Archives for January 2013

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Investing Based on Economic News

A reader writes in, asking:

“I am a recent retiree looking to balance protection and income in my investment portfolio in this difficult economy. Given the recent troubles in the eurozone and the news that the UK might leave the EU, do you think US investors should be moving away from european stocks?”

Generally speaking, I do not think it makes sense to adjust one’s allocation to a given stock, industry, or country based on economic news.

The reason I don’t think it makes sense to make such changes is that new information about a stock (or a group of stocks, such as a country or region) is typically reflected very quickly in the stock’s price. (This is what people mean when they say the market is “efficient.”)

As a result, investing based on economic news is an “early bird gets the worm” sort of thing. And, if you found out about the news in question by reading it on CNN, Google News, or some other website with many thousands of readers, you are not the early bird.

In fact, you wouldn’t even be the early bird if you were the journalist writing the story. If you were the source the journalist called to get information about the story, then you might be the early bird. (Or rather, you might have been the early bird, if you had acted on the information several days or weeks ago.)

In other words, you can reasonably expect to earn extra returns by reacting to economic news only if you have reason to think that the rest of the market:

  1. Doesn’t know about the news (though you would then want to be careful of insider trading rules), or
  2. Is interpreting the news incorrectly (and therefore pricing the stock or group of stocks incorrectly).

And given how many analysts there are paying attention to every corner of the market, such situations don’t arise terribly often for most investors.

I think Vanguard Chief Economist Joe Davis gave excellent advice in a 2012 interview for Vanguard’s client newsletter:

“I encourage our clients to try to minimize the attention they pay to economic news, because I think that can actually lead to the pitfall of wanting to react.”

What to Do with a Lump Sum?

A reader writes in, asking:

“I have about $200,000 of cash that I’m looking to deploy. I have settled on the “coffeehouse” allocation a la Bill Schultheis. [Mike’s note: See here.] But I am weighing the pros and cons of getting in at once or in increments over time.”

This is one of those classic investing questions that get asked over and over. Fortunately, there’s no shortage of research addressing the topic.

For example, a Vanguard study from 2012 used historical returns in the U.S., the U.K., and Australia to compare the results of dollar-cost averaging (that is, spreading out the investment over time) as opposed to lump-sum investing. The conclusion: Relative to investing the money all at once, dollar-cost averaging typically results in lower returns and lower risk.

And that outcome is precisely what we would expect, given that (relative to investing the money all at once) dollar-cost averaging results in a higher average allocation to cash and a lower average allocation to stocks over the period. In other words, dollar-cost averaging (as an alternative to lump-sum investing) doesn’t achieve anything magical. It just slows down the rate at which you move from cash into your targeted asset allocation.

And therein lies the problem with spreading out the investment over time. If you really do think your targeted asset allocation will be a good fit for you several months from now, why wouldn’t it be a good fit right now as well?

Is Your Target Allocation a Good Fit?

Before making big changes to your asset allocation (i.e., by moving out of cash and into stocks and bonds) it’s important to do some thinking about your risk tolerance.

For example, if the lump sum of cash is the result of an inheritance that dramatically increased the size of your overall portfolio, there’s a good chance that your risk tolerance is different from what it was prior to receiving the inheritance.

Or, if the reason you have a pile of cash sitting around is that you sold all your stock holdings at the beginning of 2009 and it’s taken four calendar years of positive returns for you to start thinking about getting back into the market, then you probably have a fairly low risk tolerance — much too low for the allocation that you held prior to getting out of the market.

In other words, if you’re experiencing significant hesitation about moving into your desired asset allocation, you should consider the possibility that that’s a sign that the allocation you have planned to use is not actually a good fit for you.

In that way, dollar-cost averaging actually can be useful for testing out your target asset allocation. Implement it with a piece of your portfolio and see how it feels. Of course, ideally, the test should encompass both a bull market and a bear market — and that would likely take several years. Still, if you’re experiencing anxiety about making the change, even a brief test may be preferable to no test.

What Happens to Bond Funds When Rates Go Up?

One recurring theme in emails from readers is that people are worried about what will happen to their bond funds when interest rates rise.

As we’ve discussed before, there is an inverse relationship between bond prices and interest rates. When interest rates rise, bond prices fall. And if you own a bond fund, the price of your fund will fall by the average duration of the fund, multiplied by the magnitude of the rise in interest rates.

But in the real world, there’s a little bit more going on than in the contrived hypothetical examples. In real life:

  • Interest rates don’t increase all at once, then stay put. Instead, rate changes occur over a period of time.
  • Meanwhile, you’re earning interest on the bonds, which helps to offset any price declines, and
  • Your reinvested fund dividends will be buying bonds that have higher yields.

So while we can calculate a very good approximation for how far a fund will fall when rates increase by Y% on a given day, that doesn’t necessarily reflect how the bond fund will perform if interest rates increase by Y% over a period of several months or years.

