000 in income to use as needed while you were waiting for your stock portfolio to recover.  If 2017-2027 looks like 2000-2010, with the meager stock market returns during that period, you would gain about $400,000 over the period with an all-stock portfolio.  If you had the stock-bond portfolio, you would still gain about $1,080,000 through the period due to the dividends and interest payments that you were collecting during the time.  You would have substantial gains from your portfolio, rather than having a lost decade.

So, in conclusion, while you will probably do better with all stocks over long periods of time (two decades or more), you might actually do better if you mix in some bonds for shorter periods of time.  This is because the high stock returns are due to a few short periods, while bond returns are fairly steady and constant.  So don’t fear the bond.  Learn to love it for the steady returns it provides.

Have a burning investing question you’d like answered?  Please send 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.

Is an Annuity Right for Part of Your Retirement Funding?


This is part of a series of posts for an online class on how to use your investments to fund your retirement.  To find other posts in the series, select the category  “Retirement Investment Class” under “Retirement Investing” at the top.  The posts will appear in reverse order, with the newest post first. 

I have recently gained a new appreciation for annuities, or at least the promise that an annuity holds.  At one point I swore off annuities entirely and there are good reasons to do so.  These include:

  1. You can do better investing the money yourself.
  2. The fees can be high.
  3. You generally have little flexibility once you have made the purchase, and may need to pay a big fee to receive any of the money back.

But then I realized the true purpose of an annuity is the same as it is for any insurance product:

To shift your risk to the insurance company in exchange for the cost paid.

All annuities pay you a specified amount of money for a specified period of time in exchange for you handing over a load of money to the insurance company.  For example, you give them $100,000 and they agree to pay you $500 per month for the rest of your life.  In many ways this is like a pension plan where you receive payments, except this is from an insurance company instead of an employer.  In fact, many employers that still have pension plans use annuities to make the payments once individuals retire so that they don’t need to worry about it.  They just buy an annuity that pays the former employee whatever is needed when they retire and then the employer’s part is done.  You can create your own pension using an annuity if you commit your 401k funds or other retirement savings.

Now while there are probably as many different kinds of annuities as there are stars in the sky, since they are all just insurance polices and the types are only limited by the imagination of the companies that create them, there are really only two types of annuities that should hold any interest for you.  These are immediate annuities and deferred annuities.  And here we just want the plain vanilla types – no bells and whistles.

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Immediate annuities are just that – you give them money and they immediately start making payments to you.  These are used to provide regular income without needing to worry about what the markets are doing, buying and selling mutual funds, or performing other actions.  Deferred annuities pay after you reach some certain date, for example, starting to pay you $5,000 per month after you reach age 85.  These are used as insurance against outliving your money.

So why are annuities not as good as investing yourself, in general?  The reason is both that they charge fees (which can be big) and the return you get from an annuity, including fees, will not be as great as you would get if you had invested yourself.  For example, if you were to invest $1 M at age 65 in a balanced stock and bond portfolio, you would be able to receive about $40,000 per year, indexed for inflation, until you were age 95.  At that point you would have on average about $2 M in the account and have received about $1.8 M in payments during that time.  The $2 M would be able to buy about what $1 M can buy today, so you would effectively have all of the money you started with, plus have received an income to fund a $40,000 (in year 2018 dollars) per year lifestyle.

If instead you were to put the money into an immediate annuity, you might start getting paid about $75,000 per year, fixed.  If you then died at age 95, you would have received about $2.25 M during that period.  This sounds better than the $1.8 M you received from the investment portfolio, but the insurance company would keep the money you gave them when you died, leaving nothing for you to pass on to your heirs or from which to pay for your final expenses.  You would have gotten $450,000 less in income from investing, but would have $2 M in savings remaining instead of nothing.  Because an account can withstand about a 4% withdrawal rate without declining in value over time, spending at this rate can be done essentially forever, assuming no black swan market event occurs.

In addition, while you would start out better with the annuity, receiving $75,000 per year instead of $40,000 per year from the investment account, by the time you were 95 you would be receiving about $80,000 per year from the investment account where you would only be receiving $75,000 per year from the annuity.  While your spending power would start out greater with the annuity, the payments from the investing account would pass it up along the way and you’d be having a little more trouble meeting expenses with the annuity near the end.

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So why would you want to have an annuity instead of just investing yourself?  The beauty of the annuity is that you would (nearly) eliminate the risk of a market drop affecting your income.  Annuities also help protect you in the case that you live longer than average since many of them pay income until you die.  In fact, you’ll be able to utilize more of your money while you are alive using an annuity than you would investing yourself because, while you would need to limit your withdrawals to make sure you didn’t run out of money before you die if you’re investing yourself, the insurance company knows that if they sell 10,000 annuities, the average age at which people will die and distribution of ages is predictable and they can determine with a fair amount of certainty how much they’ll need to pay out.  They are therefore able to provide a higher payout per month than they could if they were just insuring a single person who might live to be 115.  If they know from historic data that the average person would live to age 84, for example, and how many people will live longer, they can determine the maximum payout they can make and not lose money.

