Archives for March 2016

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Where Does the Money Go When the Market Is Down?

A reader writes in, asking:

“One thing I’ve never understood is where the money goes when the stock market goes down. Let’s say the market is down a collective $100 billion over a period of time. Did the money just disappear? Did it go to cash or some other asset? I have the same question when the market is up. Where’s the money coming from?”

The money doesn’t go anywhere, per se. If the stock market’s value is down $X, it isn’t because $X actually moved out of the stock market and into other asset classes. What’s actually going on is easiest to explain by analogy.

Imagine that you buy a home for $300,000. One year later, you hire a qualified appraiser to assess the value of your home. His answer is that based on recent sales of similar homes in the area, your home is now worth $270,000. Your home declined in value by $30,000, but that $30,000 didn’t go anywhere. And no cash has even changed hands at all.

And the same thing can of course happen in the other direction. (That is, your home could increase in value without any cash changing hands.)

A similar thing happens with stocks. The difference is simply that the most recent price at which the stock has traded is generally considered to be the current value.

For example, imagine a company that has 1 million shares of stock outstanding. If the stock is currently worth $90, the company’s total market capitalization (i.e., total value) is currently $90 million.

Now imagine that you have 1,000 shares of stock in this company, and you want to sell it. But at this particular point in time, the highest price anybody happens to be willing to pay for the stock is $89.

You sell the stock, meaning that $89 is now considered to be the market value for each of the company’s 1 million shares. So the total market capitalization of the company is now $89 million, or $1 million less than a few seconds ago. But only $89,000 has changed hands. And, in total, no money at all actually came into the market or left the market. (The buyer put $89,000 into the market, but you took $89,000 out of the market.)

In other words, the market can go up (or down) by quite a bit with only a relatively small amount of money changing hands. This is a result of the fact that when shares of a company are traded at a new price, all shares of that company (or more specifically, all shares of the same share class of that company) are now valued at that new price.

Investing Blog Roundup: Roth IRA Flexibility

Roth IRAs are of course intended primarily for retirement savings. But, as Vanguard’s Maria Bruno reminds us this week, Roth IRAs are very flexible, and isn’t necessarily a mistake to use the money for other purposes.

Investing Articles

Other Money-Related Articles

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Evaluating Vanguard’s New Core Bond Fund

A reader writes in, asking:

“Apparently Vanguard’s new Core Bond Fund is going to be similar to the Total Bond Market Index Fund, but actively managed with an eye as to upcoming interest rate hikes and cuts.

Am interested if you think this fund is worth looking at to complement the Total Bond Market Index Fund in a way to attempt to ‘time’ interest rates. Would it be a bit easier to ‘time’ interest rates than the market? There are some long term trends I think we all can agree on. For example, sooner or later interest rates will once again rise. Of course knowing when and how much rise there will be is the rub. I would also be interested if you knew what the proposed duration of this fund was, as I did not notice while doing my preliminary research.”

For those who haven’t yet heard about the new Vanguard Core Bond Fund, you can read Vanguard’s announcement here or see the fund info page here.

Here are a few of the details:

  • The plan is for the new fund to be an actively managed counterpart to the Vanguard Total Bond Market Index Fund — investing in similar securities, but trying to outperform via “security selection, sector allocation, and, to a lesser extent, duration decisions.”
  • The fund will have an expense ratio of 0.25% (0.15% for Admiral shares).
  • The fund is supposed to have a duration ranging from “0.5 years above or below the fund’s benchmark, the Barclays U.S. Aggregate Float Adjusted Index,” which would give it an average duration roughly in the 5-6 years range.

As I’ve said before I do not necessarily have any opposition to using actively managed funds. The problem is simply that most actively managed funds cost quite a bit more than their passively managed counterparts. And lots of research (a few cases of which are mentioned here) has shown that lower-cost funds tend to outperform higher-cost funds.

And on that note, the good news is that this new fund is pretty darned cheap for an actively managed fund. It is, however, still somewhat more expensive than the Vanguard Total Bond Market Index Fund, which has an expense ratio of 0.20% (0.07% for Admiral or ETF shares).

With regard to the question of whether it’s easier to predict interest rate movements than stock market movements, I am not aware of any evidence showing that to be the case. Perhaps ironically, one of the more compelling arguments I’ve seen against trying to predict interest rates comes from a 2011 Vanguard research paper.

On pages 6-7 of the paper the authors discuss how well the market (as a whole) does at predicting both the federal funds target rate and the yield on 10-year Treasuries. In short, the predictions are terrible. (Figure 7 is particularly noteworthy. In the figure, each of the little hairs extending away from the dark line shows the market’s prediction at a given time. As you can see, it’s pretty rare for the predictions to line up with what actually occurred going forward.)

