Tag Archives: Investment terms

The Biggest Myth About Index Investing

Reader Mailbag: Dividend Investing vs Index Investing

John Bogle has done a great job of “selling” index investing.  He started the Vanguard group with the promise that you could invest in the stock market “on the cheap.”  It’s the thing that made the Vanguard group the second biggest fund family in the country.

Selling things based on price is always popular with the public.  It’s the key to the success of Wal Mart,  Amazon, and a lot of “Big Box” stores.

But Bogle based his sales pitch not just on price, but also the promise that if you bought his funds you would do better than if you bought his competition.  He cites statistics to show that the average mutual fund has under-performed the index, so why not buy the index?

The resulting popularity of index investing has had one big, unfortunate side-effect.  It has created the myth that they are safe.

A government employee planning to retire in the near future asked this question in a forum:

“I plan to rollover my 457 deferred compensation plan into Vanguard index funds upon retirement in a few months. I currently have 50% in Vanguard Small Cap Index Funds and 50% in Vanguard Mid Cap Index Funds and think that these are somewhat aggressive, safe, and low cost.”

The problem with the Vanguard sales pitch is that it’s worked too well.   The financial press has given index investing so much good press that people believe things about them that are not true.

Small and Mid-cap stock index funds are aggressive and low cost, but they are by no means “safe.”  For some reason, there is a widespread misconception that investing in a stock index fund like the Vanguard 500 index fund or its siblings is low risk.  It’s not.

But unless you get a copy of the prospectus and read it carefully, you have to bypass the emphasis on low cost before you get to this warning:

“An investment in the Fund could lose money over short or even long periods. You should expect the Fund’s share price and total return to fluctuate within a wide range.”

The fact is that investing in the stock market is never “safe.”  Not when you buy a stock or when you buy stock via an index fund.  There is no guarantee if any specific return.  In fact, there is no guarantee that you will get your money back.  Over the long term, investors in the stock market have done well if they stayed the course.  But humans have emotions.  They make bad decisions because of misconceptions and buy and sell based on greed and fear.

My concern about the soon-to-be-retired government employee is that he is going to invest all of his retirement nest-egg in high-risk funds while believing that they are “safe.”  He may believe that the past 8 years can be projected into the future.  The stock market has done well since the recovery began in 2009.  We are eventually going to get a “Bear Market” and when that happens the unlucky retiree may find that has retirement account has declined as much as 50% (as the market did in 2008).  At some point he will bail out and not know when to get back in, all because he was unaware of the risk he was taking.

Many professional investors use index funds as part of a well-designed diversified portfolio.  But there should be no misconception that index investing is “safe.”  Don’t be fooled by this myth.

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A reader asks: what’s the difference between risk tolerance and risk capacity?

Korving -1016 RET web

That’s an interesting question and it depends on who you ask.  The investment industry measures risk in terms of volatility, taking the opportunity for both gains and losses into consideration.

I will answer with a focus on losses rather than gains because, for most people, risk implies the chance that they will lose money rather than make money.

 Risk tolerance is your emotional capacity to withstand losses without panicking.  For example, during the financial crisis of 2008 – 2009 people with a low or modest risk tolerance, who saw their investment portfolios decline by as much as 50% because they were heavily invested in stocks, sold out and did not recoup their losses when the stock market recovered.  Their risk tolerance was not aligned with the risk they were taking in their portfolio.  In many cases they were not aware of the risks they were taking because they had been lulled by the gains they had experienced in the prior years.

People who bought homes in the run-up to the real estate crash of 2008 were unaware of the risk they were taking because they believed that home prices would always go up.  When prices plunged they were left with properties that were worth less than the mortgage they owed.

This exposed them to the issue of risk capacity.

Risk capacity is your ability to absorb losses without affecting your lifestyle.  The wealthy have the capacity to lose thousands, millions, or even billions of dollars.  Jeff Bezos, founder of Amazon, recently lost $6 billion dollars in a few hours when his company’s stock dropped dramatically.  Despite this loss,  he was still worth over $56 billion.    His risk capacity is orders of magnitude greater than most people’s net worth.

The unlucky home buyer who bought a house at an inflated price using creative financing found out that the losses they faced exceeded their net worth.  As a result many people lost their homes and many declared bankruptcy.

There are some new tools available to measure your risk tolerance and determine how well your portfolio is aligned with your risk number.  Click HERE to get your risk number.

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What’s Your Risk Number?

risk

Defining how much risk someone is willing to take can be difficult.  But in the investment world it’s critical.