Note that if you die young, say at age 66 when you buy the annuity at age 65, the insurance company would probably keep your whole $1 M.  This makes up for the people who live to be 100 and withdrawal more than the insurance company can make from their investment.  This is the nature if insurance – some people pay for more than they use to make up for those who pay for less than they use.     

And therein lies the reason that some people would want to use an annuity and others should invest for themselves.  If you are interested in leaving a lot of money to your kids or a favorite cause and you have enough money saved to allow you to generate enough income for expenses using 3-4% of the value of your savings each year, invest yourself.  If you don’t want to leave money, yet you don’t want to risk running out of money either, use an annuity.  You could also do a little of both, using an annuity for a portion of your savings to gain the additional income, but keep some invested in stocks to provide growth to allow you to increase your income should you live a long time and inflation starts really affecting the buying power of your annuity payments.

As far as what an annuity can and should pay you. realize that the insurance company will invest the money, probably mostly in common stocks if they don’t use the money to underwrite other insurance policies,.  The most they could pay would therefore be equal to the withdrawal rate they could make for the average life expectancy and have the money last.  As an example, if a person who is 65 buys and $1 M annuity and the insurance company figures out that the average person in the buyers risk-pool is likely to live 30 years, they could pay about $5368 per month or $64,418 per year if they were able to make an annualized rate-of-return of 5%, or about $7337 per month or $88,050 per year if they were able to make an annualized rate-of-return of 8%.

The amount they would offer would be somewhat less than this since they would take a fee off-the-top to pay the person selling you the policy, plus the insurance company would want to make a profit from the policy to make it worth their time, plus they may want to pay a bit lower than they would expect to make in case the markets don’t perform well during the period and don’t return as much as they were expecting.  They might therefore offer you $4500 per month if they were expecting to make 5% instead of the $5368 per month that they were expecting to make investing the money.  If there is ample competition (and you should shop around to make sure you get the maximum pay-out you can while still using a solid provider), you should get a reasonable return and their profit should be reasonable for the risk they are taking and their costs.

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Annuities are also a great choice if you have not saved as much as you really should have.  For example, if you have only saved up $250,000 by retirement, plus you have a home worth $500,000, you could maybe downsize or move to a lower-cost area and pull $350,000 out of your home.  (You could also possibly use a reverse-mortgage if you wanted to stay in your home, but again you would be paying a lot of fees in doing so.)  You could then take the $600,000 you had available and maybe buy an annuity paying $3,000 per month, or $36,000 per year.  Combined with Social Security, you should be able to make it through, although it might get tight if you live a long time after retirement.  You should therefore work as long as you can and build up all that you are able before you retire.  This will both increase your possible pay-out and reduce the number of years you’ll be in retirement.

But what if you want to have a good chance of spending most of your money, but want to get a better return that you will from an annuity?  If you have saved enough to fund your monthly expenses from investment returns, there is a way that you can invest yourself and still use more of your money than you will if you limit yourself to a 3-4% withdrawal, yet still have a low chance you will outlive your money.  The secret is to start out conservative, but then increase your withdrawal rate as you go.

For example, if you had $1 M and retired when you were 65, you would start out at 4%, or $40,000 per year.  At this rate there is a good chance your portfolio value will not drop at all (in inflation-adjusted terms).  If you wanted to be even more conservative, you could limit yourself to 3%.  After five years, at age 70, you could start spending at a rate that would exhaust your savings in 30 years, assuming some reasonable rate-of-return.  For example, as shown before, a 5% rate-of-return would result in a yearly payment of $64,418 as shown before.  Because your chances of living to 100 are fairly low (depending on the ages of your parents when they died, your current health, and other factors), you are fairly safe increasing your spending and starting to spend down your savings at this rate.

If you are still worried, you could also take some of the money and buy a deferred annuity that kicks in at age 90 or something.  Since it is unlikely that the insurance  company would expect you to receive many (or any) payments from this policy, the amount you would need to contribute to receive enough income for expenses at age 90 and beyond would be fairly low.  Plus, your expenses at age 90 if you live that long will likely be fairly modest.

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.

Building a Retirement Portfolio with Mutual Funds


This is part of a series of posts for an online class on how to use your investments to fund your retirement.  To find other posts in the series, select the category  “Retirement Investment Class” under “Retirement Investing” at the top. 

Let’s say that you have $2M saved up in your 401k and are ready to retire.  Let’s also say that you need about $50,000 per year to live on the first year, with that amount growing with inflation each year.  Today we’ll discuss how you would use a set of mutual funds to to generate the income that was needed while keeping up with inflation to avoid outliving your money.

