Archives for September 2009

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Investing Rules of Thumb

People like to simplify. We like easy-to-follow guidelines and easy-to-implement instructions. That’s why rules of thumb are so popular. The two investing rules of thumb that I see quoted most frequently are to:

  1. Set your bond allocation (as a percentage of your portfolio) equal to your age, and
  2. Save and invest 10% of your income.

I really like the first one. I think it’s quite helpful. The second one, however, is a mess.

“Age in Bonds”

Why is the “age in bonds” rule helpful? Because asset allocation comes down to just two variables:

The rule accounts for one of those variables (holding period). So all you need to do is adjust the rule’s prescription based on your volatility tolerance. No problem.

“Invest 10% of Your Income”

In contrast, the question of how much of your income to invest each year involves many more variables than the question of asset allocation. Specifically, it depends upon:

  • The age at which you started investing,
  • The age at which you plan to retire,
  • Whether or not you plan to continue working part-time,
  • Whether or not you expect Social Security to pay out at the rate it’s currently promising,
  • Whether or not you’ll have any pension income,
  • Whether or not you’ll own your home, and
  • What you plan to do in retirement. (Do you plan to travel the world? Or mostly just hang out in your hometown with your grandkids?)

The “invest 10% of your income” rule doesn’t account for a single one of those variables! If you ask me, that’s a dangerous oversimplification.

When a Rule of Thumb Doesn’t Cut It

Sometimes there’s really no shortcut. Sometimes you actually have to do the math (or find an advisor or online calculator to do it for you).

That’s the case when determining how much you’ll need to invest each month. That’s the case when determining how much life insurance you need. That’s the case when determining whether you should form an S-corp or C-corp for your business.

You get the idea. When it comes to your finances, rules of thumb can be dangerous. Even if there is a rule that pertains to the question you’re seeking to answer, it’s best to learn the reasoning behind the rule so that you can decide for yourself whether or not you should follow it.

Should I Convert my Traditional IRA to a Roth IRA?

Due to recent market declines and the changes in conversion rules for 2010, there’s been a lot of interest in converting traditional IRAs to Roth IRAs lately.

What worries me is that some investors seem to be focusing entirely upon whether they can convert their IRA to a Roth without bothering to determine whether they should convert it.

In that vein, I thought it would be beneficial to point out three scenarios in which it might not make sense to convert a traditional IRA to a Roth IRA.

You Expect A Lower Tax Bracket in Retirement

If you expect your tax bracket in retirement to be lower than your 2011 tax bracket, converting is unlikely to be advantageous.

And no, the market being down from where it was in early 2008 does not change that fact. Paying, for example, 25% now is not better than paying 15% later, even if that 15% is on a larger total. (Remember the commutative property of multiplication? It still works.)

Please note that this means that the people who weren’t eligible in 2009 or prior years due to income restrictions but who will be eligible in 2010 (when the income restrictions are temporarily removed) are actually somewhat unlikely to be in the group who would benefit from a conversion.

You Don’t Have the Cash On-Hand

If you don’t have the cash available to pay the tax on the conversion, then it’s unlikely to be a good idea. If you use money out of the IRA to pay the tax, the amount you withdraw counts as a non-qualified distribution and will be subject to the 10% penalty if you’re under 59Β½. This is not a good thing.

You’re Seeking to Avoid RMDs

Something that gets mentioned frequently when discussing Roth conversions is that, unlike traditional IRAs, Roth IRAs are not subject to Required Minimum Distribution rules.

That’s true. But does it make sense to enact a Roth conversion (which is, essentially, a voluntary whole-IRA distribution) now in order to avoid Required Minimum Distributions later? I’m not convinced.

Not That Roth Conversions Are a Bad Thing…

Of course, the point of all this isn’t to say that converting your IRA to a Roth IRA is a bad idea. Many investors really would save money in the long-run by converting. But please don’t do it on the assumption that it’s automatically beneficial just because you’re eligible. πŸ™‚

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Volatility Tolerance and Market History


Out the Window

I know that I’m unlikely to die in a plane crash. But when I fly, if the turbulence gets a bit nasty, it still freaks me out. One part of my brain knows something (“traveling via plane is relatively safe”), yet another part of my brain is not convinced.

In contrast, my dad is completely undisturbed by turbulence. Why? Because he flies so frequently that he’s become desensitized to it. The part of his brain in charge of fear has experienced turbulence countless times and has seen that it has yet to harm him. He now knows–both on an intellectual level and on a gut instinct level–that turbulence is no big deal.

What does this have to do with investing?

Even a novice investor knows that the stock market has good periods and bad periods. But when you’re checking your 401(k) balance and seeing that it’s down 35% from a year ago, it can be scary. It can be hard to believe that a bull market will eventually come along. (“I know plane rides are supposed to be safe, but I’m still pretty freaked out right now!”)

If, however, you’ve been through a few bear markets before, and you’ve seen the market rebound from each, it’s a lot easier to keep your cool and refrain from getting out of the market at the wrong time. (“Eh…no big deal. Just a little turbulence.”)

How You Can Benefit

Obviously there’s no way to speed up your own experience of bull and bear markets. But you can take the time to read about market history. If you expose your brain to enough examples of market crashes and market rebounds, it will (hopefully) start to get the idea. (My suggestion as a place to start is Bernstein’s Four Pillars of Investing.)