The authors also note that shortening the duration of one’s bond holdings due to an anticipated rise in interest rates means forgoing the higher yields that could have been earned on longer-duration bonds while waiting for rates to rise. In the authors’ words:

“Finally, in addition to interest rates’ unpredictability, it’s important to consider that even if a manager makes a correct call on the direction of rates, the timing and magnitude of any change are crucial, as a short-duration strategy is a “negative carry” position. In an environment characterized by a steep yield curve, this negative carry can mean a significant return forfeiture if yields do not rise as anticipated. Even then, a manager who correctly predicts a rise in interest rates could likely suffer a performance penalty if rates rise less than forecast or if the timing of the change is either too early or too late.”

So, frankly, I would be surprised if the fund is able to reliably add value by predicting interest rate movements.

In other words, if I were to buy the fund, it would be as a low-cost way to bet on the managers’ ability to exclude specific bonds that will underperform (e.g., due to credit troubles) rather than as a way to bet on somebody’s ability to predict interest rates. But personally, I’d prefer to just stick with my index funds rather than make any such bets.

Investing Blog Roundup: Self-Directed IRA Pitfalls

Monday’s article about self-directed IRAs drew some horror stories from readers. One reader also shared two articles which more thoroughly discuss the potential pitfalls. They’re worth a read if a self-directed IRA is something you’re considering.

Other Investing Articles

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Is a Self-Directed IRA a Good Idea?

A reader writes in, asking:

“I recently made an acquaintance who works in the financial industry. He suggested to me that I look into opening a ‘self directed IRA’ where I would have more choices of how to invest, including some things that sound pretty attractive. Is this a good idea, or should I be skeptical?”

A self-directed IRA is an IRA with a custodian that allows you to invest in things other than the standard choices available in a typical IRA at a brokerage firm (e.g., stocks, bonds, mutual funds, CDs, etc.). In other words, a self-directed IRA is a way to use your IRA to invest in so-called “alternative” investments (e.g., real estate or a small business).

And it’s not unthinkable that you might want to invest in something other than what’s available via a typical IRA account, so there’s nothing inherently bad about the self-directed IRA concept.

That said, opening a self-directed IRA sometimes works out very badly for either (or both) of two reasons.

There Are No Investment Unicorns

In many cases, a self-directed IRA is opened at the suggestion of somebody who is recommending a particular investment product/strategy, suggesting that such product/strategy will offer outsized returns. Unfortunately, in such cases the only sure bet is that the person recommending this strategy will make a good chunk of change if you buy what they’re selling.

It’s absolutely true that there are all sorts of things that have the possibility of higher returns — even much higher returns — than a boring “total stock market” index fund. But if anybody tells you that such higher returns are available without a higher level of risk, that person is either a) ill-informed or b) trying to take advantage of you.

Prohibited Transactions Are Bad News

The second reason that self-directed IRAs can be a bad idea is that they dramatically increase your chance of engaging in a prohibited transaction.

Internal Revenue Code section 4975 outlines several types of transactions that are prohibited for IRA accounts. Most IRA owners don’t have to worry very much about such prohibitions, because the typical IRA at a brokerage firm or fund company is relatively foolproof in this regard. That is, the IRA custodian keeps you pretty well safe by limiting the things you can do with the account. In many cases, a self-directed IRA will have no such protections. And with self-directed IRAs, people do run afoul of the prohibited transaction rules on a regular basis.

So what happens when you engage in a prohibited transaction? Here’s how the IRS describes the result:

Generally, if you or your beneficiary engages in a prohibited transaction in connection with your traditional IRA account at any time during the year, the account stops being an IRA as of the first day of that year. If your account stops being an IRA because you or your beneficiary engaged in a prohibited transaction, the account is treated as distributing all its assets to you at their fair market values on the first day of the year. If the total of those values is more than your basis in the IRA, you will have a taxable gain that is includible in your income.

In case it isn’t clear, that’s a very bad outcome. You would have a large amount of money appearing as taxable income in a single year (assuming the account is of a significant size, that is), and you would completely lose out on the continued benefit of the IRA going forward (i.e., the ability to grow your money at a faster rate due to not having to pay tax along the way).

Investing Blog Roundup: The Story Behind the First ETF

This week a reader directed me to a fascinating story that I’d never heard before: the story behind the first ETF. Admittedly, it’s not useful information, per se. But I found it very interesting to learn about the chain of events that led to the creation of the first ETF — and, eventually, an entire sub-industry.

Investing Articles

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