The rule-of-thumb is that you can withdraw somewhere between 3% and 4% of your portfolio each year and have a very good chance of having it last through a 30-year retirement.  In fact, the balance could grow under a lot of scenarios.  Withdrawing $50,000 per year from a $2M portfolio would therefore be right in line  with the guidance, since you could withdraw about $60,000 per year and stay at the low end of the range.  You have done well saving and investing throughout your career to put yourself in good shape for retirement.

Ideally you would generate a lot of the income you need for expenses from income producing assets.  You would therefore put a portion of your portfolio in an income or a bond portfolio.  You would also want a portion of the portfolio to grow and keep up with inflation, so you would want to invest the rest in growth and value stock funds.

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We’ll use Vanguard funds as an example.  Looking through their list of funds for income funds, I find the Vanguard Total Bond Market Index fund.  This is a fairly safe fund, although the price could decline if interest rates rise or a serious recession occurs that causes several companies to default on their loans.  In general, as long as I planned to hold this fund regardless of interest rate changes such that price drops due to rising interest rates would not be an issue, chances are good that I would not have any issues.

It is described at the Vanguard website as:  “This fund is designed to provide broad exposure to U.S. investment grade bonds. Reflecting this goal, the fund invests about 30% in corporate bonds and 70% in U.S. government bonds of all maturities (short-, intermediate-, and long-term issues). As with other bond funds, one of the risks of the fund is that increases in interest rates may cause the price of the bonds in the portfolio to decrease—pricing the fund’s NAV lower. Because the fund invests in all segments and maturities of the fixed income market, investors may consider the fund their core bond holding.”

This fund is yielding about 2.5%, so a $1M investment would be paying about $25,000 in interest each year, plus a capital gain from time-to-time.

There is also the High Yield Corporate Bond fund, which is paying about 5.1%, or about $51,000 per $1M invested.  This fund is more risky since the bonds it is investing in are low quality, meaning the companies would be more likely to default than they were with the first fund.  During a recession, I would see some bigger losses in this fund, so I would want to limit my exposure despite the higher yield.  It is described at the Vanguard website as:

“Vanguard High-Yield Corporate Fund invests in a diversified portfolio of medium- and lower-quality corporate bonds, often referred to as “junk bonds.” Created in 1978, this fund seeks to purchase what the advisor considers higher-rated junk bonds. This approach aims to capture consistent income and minimize defaults and principal loss. Although this is a bond fund, high-yield bonds tend to have volatility similar to that of the stock market. This fund may be considered complementary to an already diversified portfolio.”


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I would also look at REITs, which invest in real estate and also generate a reasonable cash return due to the properties in which it invests.  The Vanguard Admiral REIT fund is described as:

“This fund invests in real estate investment trusts—companies that purchase office buildings, hotels, and other real estate property. REITs have often performed differently than stocks and bonds, so this fund may offer some diversification to a portfolio already made up of stocks and bonds. The fund may distribute dividend income higher than other funds, but it is not without risk. One of the fund’s primary risks is its narrow scope, since it invests solely within the real estate industry and may be more volatile than more broadly diversified stock funds.”

It is yielding about 4.3%, or $43,000 per year for a $1 M investment.  REITs would move around a bit since their value depends on the value of the properties it holds, rents they can charge, and other factors.  This portion of the portfolio would also have a growth component since the property values would increase with inflation and as fewer properties were available to buy for a growing population.

You would want your investment mix to be maybe 50% income, 50% growth at 65 years old, so that would leave $1M to invest among these three funds.   I would probably put 50% in the safer bond fund, 25% in the junk bond fund, and 25% in the REIT fund.  This would result in an income of:

Total Bond Fund: $500,000 invested, income $12000/year

High Yield Bond Fund:  $250,000 invested, income  $13,000/year

REIT Fund: $250,000 invested, income $11,000/year

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Your total income would therefore be about $36,000 per year, so you would be about $14,000 per year short of your income goal.  The remainder would need to come from selling stocks off each year, plus a little bit of income from dividends.  For stocks I would look at the Large Cap Index Fund, which is paying out about 1.8% per year, the Small Cap Index Fund, which is paying out about 1.4%, and the Total International Index fund, which is paying out about 2.8%.  With the remaining $1M I would put about 25% in the international fund, and then put 50% in the large cap fund and 25% in the small cap fund.  This would generate income as follows:

Total International Fund:  $250,000 invested, income $7,000 per year

Large Cap Index: $500,000 invested, income $9,000 per year

Small Cap Index:  $250,000 invested, income $3500 per year

So your total income from your stock portfolio would be about $19,500 per year.  Summed together with your bond portfolio, this would equal $54,500 per year in income.  Because you are actually generating more income than you needed, you could either reinvest a portion of the income each year into stocks or bonds.  You could also cut your bond exposure a little and let more of your money grow at the faster, stock market rates.  You could expect a growth rate of about 8% on average from your stocks.