Fear of risk keeps a lot of people away from investing their money, leaving them at the mercy of the banks and the people at the Federal Reserve.  The Fed has kept interest rates near zero for years, hoping that low rates will cause a rebound in the economy.  The downside of this policy is that traditional savings methods (saving accounts, CDs, buy & hold Treasuries) yield almost no growth.

Investors who are unsure of their risk tolerance and those who completely misjudge it are never quite sure if they are properly invested.  Fearing losses, they may put too much of their funds into “safe” investments, passing up chances to grow their money at more reasonable rates.  Then, fearing that they’ll miss all the upside potential, they get back into more “risky” investments and wind up investing too aggressively.  Then when the markets pull back, they end up pulling the plug, selling at market bottoms, locking in horrible losses, and sitting out the next market recovery until the market “feels safe” again to reinvest near the top and repeating the cycle.

There is a new tool available that help people define their personal “risk number.”

What is your risk number?

Your risk number defines how much risk you are prepared to take by walking you through several market scenarios, asking you to select which scenarios you are more comfortable with.     Let’s say that you have a $100,000 portfolio and in one scenario it could decline to $80,000 in a Bear Market or grow to $130,000 in a Bull Market, in another scenario it could decline to $70,000 or grow to $140,000, and in the third scenario it could decline to $90,000 or grow to $110,000.  Based on your responses, to the various scenarios, the system will generate your risk number.

How can you use that information?

If you are already an investor, you can determine whether you are taking an appropriate level of risk in your portfolio.  If the risk in your portfolio is much greater than your risk number, you can adjust your portfolio to become more conservative.  On the other hand, if you are more risk tolerant and you find that your portfolio is invested too conservatively, you can make adjustments to become less conservative.

Finding your risk number allows you to align your portfolio with your risk tolerance and achieve your personal financial goals.

To find out what your risk number is, click here .

 

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Diversification and Emerging Markets

A well-diversified portfolio typically includes emerging markets as one of its components.  “Emerging markets” is a generic term to identify those countries whose economies are developed, but still smaller than those of the world’s superpowers (i.e., USA, Europe, Japan).

To professional investors, a well-diversified portfolio includes many asset classes, not just the most obvious: U.S. Stocks (the S&P 500) and a U.S. bond fund.

The following illustration is a great illustration of the relative performance of some of the major asset classes.

callan-periodic-table-of-investment-returns

Here we have ten key indices ranked by performance over a 20-year period.  The best-performing index for each year is at the top of each column, and the worst is at the bottom.

It is natural for investors to want to own the stock, or the asset class that is currently “hot.”  It’s called the Bandwagon Effect and it’s one of the reasons that the average investor typically underperforms.  The top performer in any one year isn’t always the best performer the next year.

A successful investment strategy is to:

  • Maintain a portfolio diversified among asset classes,
  • Stick to an appropriate asset allocation for your particular goals and objectives,
  • Rebalance your portfolio once or twice a year to keep your asset allocation in line, essentially forcing you to sell what’s become expensive and buy what’s become cheap.

In other words, re-balance your portfolio regularly and you will benefit from the fact that some assets become cheap and provide buying opportunities and some become expensive and we should take some profits.

Which brings us to emerging markets, which have been a drag on the performance of diversified portfolios for several years.

“It was a summer of love for investment in emerging markets,” according to the latest MSCI Research Spotlight.  For example, Brazil, Taiwan, South Africa and India have all been big winners, MSCI said.

The MSCI Emerging Markets Index ended August up for the year 15 percent compared to a loss of 20 percent the prior year.

“We are seeing very strong performance,” Martin Small, head of U.S. i-Shares BlackRock, told the conference.

Emerging market equities “have outperformed the S&P so far this year by more than 800 basis points and the broader universe of developed markets by almost 1,000 basis points,” according to the October BlackRock report, “Is the Rally in Emerging Markets Sustainable?” The report said EM outperformance “is likely to continue into 2017.”

For investors who have included emerging markets in their portfolios, their patience and discipline is being rewarded this year.  For those who want to have a portfolio that’s properly diversified but don’t have the expertise to do it themselves, give us a call.

 

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Questioner asks: “Should I roll my SEP IRA into a regular IRA or a Roth IRA?”

There are two issues to consider in answering this question.

  1. If you roll a SEP IRA into a regular or rollover IRA, assuming you do it right, there are no taxes to pay and your money will continue to grow tax deferred until you begin taking withdrawals.  At that point you will pay income tax on the withdrawals.
  2. If you decide to roll it into a Roth IRA you will owe income tax on the amount rolled over.  However, the money will then grow tax free since there will be no taxes to pay when you begin taking withdrawals.