I’m absolutely convinced that through education you can increase your tolerance for volatility, but you can’t do it just by reading a few blog posts. It takes repeated exposure before the subconscious part of your brain (i.e., the part that makes investing decisions πŸ˜‰ ) catches on.

Added bonus: A deep appreciation of market history should help you not only to keep your cool in bear markets but also to refrain from investing too aggressively during bull markets.

The Noise from Inside

I write a lot about blocking out the noise from the media:

  • What the market did today,
  • What this or that analyst expects the market to do next month,
  • What this or that stock did over the last few weeks.

The way I see it, all that stuff is just noise.

But every bit as dangerous is the noise from inside. A lot of noise rises up from inside ourselves.

  • When the markets go down, fear (or perhaps even panic) arises in many people. That’s noise.
  • When the markets start rising quickly, excitement, greed, and lust arise in many people. That’s noise too.

The more successfully you block out that noise, the better off you’ll be. How can you improve your chances of blocking out the noise from inside? Here are three of my favorite ways:

Have an Appropriate Asset Allocation

If you have an asset allocation that’s appropriate for your expected holding period and for your volatility tolerance, you can take comfort in knowing that–aside from rebalancing and continuing to invest–there’s nothing you really need to be doing.

Automate Your Finances

Get as much as possible on autopilot. If you’re automatically contributing to your IRA and 401(k), you don’t have much reason to check your portfolio everyday. In my experience, this helps with blocking out both the fear in down markets and the greed in up markets.

Educate Yourself

The more confident you are in the research and data upon which your investment strategy is based, the more confident you’ll be in the strategy itself. Take the time to educate yourself about investing. Read books. Read blogs. Read everything you can get your hands on.

How Do You Block Out the Noise?

What’s your favorite way of blocking out the fear, greed, or other dangerous emotions that threaten to throw your investment plans off track?

Investing Made Simple

Book6FrontCoverTiltedScaledI’ve got a big announcement for today:

My new book, Investing Made Simple: Investing in Index Funds Explained in 100 Pages or Less is now available on Amazon.

(For new readers: I write a series of books that’s intended to be something akin to CliffsNotes for financial topics. This is the latest in the series.)

Who This Book is For:

Anyone who has questions about investing, but who doesn’t want to trudge through a 300-page textbook.

What You Will Learn:

  • Asset Allocation: What does it mean, why is it so important, and how should you determine your own?
  • How to Pick Mutual Funds: Learn how to choose funds that are mathematically certain to outperform the majority of other mutual funds.
  • Roth IRA vs. Traditional IRA vs. 401(k): What’s the difference, and how should you choose between them?
  • Financial Advisors: Learn what to look for as well as pitfalls to avoid.
  • Frequent Investor Mistakes: Learn the most common mistakes investors make and what you can do to avoid them.
  • Calculate Your Retirement Needs: Learn how to calculate how much you’ll need saved in order to retire.

What the Book is Not:

  • This book is not a great work of literary art.
  • This book is not going to make you an absolute expert on the topic, and
  • This book is not going to provide you with a way to get rich overnight.

What it will do (hopefully) is provide an easy-to-understand, concise introduction to the topic of prudent investing. πŸ™‚

Overweighting Small-Cap and Value Stocks

If you take a look at the Lazy ETF Portfolios post from a while back, you’ll notice that many of the portfolios’ creators make it a point to overweight small-cap stocks and/or value stocks. Why is that?

Generally, it’s for either (or both) of two reasons:

  1. To provide additional diversification.
  2. To increase expected return.

Additional Diversification

It seems odd to think that, when it comes to U.S. stock holdings, anything could be more diversified than a fund that simply tracks the entire market. Yet Larry Swedroe, in his What Wall Street Doesn’t Want You to Know makes exactly that case:

“The appeal of owning the entire market is intuitively attractive from a diversification perspective. However, the market-cap weighting mechanism that is used to make index funds easy to manage provides a far different outcome from what one would expect….Almost 70% of the portfolio is large-cap growth stocks.”

His natural conclusion, then, is that most investors would achieve better diversification by supplementing their large-cap growth holdings with funds that track small-cap and/or value indexes. In fact, if you take a look at his “Big Rocks Portfolio,” you’ll see that approximately 2/3 of the stock allocation is invested in either small-cap or value funds.

Improving Return

The second reason that many investors decide to tilt their portfolios toward small-cap stocks, value stocks, or both is that these stocks have historically earned greater returns than their large-cap and growth counterparts. This makes sense given their risk profiles:

  • Value stocks are presumably companies whose future prospects (as companies, not as investments) are rather dim compared to other companies.
  • Small companies clearly carry a higher level of risk than well established companies that are already leaders in their respective fields.

And given that they both carry higher risk, it’s only natural that the market would demand a degree of additional return, commonly known as a risk premium. (This is the same thing that goes on with stocks as compared to bonds–the expected return for stocks must be greater than the expected return for bonds in order to get people to own stocks.)

Makes Sense to Me…

I have to admit, however, that while this strategy makes sense to me, I have not implemented it in my own portfolio. I’m not entirely sure why. Perhaps there’s some part of the idea I’m not sold on. Or perhaps I just place a high value on the simplicity of my own portfolio.

What about you? Do you tilt your portfolio toward small-cap or value funds? If so, why? If not, why not?

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