Archives for October 2011

Avoiding Big Investment Mistakes

To create a portfolio, you have to make many decisions.

You can use low-cost ETFs, or you can use low-cost index funds. Or you could use low-cost actively managed funds like Vanguard’s Wellington Fund or Wellesley Income Fund.

You can use a moderate allocation that stays fixed over time (say, 60% stocks, 40% bonds), or you could slowly shift your allocation to become more conservative over time.

You can use a “fund of funds” that is a diversified portfolio all on its own (e.g. Vanguard’s LifeStrategy funds), or you can save some money by taking a do-it-yourself approach with individual funds.

You can use a Treasury fund for your bond allocation, or you can use a Total Bond Market fund. Or you could construct a bond ladder from individual TIPS.

You can overweight small-cap/value stocks, or you can stick with a “total stock market” approach.

And the list goes on from there.

I think it’s worth discussing these topics, because you do have to make choice about each of them in order to create and implement an investment plan.

But I sometimes worry that I encourage you (readers) to get caught up in minutiae here on the blog. The reality is that either answer to any of the above decisions (as well as many more that I didn’t mention) is likely to work out just fine. There are an infinite number of reasonable ways to invest.

The Trick is to Avoid the Big Mistakes

From what I’ve seen, most investors’ success (or lack thereof) is determined primarily by whether or not they’re able to avoid the big investing mistakes — things like:

Holding a large portion of your total net worth in any one stock (especially your employer’s stock!),
Bailing out of the market after big crashes,
Getting involved with daily trading of individual stocks, foreign currencies, commodities, etc.,
Paying a sizable commission every time you invest, only to invest in funds that have high ongoing costs as well,
Listening to certain personal finance “experts” on the radio when they say you can safely withdraw 8% from your portfolio every year throughout retirement, or
Not getting started investing until late in your career.

If you get all the big stuff right, you can get many of the small things wrong and still do just fine. Conversely, one big mistake can easily outweigh any incremental gain from having a precisely-tuned asset allocation or shaving a tenth of a percent off your average investment expenses.

October 31, 2011

Investing Based on Market Valuation

I recently came across an excellent article by Todd Tresidder discussing the many imperfections of the 4% withdrawal “rule” for retirement planning. In the article, one of the suggestions Todd makes is to incorporate market valuation levels (as measured by PE10) into retirement planning decisions.

Because using market valuation (most commonly measured as PE10) as an input in investing decisions is a topic that comes up fairly often, I thought it might be helpful to share my thoughts here on the blog.

What is PE10?

PE10 is calculated as the current market price of the S&P 500, divided by the average of the last ten years of inflation-adjusted earnings for the S&P 500.

Like regular P/E ratios, the idea is that it can be used as an indicator of whether the current price (of the S&P 500, in this case) is high or low relative to earnings. The purpose of using ten years of earnings rather than just one year is to eliminate the impact of meaningless short-term fluctuations in earnings.

Uses of PE10: Asset Allocation and Withdrawal Rates

The most common suggested use of PE10 is to use it to make asset allocation decisions. For example, researcher Wade Pfau wrote a fascinating paper showing that from 1871-2009, a market timing strategy using PE10 (i.e., moving to stocks when the market is at a low PE10 and moving to Treasury bonds when the market is at a high PE10) would have significantly outperformed a simple portfolio with a fixed 50/50 stock/bond allocation.

A second, related use of PE10 is to use it as an input when deciding how much you can safely spend from your portfolio per year in retirement. Again, Wade’s research on the topic is excellent. He shows that, historically, the higher the market’s value (relative to earnings) when you retire, the less you can safely spend from your portfolio per year.

Why I Don’t Use PE10

Despite the data showing the historical usefulness of PE10, I’m not comfortable using it for my own portfolio decisions.

As a general rule, the market does not like to be predictable. For the most part, once market inefficiencies (i.e., patterns that can be used to reliably outperform the market) become well known and easy to exploit, they tend to disappear.

It seems entirely likely to me that PE10’s predictive value is a market inefficiency like any other and that the primary reason it has existed for so long is that there was no way to exploit it. That is:

Prior to computers, it would have been an enormous task to even calculate PE10, and
Prior to the existence of no-load index funds (i.e., prior to 1977), there was no cheap, easy way to invest in the market as a whole. Moving in and out of stocks to capitalize on PE10’s predictive value would have meant buying or selling a large portfolio of individual stocks and paying transaction costs that are far higher than they are today. (Higher commissions, higher bid/ask spreads, and usually higher taxes.)