If you roll your SEP into a Roth, be sure to know ahead of time how much you will have to pay in taxes and try to avoid using some of the rollover money to pay the tax because it could trigger an early withdrawal penalty – if you are under 59 1/2 .

It’s up to you to decide which option works best for you.  If you are unsure, you may want to consult a financial planner who can model the two strategies and show you which one works better for you.

As always, check with a financial professional who specializes in retirement planning before making a move and check with your accountant or tax advisor to make sure that you know the tax consequences of your decision.

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What happens if you are 70 ½ and you have an IRA and a 403(b)?

RMDs, or Required Minimum Distributions have to be taken after you become 70 ½ if you have a retirement account such as an IRA or 401(k).   To determine the amount you are required to take, the value of all of your retirement accounts have to be added together.  If you have multiple retirement accounts you can take the RMD from only one account and leave the others alone … unless you have a 403(b) plan.

403(b) plan accounts must be added to the total of the retirement accounts to determine the RMD.  But  you can’t use distributions from IRAs to satisfy the RMDs from 403(b)s, nor can you use 403(b) distributions to satisfy IRA RMDs.

However, if you have several different 403(b) accounts, you can take the RMD from just one of the accounts, as long as it’s at least as much as the RMD based on the sum of all of the 403(b) accounts.

If you are retired, you may be able to simplify your life by rolling all of your retirement accounts into an IRA.  That way you can eliminate a lot of confusion, and the potential penalties that go along with making a mistake.

If you have questions about retirement accounts, call us.

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Negative Interest Rates – Searching for Meaning

We have mentioned negative interest rates in the past.  Let’s take a look at what it means to you.

Central banks lower interest rates to encourage economic activity.  The theory is that low interest rates allow companies to borrow money at lower costs, encouraging them to expand, invest in and grow their business.  It also encourages consumers to borrow money for things like new homes, cars, furniture and all the other things for which people borrow money.

It’s the reason the Federal Reserve has lowered rates to practically zero and kept them there for years.  It’s also why the Fed has not raised rates; they’re afraid that doing so will reduce the current slow rate of growth even more.

But if low rates are good for the economy, would negative interest rates be even better?  Some governments seem to think so.

Negative interest rates in Japan mean that if you buy a Japanese government bond due in 10 years you will lose 0.275% per year.  If you buy a 10 year German government bond today  your interest rate is negative 0.16%.   Why would you lend your money to someone if they guaranteed you that you would get less than the full amount back?  Good question.  Perhaps the answer is that you have little choice or are even more afraid of the alternative.

Per the Wall Street Journal:

There is now $13 trillion of global negative-yielding debt, according to Bank of America Merrill Lynch. That compares with $11 trillion before the
Brexit vote, and barely none with a negative yield in mid-2014.

In Switzerland, government bonds through the longest maturity, a bond due in nearly half a century, are now yielding below zero. Nearly 80% of Japanese and German government bonds have negative yields, according to Citigroup.

This leaves investors are searching the world for securities that have a positive yield.  That includes stocks that pay dividends and bonds like U.S. Treasuries that still have a positive yield: currently 1.4% for ten years.  However, the search for yield also leads investors to more risky investments like emerging market debt and junk bonds.  The effect is that all of these alternatives are being bid up in price, which has the effect of reducing their yield.

The yield on Lithuania’s 10-year government debt has more than halved this year to around 0.5%, according to Tradeweb. The yield on Taiwan’s 10-year bonds has fallen to about 0.7% from about 1% this year, according to Thomson Reuters.

Elsewhere in the developed world, New Zealand’s 10-year-bond yields have fallen to about 2.3% from 3.6% as investors cast their nets across the globe.

Rashique Rahman, head of emerging markets at Invesco, said his firm has been getting consistent inflows from institutional clients in Western Europe and Asia interested in buying investment-grade emerging-market debt to “mimic the yield they used to get” from their home markets.

Clients don’t care if it is Mexico or Poland or South Korea, he said, “they just want a higher yield.” ….

Ricky Liu, a high-yield-bond portfolio manager at HSBC Global Asset Management, said his firm has clients from Asia who are willing for the first time to invest in portfolios that include the highest-rated junk bonds.

How and where this will end is anybody’s guess.  In our view, negative interest rates are an indication that central bankers are wandering into uncharted territory.  We’re not convinced that they really know how things will turn out.  We remain cautiously optimistic about the U.S. economy and are staying the course, but we are not chasing yield.

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Making Smart Decisions About Social Security

Social Security CardDeciding when to start collecting your Social Security retirement benefits is an important choice that will impact the income you receive for the rest of your life.  The decision can also affect the income and lifestyle of a surviving spouse.

