Archives for December 2008

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What to Do with Your 401k

While reading a recent issue of Money, I came across a T. Rowe Price ad that said the following:

Give your old 401(k) the attention it needs.

If you have an old 401(k), it’s not enough to just leave it alone and wait for it to grow. It takes constant management over the years.

Yeah, heaven forbid somebody simply put her money into a handful of diversified, low cost mutual funds and then let it grow. Much better to “constantly manage” it.

I’m curious: What do they mean by “constant management” anyway? And what good do they expect to come from it?

From what I’ve seen, the more a person “manages” his money, the more he moves it around. This is not a good thing, given that most of us end up basing our decisions–at least in part–on past performance. Constant management seems like a path to performance chasing, lower returns, and higher stress. Sounds great.

And I was actually starting to respect T. Rowe. Price! 😉

Volatility in Retirement: Not a Good Thing

Earlier this month, I took a look at how volatility affects your return when dollar-cost-averaging into an investment. (In short, it increases it.)

While in St. Louis for the holidays, I had a conversation with a family member that made me think that it might be prudent to explain the other side of the equation: Volatility’s effect on returns when dollar-cost-averaging out of an investment.

The short version is that, when DCA’ing out, volatility has the opposite effect that it does when DCA’ing in. In other words, it has a significant negative effect on returns.

Why?

For the exact same reason that increased volatility helped returns when buying shares: Volatility drives the average price per share downward. Unfortunately, however, a lower price per share is not a good thing when you’re the one selling. 😉

Conveniently enough, most retired investors are already capitalizing on this fact (even if they’re entirely unaware of it) because conventional wisdom says that retired investors should own more bonds and less stocks.

Now, does this mean that when somebody retires they should move all their money into no-volatility investments? Of course not. Over time, stocks outperform bonds (even with volatility having a downward effect on return). The only way for most investors to make it through a 30-year retirement is with a large portion of their portfolio in equities.

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When to Panic and Stop Investing in Stocks

Over the last several weeks I’ve been mulling over exactly how low the market would have to go before I became uncomfortable buying stocks.  The more I thought about it, the more sure I became that there’s no point at which I’d stop buying stocks.

If the market dropped to 1/4 its current price (yeah, that’d make an 85% one-year decline), I’d still be buying stocks. In fact, I’d still be buying them at that price even if I knew they had no prospects for appreciating in value.

Why?

Dividend Yield.

As I write this, the dividend yield on a share of an S&P 500 index fund is approximately 3%. (For reference, dividend yield is calculated as dividends paid per share divided by the current price per share.) As the price of our stock market declines, the dividend yield goes up. That’s just how the math works.

And that is why I plan to continue buying equities regardless of how low the market goes. For example, if the market really did fall to 1/4 of it’s current price, the dividend yield would be greater than 12%. That’s absurdly high. High enough that it would provide an excellent return even without any price appreciation. Of course though…

None of this will happen

…precisely because of the dividend yield. As dividend yields rise (due to falling share prices), shares begin to look more and more attractive (and not just to crazy equity zealots like me, but to mutual fund managers as well).

This is a part of the reason that bear markets eventually bottom out and begin to turn upward. In effect, there’s somewhat of a floor below which stock prices tend not to fall.

So again, we come to the conclusion that the the only scenario in which stocks would not be an excellent long-term investment is one in which corporate earnings (and thus dividend payments) decline precipitously from where they are now. Call me crazy, but I just don’t see that happening (at least, not in the magnitude that would be required in order to make stocks a poor long-term investment).

How to Choose an Index Fund | Which Index to Invest In

I’ve had a couple people recently tell me that they know they want to invest via an index fund, but they don’t know how to choose which one to invest in. Really, there’s two separate questions to answer:

  1. Which index do you want your fund to track?
  2. Which of the funds that track that index do you want to invest in?

Which index to track?

There are really too many indexes to list in one place. Generally, the best approach is to figure out what allocation you want (“U.S. vs. International” and “developed markets vs emerging markets”), then find an index–or combination of indexes–that will allow you to meet that allocation. Here are a few of the most common indexes to get you started:

S&P 500: Without a doubt, the most frequently tracked index. It includes 500 of the biggest (Note: not the 500 biggest) companies in the U.S. as measured by market capitalization.

Wilshire 5000: The second most commonly tracked index. It includes every publicly-owned U.S. stock for which there is readily-available price data. (Note: It originally included 5,000 companies, but now it includes far more.) If you want to own the entire U.S. stock market, this is the way to do it.