So rather than a data set of 140 years, we’re left with just 34 years (1977-2010). For an indicator that is only supposed to have useful predictive value over periods of 10+ years, 34 years isn’t a heck of a lot to go on.

Is Using PE10 a Terrible Idea?

Despite my personal lack of confidence in PE10 as a useful predictor, I think I’d place PE10-based decisions in the group of investment approaches that are at least reasonable — far better than, say, day-trading individual stocks.

For instance, if PE10 was at a historical high at a time when TIPS yields were also very high, I wouldn’t fault somebody for moving more of their portfolio to TIPS. Similarly, I think it would be reasonable to use a lower withdrawal rate if you retire at a time with unusually low TIPS yields and an unusually high PE10.

On the other hand, I’d be extremely reluctant to suggest either moving more of a portfolio to stocks or using a higher withdrawal rate from a retirement portfolio just because PE10 is low by historical standards.

October 26, 2011

Asset Allocation for Young Investors

I recently had the pleasure of attending a Q&A session with a few Vanguard executives and fund managers. One of the questions asked was why the Vanguard Target Retirement funds have such a stock-heavy allocation for young investors (90% stocks, 10% bonds for investors more than 25 years from retirement).

John Ameriks (the head of Vanguard’s Investment Counseling & Research group) replied that the majority of a young investor’s total economic wealth is in the form of “human capital” (that is, future earnings from work), so Vanguard uses a high-risk portfolio to balance out the large, low-risk human capital asset.

Is Human Capital Low-Risk?

My problem with that line of thinking is that — if what I’ve seen from my friends, family, and classmates over the last several years is anything like normal — the typical 20-something’s work income is anything but low-risk. More often, it’s a relatively unpredictable rotation between periods of employment, unemployment, and underemployment.

If I were to suggest an allocation to balance out the human capital of a typical member of Generation Y, I’d suggest something conservative rather than aggressive.

Should Young Investors Have Conservative Allocations?

Despite my qualms above, I still think stock-heavy allocations make sense for many young investors. While the last decade has been lackluster for stock returns, I’m still convinced that the longer you hold stocks, the more likely they are to have positive returns, and the more likely they are to outperform lower-risk investments.

For a young investor trying to determine whether an aggressive allocation is appropriate, I think the two most important questions are:

How certain are you that the money in question will not need to be spent within the next 20 years or so?
What’s the most that your portfolio could decline before you started to get nervous?

If you know that the money will not be needed before retirement and you are confident that you would be comfortable with declines in the range of 40-50%, then I think a stock-heavy allocation is quite reasonable.

On the other hand, if you’re not comfortable with large declines, a stock-heavy allocation is a poor idea. One instance of panic-selling during a market low can be more than enough to offset any extra gains that you might get from allocating more to stocks.

Similarly, for young people with uncertain job prospects and little certainty that their investable money will ultimately be retirement money, a more conservative allocation makes a lot of sense. For money that’s a cross between retirement savings and an emergency fund, it makes sense to use an allocation that’s somewhere between the allocation you’d use for either one.

In other words, there’s more to asset allocation than just age. Conventional wisdom may say that most investors your age should be loading up on stocks. But that doesn’t necessarily mean that you should.

October 24, 2011

Investing Blog Roundup: Christine Benz Interviews John Bogle

At the Bogleheads event last week, Christine Benz of Morningstar sat down with John Bogle for a two-part interview. In the first part they discussed realistic stock and bond market expectations, and in the second part they discussed alternative investments and being an oblivious investor — though they didn’t use those words of course. 😉

Investing Articles

Investing in Three Dimensions (and Part 2) from Rick Ferri
Stock Market Volatility: Myth or Truth? from Allan Roth
Separating Financial Advice from Mutual Fund Fees from Money Smarts Blog
Has the Small-Cap Premium Disappeared? from Larry Swedroe
Monte Carlo Mania from Wade Pfau

Blog Carnivals

Stock Carnival hosted by Fast Swings

Thanks for reading!

October 21, 2011

What Are Stable Value Funds?