 

Want all the details on using Investing to grow financially Independent?  Try The SmallIvy Book of 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.

Retirement Investing Choices: Annuities


This is part of a series of posts for an online class on how to use your investments to fund your retirement.  To find other posts in the series, select the category  “Retirement Investment Class” under “Retirement Investing” at the top. 

Now that we’ve discussed how much you need to save for retirement and provided some information on mutual funds and ETFs, we can start to discuss some of the different investment options for your retirement portfolio and their role in the big picture of things.  Today we’ll start with an asset called an annuity.

An annuity is an income vehicle issued by an insurance company.  In exchange for turning over some of your money to the insurance company, they agree (guarantee) to pay you a specified amount of money for a specified period of time, which could be the rest of your life.  Because annuities are insurance contracts, there are all sorts of different types, limited only by the insurance company’s creativity in designing a product they hope they’ll buy.

The main benefit of an annuity is the guaranteed income.  That guarantee comes at a price, however, in that the income you receive will be less than the income your money could have generated if you had invested it on your own.  They should therefore be used when security is more important than return, or if you simply don’t want to fool with things and are willing to accept less in exchange for your time and effort.  Annuities are a fix-it-and-forget-it type of investment.

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The most basic type of annuity, called an immediate annuity, simply pays you a specified amount of money starting immediately for a prescribed period of time, often the rest of your life.  For example, let’s say that you buy an immediate annuity at age 70, giving the insurance company $1 M.  They may in exchange give you $4,166 per month, or $50,000 per year, for the rest of your life.  If you live to age 90, you would then have collected $1 M back from from the policy.  If you live to age 100, you’ll have collected  $1.5M.

All policies are different, so you should read the terms carefully, but many policies would simply keep your original $1 M investment when you died.  So if you die at age 71, you would have only receive $50,000 back from the insurance company for the $1 M you gave them.  They would make out very well on the policy.  This makes up for the people who live to age 100, and is the nature of insurance – they make lots of money from some policies to make up for the others where they lose money.  Some policies might reimburse your heirs a portion of the investment if you die before a certain age, but this is not a certainty.  Again, the are contracts between you and the insrance company and can all be different, so you should carefully read and understand the terms (and maybe have an attorney or CPA read the policy as well) before you buy anything.

 

Another popular type of annuity doesn’t pay right away, but instead starts to pay when you reach a specified age in the future.  These are useful if you’re worried about running out of money later in life.  For example, at age 50 you could buy a policy that starts to pay you a monthly amount at age 80.  The earlier you buy these policies, the less they cost for a given pay-out (since you’re taking a chance that you’ll never reach that age, plus you’re letting the insurance company use your money for all of those years).  These can be a very useful way to guarantee that you won’t be destitute should you live a long time.  They are also relatively inexpensive since there is a real possibility the insurance company may get to keep the money and never pay out anything.  The later in life the policy starts pa, the less it should cost.

While there are limited exceptions (insurance companies spend a lot of money doing calculations and making sure that they come out ahead), on average you’ll not do as well with an annuity as you would have had you invested on your own.  While you might be taking some of the insurance company’s money if you live to age 100, most people will not live past 85 or 90.  Taking the same example of a $1 M nest egg described above, if you had invested the money instead of buying an immediate annuity, a properly designed portfolio of stocks and bonds should allow you to withdraw about $30,000 – 40,000 per year for the rest of your life, indexed for inflation, without ever touching the principle.  This means you could have withdrawn about $1,050,000 between the ages of 70 and 90 and still have had $1.6 M to leave to your kids when you died.  This is compared to receiving $1 M from the annuity and having nothing to leave your kids.

If you lived to age 100, you’d have withdrawn about $1.8 M from the portfolio, versus receiving $1.5 M from the annuity, and now have $2 M to leave to your kids (which will buy what $1 M buys today).  Investing on your own, instead of buying an annuity, will generally result in you both receiving more income while you are alive and in you having more money to pass on to your kids.

So, with an annuity, you’re trading risk – the risk that you won’t invest well or that the markets just won’t cooperate – in exchange for giving up some return on your money.  The insurance company now takes on this risk and needs to find ways to invest the money to ensure that they have enough money to pay the policy holders while still making a reasonable profit.  They set their pay-outs in such a way to make sure that they cover this risk, on average, just like how set their car insurance rates high enough to cover claims and still make money.  The amount they pay is also generally fixed (for example, $50,000 per year), so your spending power will decrease over time due to inflation.

You may worry that an insurance company may charge you way too much for an annuity, resulting in a huge profit for them, but market forces should generally take care of this for you as long as you do your part and compare products from several different providers to get the best deal.  As long there are enough insurance companies out there competing for your business, you should get the maximum return possible with the insurance company making just enough money on your policy to pay the person who sold it to you, keep the lights on, and make a reasonable profit for their shareholders.  You’ll still be paying for all of this overhead, but that is what you are trading for the security of a monthly payment instead of the less unpredictable returns from an investment portfolio.  Just make sure you do your part and shop around for the best return, since once you buy in it is expensive to undo the deal, even when you can.