Wilshire 4500: The Wilshire 5000 after subtracting all the companies included in the S&P 500. If you already own an S&P 500 index fund, this index can be useful for adding some exposure to small and mid-cap companies.

FTSE All-World Index: Tracks 2,700 stocks both in the U.S. and abroad (including both well-established and developing markets).

FTSE All-World ex US Index: Tracks a broad range of non-U.S. stocks in both developing and well-established markets.

Which fund to use?

Once you’ve chosen which index you want your fund to track, you still need to choose which fund to invest in, as there are numerous funds that track most of the indexes mentioned above. As you’d expect, this decision comes down to a few simple considerations:

Expense ratio of the fund: In terms of return provided by the fund, this is without a doubt the single most important factor.

Minimum investment: Of course, if the amount you have available to invest doesn’t meet the minimum investment requirement for a given fund, you’ll need to find a different one. (For example, most Vanguard index funds have a $3,000 minimum investment.)

Customer Service/Quality of Online Interface: If you’re going to be giving a company your business, things like this matter. Unfortunately, this is difficult to evaluate until you’re already a customer. My only suggestion here: Ask around.

Decrease Your Risk by Understanding Your Investments

I was getting caught up on my feed reader yesterday. Lots of people discussing the Madoff scandal. One such post was this wonderful one by Aswath Damodaran (a Finance Professor at NYU). Here’s what I really liked:

There are two questions that we can ask about these investors [professional money managers]:

a. How much money (returns) did a particular investor make over a period or periods?
b. Why did they make the returns that they did?
As Aswath notes, we tend to get drawn into answering the first question, while ignoring the second (especially if the answer to the first question is a good one!). And this isn’t terribly surprising.

  • The first question is easy to answer, and it’s easy to use to compare various money managers.
  • The second question, on the other hand, is easy to discount due to the fact that it’s necessarily going to be answered in far less objective ways.

If you’ve spent any time reading the purported strategies of mutual funds, you know that the bulk of them are nearly identical (“Invest in proven companies that are leaders in their industries,” “Invest in equities that we feel are attractively priced,” etc.). Given how similar–and how obvious–these statements are, it’s no surprise that we don’t put a lot of value in them.

However, to ignore them is a mistake. Before turning our money over to somebody, it’s important that we know what they intend to do to earn their pay. (“Their pay” = the excess of their costs over the costs of an index fund). And if their argument isn’t convincing–or if we don’t understand it–why entrust them with our money? There are always other options.

As Warren Buffett says, “Risk comes from not knowing what you’re doing.” If we’re going to turn our money over to somebody, let’s at least make sure we understand what they’re going to do with it.

Overdiversification: Building Your Own High-Cost Mutual Fund

Does this sound like anybody you know?

  • 401(k) at current job: 5 mutual funds
  • 401(k) still with previous employer: 4 mutual funds
  • IRA: 3 mutual funds, handful of stocks
  • spouse’s 401(k) at current job: 5 mutual funds
  • Spouse’s IRA: 4 mutual funds, another handful of stocks

Grand total: Somewhere from 15-25 different mutual funds and a seemingly random assortment of stocks.

What’s the Problem?

What this person has amassed is the equivalent of an index fund, with the noteworthy difference that the fees being paid are the higher fees that come with actively managed funds. (That is, this person is probably paying 1.5%-2.5% in fees per year rather than 0.2% per year.)

People invest in actively-managed funds with the hope that the fund manager(s) can outperform the market. While there’s less than a 50% probability that a fund manager can beat the market, it’s certainly not impossible. The problem, however, is that once you own more and more actively-managed funds, the chance of them–in total–beating the market becomes more and more slim.

Imagine this scenario:

  • You’re flipping a coin.
  • Heads means your fund beats the market. Tails means your fund underperforms the market.
  • However, this coin is a trick coin, and it comes up tails 55% of the time.

Of course, if you only have to flip the coin once per year, your chance of beating the market is 45%. Not great, but not awful. But if you have to flip the coin 15 times each year (ie, you own 15 actively-managed funds), your chance of coming out ahead is significantly lower than 45%.

Or to look at it without using hypothetical coin flip scenarios, just consider this: The way that a fund manager hopes to outperform the market is by over or underweighting certain stocks (or certain sectors or asset classes) when they feel it’s advantageous.

Unfortunately, the more funds you own, the more likely it is that some of the managers are taking completely opposite strategies, thereby cancelling out any potential advantage to be gained, but still leaving you with the higher cost.

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