Take, for example, Vanguard’s Intermediate-Term Treasury Fund. It has an average duration of 5.2 years and an average maturity of 5.5 years. From 6/13/2003 to 3/28/2005, yields on 5-year Treasuries rose 2.4% from 2.08% to 4.48%. If that decline had happened all at once, the value of the fund would have fallen by somewhere in the ballpark of 12.5%(2.4% rate increase, times 5.2 average duration).

But, because the rise in rates occurred over a period of 21 months, here’s what actually happened (chart courtesy of Morningstar):


It’s hard to see the scale of the y-axis (click the image to see it in full-size), but the decline was much less than 12%. Over the period, a $10,000 initial investment fell to $9,885 (a decline of just 1.15%). At the worst point (the end of July 2003), the value was $9,454 (a decline of 5.46%).

There are two important takeaways here.

First, if interest rates rise very suddenly, a bond fund could indeed experience a sharp decline (depending on its duration). However, if interest rates rise very gradually over a period of a few years, the fund’s performance is likely to be simply flat — or just slightly negative or positive.

Second, if you hold the fund long enough (specifically, for a period of time longer than the fund’s duration), a rise in rates works out to your advantage because your reinvested dividends will be buying higher-yielding bonds. (And if you’re in the accumulation stage such that you’re regularly putting more money into the fund, your break-even point will come even sooner.)

In other words, an increasing rate scenario isn’t necessarily a catastrophe for bond investors. It depends how quickly rates rise, how far they rise, what the duration of your holdings is, and how long you will be holding them.

3 Tips to Maximize Your Investments

A reader recently asked me a very open-ended question. He simply wanted a few tips for maximizing his investments. Having spent last week covering somewhat arcane topics, I thought a back-to-basics article sounded like a good idea.

So without further ado, my three best tips for maximizing your investments:

  1. Maximize your savings rate,
  2. Pick an asset allocation that is suitable for your risk tolerance and stick with it (until your risk tolerance changes), and
  3. Minimize the investment-related costs that you pay.

They’re not very exciting, are they? I would argue, however, that just about everything you need to know about investing falls into one of these three categories.

Priority #1: A Sufficient Savings Rate

This one is straightforward: If you’re not saving enough, not even a perfectly crafted portfolio will get you to your goals.

Choosing an Asset Allocation

When it comes to asset allocation, the goal is simply to avoid creating a portfolio that’s much too conservative (such that your returns would probably be very low) or much too aggressive (such that you’ll likely end up panicking and “selling low” during a bear market).

It’s important to understand that no matter how much research you do, you will never find the perfect asset allocation — because there is no such thing. Instead, there’s a whole spectrum of satisfactory allocations, which can be achieved by adjusting any of the levers that affect the risk level of your portfolio:

  • Your overall stock/bond allocation,
  • The riskiness of the stocks within your portfolio (with small-cap stocks being riskier than large-cap stocks, value stocks being riskier than growth stocks, and emerging market stocks being riskier than developed market stocks), and
  • The riskiness of the bonds in your portfolio (with nominal bonds being riskier than inflation-adjusted bonds, corporate bonds being riskier than Treasury bonds, and long-term bonds being riskier than short-term bonds).

In other words, even if you limit yourself to funds from just one fund company, there are a hundred different ways you could put together a portfolio with a risk level that is suitable for your needs.

Reducing Costs

As an investor, there are many costs that you face, and it is generally to your advantage to reduce them as much as possible.

Firstly, there’s generally no need to pay any account fees or brokerage commissions these days, given that multiple brokerage firms (e.g., Vanguard, Fidelity, Schwab, TD Ameritrade) offer the ability to build ETF or index fund portfolios without paying any such costs.

Next, you’ll want to make a point to select funds with low expense ratios, given that a fund’s expense ratio is the best predictor of its future results.

And because taxes are a cost too, it’s usually in your best interests to:

  • Get the most of your tax-advantaged space by contributing to IRAs and qualified plans at work before investing in a taxable account,
  • Carefully consider whether you should be making Roth contributions, pre-tax (“traditional”) contributions, or both, and
  • Invest in a tax-efficient manner when forced to use a taxable account (e.g., by tax-loss harvesting and using tax-efficient funds).

And finally, if you decide to pay for professional assistance with your portfolio, you’ll want to find the most cost-effective way to buy the service(s)s you need — which often means staying away from bundled offerings that include many services in which you have no interest.

Divorce as a Social Security Strategy?

As we recently discussed, it’s only possible for one spouse in a married couple to use the “restricted application” Social Security strategy, in which, upon reaching your full retirement age, you file a restricted application for just spousal benefits, thereby allowing you to collect some cash while your own retirement benefit continues to grow until age 70.

The rule that gets in the way of both spouses using this strategy is the rule that says that you cannot claim a spousal benefit if you’re claiming a retirement benefit that is based on a primary insurance amount* that’s greater than 50% of your spouse’s primary insurance amount.