Realize also that people selling annuities to you generally make a commission from the sale, which both adds to the cost and makes them eager to sell you something, even if it isn’t the best thing for you.  Many of these salesmen know little about what they’re selling.  They just know what they’ve been told to tell you to get you to buy.  In general the choice to buy an annuity should be yours, not the result of a high-pressure sale, and you should take the time to read the policy and review it with whatever professionals you need to make sure you’re making a good decision.

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Some annuities also make offers of additional potential returns based on the stock market or come with other bells and whistles. While this may sound enticing, you’ll do better just buying a smaller annuity and investing the rest of the money yourself.  Remember that the insurance company needs to make money, so the returns they’ll provide will be well lower than market returns.  Only buy annuities when you want a guaranteed return, not as a way to invest in the stock market.

Finally, know that the guaranteed return from an annuity is only as good as the insurance company who you buy the policy with (and whomever they sell it to).  If we see another Great Depression, it is very likely that the insurance companies would all go broke and leave policy holders in the lurch.  Because they need to invest the money in the markets themselves, if most businesses are going bankrupt, they would not have the money to pay out the payments each year in a collapsing market.  Note that the supposed “great recession” was nothing like the Great Depression.  Luckily such market events happen fairly rarely.

Have a burning investing question you’d like answered?  Please send 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.

What Are Growth and Value Funds?


This is part of a series of posts for an online class on how to use your investments to fund your retirement.  To find other posts in the series, select the category  “Retirement Investment Class” under “Retirement Investing” at the top.  The posts will appear in reverse order, with the newest post first. 

In the last post in this series, How to Evaluate Mutual Funds and ETFs, we briefly talked about the Style Box.  Today we’re going to go into a lot more depth on how to use this useful little tool for evaluating mutual funds and the concepts behind it.  This is one of the most important topics for determining how to determine your asset allocation.  Get this right and you’ll gain a couple of percentage points of return each year, which will translate into millions of dollars in a retirement account held over four decades or more.  It is still important in retirement investing as well, although how you allocate your money will be somewhat different.

Today we’ll discuss the style box typically used for stock mutual funds.  Bond funds use one as well, although the categories would be different.  A sample stock fund style box, taken from the description of one of Schwab’s mutual funds, is shown below.  On the bottom, horizontal axis, the investment style is shown, going from Value to Growth investing.  In the middle is Blend, which just means it is a combination of both Value and Growth investing.  On the vertical axis is the market cap, including small, mid, and large cap.  We’ll go over each of these categories.

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Investment Style

There are two main styles of investing, both of which have been applied successfully and both of which work well at different times.  The first is value investing, which is based on what is known as the Firm Foundation Theory.  The Firm Foundation Theory says that a stock has an appropriate price, or value, based upon the fundamentals of the company.  Stocks that have a price exceedingly below this value are considered inexpensive and likely to increase in price, while those that are priced way above this value are considered high in price and likely to decline back to the appropriate value.

People who are value investors would look at earnings, property, and the prospects for future earnings and determine a value for the company.  They might, for example, look at the price/earnings ratio, or PE, which is the price of the stock divided by earnings per share.  They would compare the PE value to both the historic range of values for the company and to the PE ratios of other companies in the same line of business.  They would seek to buy stocks that have a low PE, meaning that they are cheap compared to their value, and sell stocks they hold that have a high PE, meaning that they are expensive compared to their value.

Growth Investing involves finding stocks in companies that are growing rapidly and buying their shares.  This often involves finding the stocks that are reaching all-time highs and buying their shares, relying on the momentum of the company’s share price to continue.  Growth investors would look at things like earnings and dividend growth rate, the number of new stores that are being opened or the potential size of new business lines a company is creating.  They would tend to buy smaller companies that have potential to grow, shying away from companies like WalMart and McDonald’s that have already expanded greatly and would have difficulty doubling their earnings.

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Often value investors are buying stocks in companies that are having financial issues, which makes value investing slightly more risky than growth investing since some of the companies they’ll buy will not be able to turn things around and go bankrupt.  Growth investing also has a risk, however, since sometimes companies grow too fast, taking on debt while they do so, and end up needing to sell off assets and restructure. Growth investors are also buying shares of stock when they have already gone up in price, hoping that they will continue to go up, so they sometimes overpay for them.  Over the history of the US markets, value investing has outperformed growth investing on average but not always.  An exception is the period from 1980 through 2000, during which time growth was king.  Growth also outperformed value from 2008 through 2016, although value has done better during this last year.