When it comes to Social Security, you may be wondering whether you should: 

  • Start collecting early but receive a reduced benefit?
  • Wait until Full Retirement Age to start collecting your full benefit?
  • Delay past Full Retirement Age to maximize your benefit?

To help make an informed decision, you’ll want to consider a number of key factors, including your marital status, your health, your plans for retirement and your retirement income sources…just to name few.

Your Full Retirement Age (FRA) is the age at which you qualify for 100% of your Social Security benefits (known as your Primary Insurance Amount).  Your FRA is based on your year of birth.

When you’re ready to start collecting benefits, you should apply for Social Security no more than four months before the date you want your benefits to start.

If you start collecting Social Security benefits and then change your mind about your choice of start date, you may be able to withdraw your claim and re-apply at a future date, provided you do so within 12 months of your original application for benefits.  All benefits (including spousal and dependent benefits) must be repaid and you may only withdraw your application for benefits once in your lifetime.

You generally have three main options when it comes to choosing when to start collecting your benefits—often referred to as your Social Security “filing strategy.”

  • Start collecting early
  • Start collecting at Full Retirement Age
  • Start collecting after Full Retirement Age

Each filing strategy has advantages and disadvantages.

Order our white paper on Social Security claiming strategies by calling our office or going to our website.

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What’s the Difference Between an IRA and a Roth IRA

A questioner on Investopedia.com asks:

I contribute about 10% to my 401k. I want to know more about Roth IRAs. I have one with my company, but haven’t contributed any percentage yet as I am not sure how much I should contribute. What exactly is a Roth IRA? Additionally, what is the ideal contribution to a 401k for someone making $48K a year?

Here was my reply:

A Roth IRA is a retirement account.  It differs from a regular IRA in two important aspects.  First the negative: you do not get a tax deduction for contributing to a Roth IRA.  But there is a big positive: you do not have to pay taxes on money you take out during retirement.  And, like a regular IRA, your money grows sheltered from taxes.  There’s also another bonus to Roth IRAs: unlike regular IRAs, there are no rules requiring you to take annual required minimum distributions (RMDs) from your Roth IRA, even after you reach age 70 1/2.

In general, the tax benefits of being able to get money out of a Roth IRA outweigh the advantages of the immediate tax deduction you get from making a contribution to a regular IRA.  The younger you are and the lower your tax bracket, the bigger the benefit of a Roth IRA.

There is no “ideal” contribution to a 401k plan unless there is a company match.  You should always take full advantage of a company match because it is  essentially “free money” that the company gives you.

Have a question for us?  Ask away:

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The Liquidity Trap – Or How to Lose $4.5 Billion

Liquidity is defined in the Dictionary of Finance and Investment Terms as “the ability to buy or sell an asset quickly and in large volume without substantially affecting the asset’s price.”

In layman’s terms it means being able to get to your money quickly and without a major loss.  Liquid assets are things like checking accounts and money market funds.  They can also include mutual funds and stocks in large companies that trade on a major stock exchange, although in times of severe financial stress even these may see major price swings.

But there are lots of things people own that are not liquid.  The typical family’s home is a large part of their wealth.  Homes are not liquid; they can’t be sold quickly and converted to cash in times of need.  What a home can be sold for is a guess; something that millions of people learned when the housing bubble burst in 2008.  Families found that the value of their home was tens, even hundreds of thousands of dollars less than their mortgage.

Besides a home, many stocks are not liquid.  Shares in small companies with a few shares outstanding may not be liquid.  Even the very wealthy are finding out that the liquidity trap can turn them from billionaires to paupers in short order.  Forbes Magazine listed Elizabeth Holmes, the founder of Theranos,  as America’s richest self-made woman last year with a fortune estimated at $4.5 billion.  The most recent listing gave her net worth at zero.  The reason for this is fairly simple.  Her net worth was based on the value of one stock: Theranos.  The stock was not publicly traded and if she had tried to sell some of it the share price would have plummeted because it would show a lack of confidence in the future of the company.

So when Theranos ran into serious problems Holmes could not get out and her fortune literally disappeared into thin air.

The average person can avoid the liquidity trap by following a few simple rules.

  1. Do not put too much of your personal wealth in things – like homes – that can’t be easily sold.
  2. Do not put too much of your personal wealth in one stock. You do not want your net worth to evaporate because of poor decisions by corporate management.
  3. Smart investors spread their financial assets widely.  Realizing that they cannot accurately predict the future, they own stocks and bonds, domestic and foreign.  If they don’t have the means to diversify using individual stocks and bonds they use mutual funds or ETFs.
  4. Get an advisor. Most smart people use professionals when they need medical, legal or financial advice.

For more information, contact us.

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