The reason this rule is a problem is that, in order for you to claim a benefit as a husband/wife, your spouse must have already filed for his/her retirement benefit. And if both of you have filed for your retirement benefits (in order for each of you to allow the other person to claim spousal benefits), one of you will be ineligible for a spousal benefit due the rule above.

A few clever readers noted that the rules are different for divorced spouses. For people who have been divorced for at least two years (after having been married for at least ten years), in order to claim a spousal benefit on your ex-spouse’s work record, there’s no requirement that your ex-spouse have filed for benefits (only that he/she could file for benefits).

The question these readers asked: Would it be possible to get divorced two years prior to full retirement age, so that each spouse could get spousal benefits (as an ex-spouse), while allowing his/her own retirement benefit to grow until 70?

In short, yes.

But You Have to Get Divorced.

While this strategy could be used in many cases to achieve more Social Security benefits for a few years, the negative ramifications (financial and otherwise) are likely to outweigh the additional benefits received.

For example, there’s the cost and hassle of the actual divorce process, including the creation of all the documents you would need (e.g., durable power of attorney for medical care and for finances) in order to come as close as possible to replicating the rights that you have in a legally recognized marriage.

Then there’s the fact that you’d both be filing taxes as single rather than married filing jointly. In many cases (if one of you has significantly more taxable income than the other, for example), that’s likely to result in a higher total tax bill.

And if one of you dies while you’re divorced, the other would inherit any IRAs or other retirement accounts as a non-spouse beneficiary, for whom the rules are not as advantageous as for a spouse beneficiary.

And finally (and probably most obviously), you would want to consider the possibility that a divorce — even a purely financial one — could have a detrimental impact on the relationship itself.

*For those new to Social Security discussions, “primary insurance amount” refers to the size of a person’s retirement benefit if he/she were to claim it at his/her full retirement age.

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Finding the Best Time to Invest

As mentioned in a recent article, fellow blogger The Finance Buff has been running an experiment with his IRA contributions for the last two years. Here’s how he explains the experiment:

“Instead of contributing $5,000 at the first opportunity [$5,500 for 2013], I would wait for a small dip because prices almost always go down during the year.

Being chicken little, I didn’t want to wait too long. So I set my limit at 2%. I took a note of the closing price that I would’ve got had I done what I always did in previous years: go all-in on day one. I set an alert based on that closing price minus 2%. If I could get in at a price 2% lower than I otherwise would have, I would be satisfied and call it a day.”

I bring this up because I often receive emails about assorted variations on this type of strategy (i.e., strategies that wait for some specific signal to buy, instead of buying as soon as possible).

Relative to other strategies that attempt to beat the market, these strategies have one big advantage: They’re unlikely to increase costs in any way. (In contrast, many market timing or stock selection strategies result in more frequent transactions, thereby increasing trading costs and taxes. And strategies based on the use of actively managed funds increase costs via expense ratios.)

Because these wait-until-[something]-to-buy strategies shouldn’t increase costs, whether or not they’re a good idea is simply a question of whether the purchase timing indicated by the signal is better or worse than buying as soon as you have the money available.

Is a High Probability of Winning Good Enough?

Given the inherent volatility of the stock market, a 2% decline isn’t very much. Such a decline is likely to happen at some point in most years. In other words, The Finance Buff’s version of the strategy has a high probability of success in any given year.

But, in itself, that doesn’t necessarily make the strategy a good idea.

By way of analogy, consider a game in which you roll a 6-sided die. If you roll a 1, 2, 3, 4, or 5, I give you $1. But if you roll a 6, you have to give me $10. This is obviously not a good game for you, despite the fact that you have a high probability of winning money on any given roll.

In the case of TFB’s strategy:

  • A “win” results in an additional one-time return of roughly 2% (due to having purchased at a 2%-lower price), and
  • A “loss” happens when the market marches steadily upward all year, such that the buy-signal never occurs at any point, so the cost of a loss is missing out on a year of good returns.

So, how can we determine whether the probability-weighted gains from the “wins” are likely to exceed the probability-weighted cost of the “losses”?

Reducing the Number of Days In the Market

The primary attribute of wait-for-a-buy-signal strategies is that, relative to investing the money as soon as it’s available, they reduce the number of days that you’re in the market. (For example, in TFB’s version of the strategy, the excluded period is, “days in each calendar year prior to the first decline of 2% from the year’s starting price.”)  So the relevant question is whether or not the days that you are out of the market have a positive or negative expected return.

Of course, in general, the stock market has a positive expected return. Therefore, for the strategy to work over the long-term, it must be excluding days that are unusual in some way. That is, it must reliably exclude days that have not only below-average returns, but below-zero returns.

If you cannot think of a convincing reason why the particular group of excluded days would have a negative expected return, it doesn’t make any sense to use the strategy. Instead, you would want to invest your money as soon as it’s available to invest.

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