Market Cap

Market cap, or market capitalization, is how large a company is.  Market cap is found by multiplying a stock’s price per share by the number of shares outstanding.  Small cap companies obviously have small market values, while large caps are huge enterprises like Home Depot and Google.  Small caps have more room to grow, given their small size, which means that they have a lot of growth opportunities, but large caps have the ability to get better pricing through concessions from vendors, as well as the ability to weather downturns by expanding into multiple business lines and/or parts of the world.  Mid caps fall between the nimble small companies and the Fortune 500 companies, but should be thought of as an extension of small caps since they tend to perform similarly.

Over long periods of time, small caps will outperform large caps since they have more room to grow.  The exception is turn-around companies that shed a lot of the old baggage and in a sense become new companies again.  During any given 10-year period small caps may outperform large caps, or large caps may outperform small caps, so you can never really be sure about which asset class would make the better investment.  If I were buying and holding for a 40-year period and had to choose one, I would buy small caps since they would grow more than large caps and outperform.  If I were holding for a 10-year period, however, I would probably choose large caps since they would likely hold up better should a business downturn occur since they have more cash reserves and financial stability.

 

Setting up a Portfolio

Now that we’ve discussed the style box and the different investing styles and market capitalizations, how does an investor put this to use?  In setting up a portfolio, you’ll  want to cover the full spectrum of investing styles and company sizes.  You don’t know which style and company size will perform best during any given period, so you want to invest in everything to make sure you are in the sector that is doing the best at any given time.  This means that you’ll never have all of your money in the sector that does the best and make the maximum possible returns, but it also means that you’ll never be entirely in the sector that is doing the worst and miss out on a good rally or bear the brunt of a big decline.  There is no way to know which sector will do the best over the next year or ten years, and attempting to guess will normally cause you to underperform the overall markets, so it is better to accept that some portions of your portfolio will always do worse than others in exchange for always having at least some of your money in the hot sector at any given time.  Just realize that those that lag now will probably lead in the future.

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So, you’ll want to buy funds that either cover the four corners of the style box or buy both small cap and large cap blended funds that include both growth stocks and value stocks.  You can also buy mid-cap stocks to further diversify your holdings.  You can also cover everything by buying a total market fund, which basically invests in everything, all in one fund.

If you are young, because value will outperform growth over long periods, and small caps will outperform large caps over equally long periods, you may want to skew your holdings slightly into these areas if you have decades to wait.  In doing so you’ll probably slightly outperform an evenly split portfolio, but not by much.  This becomes more important the longer the time period over which you are investing since small differences only add up to big money over long periods of time.  For those already in retirement, however, it is better to either split things evenly or even skew more to the large cap side due to their larger dividends and stability.  In the next post we’ll provide model portfolios based on these ideas and show how this is done.

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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.

How to Evaluate Mutual Funds and ETFs


This is part of a series of posts for an online class on how to use your investments to fund your retirement.  To find other posts in the series, select the category  “Retirement Investment Class” under “Retirement Investing” at the top of the page. 

In the last post in the series we discussed what mutual funds, index funds, and ETFs are.  Now that you are armed with this information, the question is then, “How do I select funds to invest in with all if the choices out there?”  Today we’ll cover how to determine what mutual funds invest in, which ones you’ll want to choose for a retirement investing plan, and how to select the best funds from a group of possibilities.

Probably the best source of information on a mutual fund is its prospectus, which can be found at the website for the fund family.  While there are a lot of fund families out there, you’ll want to choose one that features index funds, since those are the least expensive.  As we discussed in the last post, index funds will outperform most active fund managers.  Vanguard and Charles Schwab both feature several index funds.  Today we’ll look at funds from Schwab.  You can find a listing of their index funds here.

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As an example, let’s look at the Schwab S&P 500 Index fund , SWPPX.  Here are some of the elements to look at:

Fund Strategy

One thing we find in the description of the fund is the fund strategy.  This is a statement of what the fund manager is trying to do when investing and is the best way to identify funds that meets the various needs you’ll have when you invest.  The fund strategy will include things such as what types of assets (stocks, bonds, derivatives, etc…) the fund will invest in, whether the manager seeks to trade stocks for gains or to hold for long periods of time, and how actively the fund will be managed.  For the S&P 500 fund, we find the following information:

“Fund Strategy

The investment seeks to track the total return of the S&P 500-® Index. The fund generally invests at least 80% of its net assets in stocks that are included in the S&P 500-® Index. It generally gives the same weight to a given stock as the index does. The fund may invest in derivatives- principally futures contracts- and lend its securities to minimize the gap in performance that naturally exists between any index fund and its corresponding index. It may concentrate its investments in an industry or group of industries to the extent that its comparative index is also so concentrated.”

-SWPPX description from Schwab website

Since this is an index fund, the goal is to track the performance of the underlying index, good or bad.  Since the S&P500 Index is a list  50 large US stocks, this fund would be a way to get exposure to large US stocks.  It does this by actually investing in the stocks in the index.  The fund may also invest in derivatives instead of buying the stocks themselves, which could add to the risk of the investment, but in this case it is probably fairly safe due to the nature of the fund.  Here the manager is just trying to replicate the performance of the index, not to time the market using derivatives.