Carolyn writes in to ask,

“I recently started a new job and am looking for some help with the 401k. The plan doesn’t offer any bond funds with expense ratios below 1%. The plan does offer a stable value fund, but I’m not really clear on what that is, and there’s no ticker symbol for me to look up the fund online. Is a stable value fund a good replacement for a bond fund when you have no other low-cost choice?”

In short, a stable value fund is a bond fund that has an additional level of protection via insurance contracts that guarantee the value of the fund against fluctuations — whereas normal bond funds fluctuate in value every day due to changes in the value of the underlying bonds.

Risk and Expected Return

Because stable value funds have a double layer of protection (high-quality bonds, plus insurance protection) they’re definitely at the low-risk end of the investment spectrum.

Their risk level is somewhat higher than that of a savings or money market account (because insurance companies don’t quite offer the same degree of protection that you get with FDIC insurance) and somewhat lower than that of a typical intermediate-term bond fund (one without an insurance “wrapper”).

And as you might expect, stable value funds typically offer higher returns than FDIC-insured accounts (because they’re investing in investments that carry some degree of risk) and lower returns than a typical intermediate-term bond fund (because of the costs of the insurance protection).

Speaking of Costs…

Naturally, the fee that the insurance company charges reduces the fund’s return. With regard to asset allocation decisions, this fee is relevant for two reasons.

First, if the fee is particularly high, it may mean that the stable value fund isn’t actually any lower-cost than the other bond funds available in the plan — in which case you may want to use one of the other bond funds instead. (Or, even better, do your best to satisfy your bond allocation using low-cost bond funds in an IRA where you have your choice of investment options.)

Second, if you do decide to use the stable value fund for your bond allocation, it’s worth recognizing that it has lower risk and lower expected return than most bond funds. As a result, you may want to adjust your overall stock allocation upward slightly relative to what it would be if you were using a typical bond fund for your bond allocation.

October 19, 2011

ETFs vs. Index Funds (revisited)

For investors who have only recently decided to switch their portfolio to low-cost, indexed investments, one of the questions that must be answered is whether to use ETFs or traditional index funds. We discussed this issue a couple of years ago here on the blog, but many things have changed since then.

Comparing Expenses

Two years ago, arguably the biggest factors in the decision were that ETFs had lower expense ratios than most index funds, but you had to pay a commission to purchase them. Since then, however, multiple brokerage firms (most notably, Vanguard, Fidelity, Schwab, and TD Ameritrade) have begun to allow for commission-free trades of certain low-cost ETFs.

On the other hand, ETFs no longer offer much (if anything) in the way of savings with regard to expense ratios. If you have $10,000 or more to invest in a given fund, you can have access to the “Admiral shares” version of most Vanguard funds, which usually have expense ratios as low as the lowest-cost ETFs. (Prior to October 2010, the Admiral shares had a minimum initial investment of $100,000 rather than $10,000.)

In short, when it comes to expenses, there is no longer a significant difference between the lowest-cost ETFs and the lowest-cost index funds.

Tax-Efficiency

Much has been written about the difference in tax-efficiency between ETFs and traditional index funds. Some people argue that ETFs have lower tax costs, while others argue exactly the opposite. As far as I can tell from comparing Morningstar’s “tax cost ratios” for several index funds and comparable ETFs, it’s not entirely clear which side of the argument is correct.

What is clear though is that both index funds and passively managed ETFs are far more tax-efficient than the majority of their actively managed counterparts — primarily due to the fact that passively managed funds have much lower portfolio turnover than actively managed funds.

More Important Considerations

For most investors, because of the industry changes in recent years, the ETF vs. index fund decision now comes down to considerations other than costs.

It makes sense to use ETFs if you care about:

Buying or selling your holdings in the middle of the day, or
Using types of orders other than market orders (limit orders, for instance).

Conversely, it makes sense to use traditional index funds if you care about:

Being able to buy fractional shares, or
Setting up automatic purchases (or sales) at regular intervals.

Personally, I don’t particularly value the advantages offered by ETFs, so I choose to use traditional index funds. For other investors, ETFs will be a better fit.

In any case, for investors using a “buy, hold, and rebalance” strategy, the differences between low-cost ETFs and low-cost index funds are slim. Your long-term success is unlikely to be affected either way as a result of the decision.

October 17, 2011