Performance Graph

On the first page of the fund description we find a chart showing the performance of the fund against the index it is trying to follow, the S&P 500 index:

The main purpose of looking at this element is to see how the fund has performed over the past several years in comparison to other funds and the relevant index.  Here you can see that the fund, SWPPX, has tracked the S&P 500  index very well.  An investment of $10,000 ten years ago into the fund would be worth $22,109 today, where an investment in the index (if you were able to do so) would be worth $22,199.  This is better than the $19,200 that an investment in the average large blend category would provide. This is the type of performance you want from an Index fund – close tracking of the index.

Fund Information

Also on the first page we find a table of general information about the fund:

The 52 week range gives you a general idea of how much the fund moves around in price.  Over the last year, it has moved about $9, or around 25% in price.  The YTD return shows how it has performed this year-to-date.  In this case it has increased about 22% because the S&P500 is having a good year.  A good YTD return isn’t always a good thing.  It is nice to see that a fund has done well when the markets have done well, but great performance last year may mean that the stocks in the fund are overbought and may not do as well next year.

The fund expenses are very important.  With the gross expense ratio and net expense ratio at 0.03%, this is a very inexpensive fund.  This is the percent of your investment that will go to fees each year.  For example, if a fund has a 1% expense ratio, you’d be paying $10 each year for every $1000 invested.  A typical managed fund will charge 1% or more.  An index fund will usually have fees between 0.25% and 0.5%.  You’ll generally want to find the cheapest funds you can find unless a more expensive fund invests in an area you can’t access otherwise.

The distribution yield is also important for retirement investing.  This fund pays a 1.65% yield, which means that you’ll receive a check for $1.65 for each $100 you have invested each year. You’ll want to have some funds that pay quite a bit more, like $5 or $8 for every $100 invested.  This would be a good fund to have in a taxable account that you wanted to hold and have compound, however, since it would generate very little income that would be subject to taxes each year.

The minimum investment shows how much you need to invest to buy into the fund the first time  (after that, you can generally invest whatever amount you wish).  In this case you only need to invest $1 to start, which again is very unusual since many funds require investments of $3000, $10,000, or more.  If you have a lot to invest, such as when you’re investing in a retirement account, the minimums won’t matter because usually meet them.  When you are just starting to invest when you’re young, however, they can be difficult to meet.

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Style box

Another critical element is the style box, which is created for each stock fund by a company called Morningstar.  One one side it shows the type of investing, value or growth.  The other side shows the the size of the assets held, going from small stocks to large stocks.  In general you’ll want to either have funds in all four corners of the box or funds at the top center (Large Blend) and bottom center (Small Blend) in your portfolio so that you cover all of the bases.  We’ll go more into the investment styles in the next post in this series.

 

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That covers the main elements you should use in evaluating a mutual fund or ETF.  Later in the series we’ll talk about gathering up your portfolio of funds, and then how to decide how much in each fund.  For now, just take a look through the data on a few funds.  You can also go to Vanguard and look at their funds, or go to Morningstar where you can get data on all sorts of funds.  If you have a question about what you find, please leave a comment.

Want all the details on using Investing to grow financially Independent?  Try The SmallIvy Book of Investing.  

Have a burning investing question you’d like answered?  Please send 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.

Mutual Funds, Index Funds, and ETFs (Oh, My!)


This is part of a series of posts for an online class on how to use your investments to fund your retirement.  To find other posts in the series, select the category  “Retirement Investment Class” under “Retirement Investing” at the top.  The posts will appear in reverse order, with the newest post first. 

While you can buy individual stocks, bonds, and REITs, the individual investor will often buy mutual funds and their cousins, index funds and ETFs, instead.  The reason is that mutual funds spread out your money over several different stocks, bonds, or other assets, so you eliminate the risk that an issue at one company will cause a devastating loss.  You can still lose money if the entire market or a whole sector of the market declines, but the level of the losses will be less severe.

In a mutual fund, investors pool their money together to buy a portfolio of assets at a reasonable cost per asset.  There are mutual funds that buy portfolios of stocks, bonds, REITs, and even gold and commodities.  Each mutual fund has a specific investment strategy, for example, buying large company stocks, but there are some funds that buy more than one asset class — stocks and bonds, for example.  In some cases a fund is free to buy basically whatever the manager wants to buy.

Mutual fund investors also pay a manager for his/her experience in investing, having the manager select the investments in exchange for a percentage of the assets held in the mutual fund.  Managers therefore have an incentive to attract investors to the fund since the more money that is under management, the more they collect in fees.  For the investor, it is just a matter of selecting which of the many mutual funds to buy.

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When you buy into a mutual fund, you send money to the mutual fund company and receive a fixed number of shares representing a fractional ownership in the assets held by the mutual fund.   The number of shares you receive is based upon the amount of money you invest and the price of the assets held by the mutual fund at some point in time, usually the closing of the markets for that day.  As more people invest in a mutual fund more shares are created, so the fraction of the mutual fund that each investor owns decreases.  But since the amount of money managed by the mutual fund increases, the value of your shares should not increase or decline just because more people invest.  The value will increase or decrease as the value of the assets in the portfolio increases or decreases.

You make money from a mutual fund investment when the assets they own go up in price and from dividend and interest payments the assets in the portfolio pay to the mutual fund.  You will typically see both capital gains and interest/dividend income each year from a mutual fund.  Capital gains are normally paid out at the end of the year, where interest and dividends are paid out more frequently.  Many people reinvest the payments, so they get more shares each year rather than getting a check.  Taxes would still be due on the payments, however, even if the money is reinvested if they mutual funds are held in a taxable account.  You can delay taxes if you invest in a tax-deferred account like an IRA or a 401k.

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So what are index funds?

One issue with mutual funds is that it costs money to pay the managers.  Managers also cause expenses when they trade shares, and can cause capital gains, and thereby cause taxes, when they trade shares within the fund.  People started to notice that most mutual funds did not provide returns that were as good as indexes, which are defined baskets of stocks or other assets designed to show the overall health of a segment of the market.  For example, a very common index, the Dow Jones Industrial Average, is a group of 30 industrial stocks that represent the performance of large industrial stocks.  Investors use indexes to judge how well the markets are doing and determine if they are doing well in their investing relative to the overall market.  Speculators use indices to try to time when they invest or sell assets.

A new type of mutual fund, called an index fund, was created.  Rather than having a manager make the investment choices, an index fund simply buys the stocks that make up the index and tries to replicate the performance of the index.  For example, an S&P 500 index fund would try to replicate the performance of the S&P 500 index, which is made up of 500 large US companies and is meant to show the performance of large US stocks.  While you still need to pay some fees and costs, because you no longer need to pay a management team, pay for researchers, and because index funds only trade shares when the index in which they invests changes its make-up, fees are a lot less.  For example, a managed fund might charge 1-2% of assets each year, where an index fund might charge 0.25% or even 0.05%.

While you might think that having a team of star managers would result in higher returns, more than making up for the extra fees charged, index funds actually provide returns that are better than 80 to 90% of the managed funds out there.  Over long periods of time, very few managed funds beat out index funds.  The reason is that because they have so much money to invest, even if a fund manager is a good stock picker, he needs to buy his first choice, second choice, and maybe even his 10th or 12th choice.  Because there are then so many stocks in the mutual fund, the return starts to match the market returns.  If the portfolio in a managed fund and an index fund is about the same, the one with the lower fees – the index fund – will provide better returns.

The plot thickens further

While mutual funds are better than individual assets for small investors, and while index funds are better than managed funds, there are still issues with index funds.  When an investor buys into a fund, the manager must invest the money, which can cause them to buy when prices are high.  Conversely, if an investor decides to sell, the manager must sell shares to return the money.  This causes costs to rise when people are jumping in and out of mutual funds, trying to time the markets.  In addition, when prices are declining rapidly during a market decline, people leaving mutual funds force the managers to sell right at the time when they should be buying, causing prices of assets in the fund to drop further.  This can cause even more people to leave the mutual fund at just the wrong time.

To solve this issue, close-ended mutual funds and ETFs were created.  In both of these types of funds, an initial amount of money is invested and a portfolio is created.  Shares are then created each representing a portion of that portfolio.  Rather than send money to the mutual fund manager, investors buy shares from other investors who already own the fund and want to sell.  Because shares are traded with the investments in the portfolio fixed, rather than new money entering the portfolio, share redemptions or purchases do not affect the portfolio performance.  This lowers costs for the fund and eliminates the issue of investors selling and driving the portfolio value down.

If you invest in an ETF or a closed-ended mutual fund, you’ll buy them through a broker rather than sending money into a fund company directly.  You’ll pay a commission each time you buy or sell shares, but the amount you’ll pay for holding the fund shares will be low when compared to traditional funds.   A closed-ended mutual fund can still be a managed fund, so you might still be paying a manager.  An ETF, or Exchange Traded Fund, is typically an index fund.  If you buy into ETFs and trade them very infrequently, your costs will be very low.   

If you do move money around from time-to-time or want to buy in small increments, a traditional index fund may be better than an ETF.  They may also be better if you want to be able to sell small amounts of the fund regularly, to take monthly withdrawals in retirement, for example.  If you are willing to put in a few thousand dollars at a time and hold long-term, ETFs will usually be better. 

 

Want all the details on using Investing to grow financially Independent?  Try The SmallIvy Book of Investing.  

Have a burning investing question you’d like answered?  Please send 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.