Archives for April 2012

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Do I Provide Biased Information? (Yes.)

Last Friday I mentioned that every source, including this one, has biases and conflicts of interest. A few readers asked for clarification regarding my biases, so I thought it would be a good idea to go over them to help you better evaluate the information you receive here.

My Conflicts of Interest

First and most obviously, I have some conflicts of interest due to the fact that I participate in a handful of affiliate programs:

  • Amazon,
  • Legalzoom and MyCorporation.com,
  • Mint.com, and
  • eHealthInsurance.

If you’re not familiar with what affiliate programs are, I’d encourage you to read this article. In short, I receive a commission any time you follow a link from my site to one of those sites and buy their products or sign up for their services. This means I have a conflict of interest in that it’s more profitable for me to recommend these companies rather than their competitors.

Obviously Amazon is the most relevant one because I rarely link to or discuss the other companies. Fortunately, Amazon does actually tend to be the lowest-cost place to buy the books that I publish.

My Biases

More importantly, like any human, I have a whole list of natural biases.

The one that probably has the largest effect on this blog is known as confirmation bias. That is, once I’ve taken a position on a topic (either in an article, in one of my books, or with my own portfolio), I have a natural inclination to:

  1. Read articles and studies that confirm I’ve made good choices with the positions I’ve taken rather than sources that would indicate the opposite, and
  2. Be undesirably closed-minded about sources providing opposing viewpoints.

do make a point to expose myself to opposing viewpoints on a fairly regular basis. But the reason I have to make a point to do this is because my natural inclination is to do just the opposite.

This (unintentional) filtering of sources probably slants the information I provide here in favor of the things that I already believe in — things like:

In other words, this bias probably results in me overstating my case at various points in time. I’d love to give you an objective assessment of the degree to which this happens. But I can’t. I’m biased.

Is Preferred Stock Safe?

A reader writes in to ask,

I left my broker recently after learning about the importance of expenses. I transferred my IRAs to low-cost index funds, and I plan on liquidating most of my taxable account to pay down my mortgage. But much of the account is in preferred securities, and I don’t fully understand how they work.

The broker said that they’re basically a hybrid security which is part equity and part fixed income. Are these relatively safe from market conditions? In other words, could they dramatically fall in value if the market goes south, or do they work more like CDs? One of them has a fixed coupon rate of 8%. Does that have anything to do with how much I’ll earn?

If these preferreds guarantee me a return for a certain period of time, then I’d hold onto them a little longer. But if they can dramatically drop just like stocks can, then I’ll probably just sell them.

Your former advisor was correct that preferred stock is somewhere between bonds and normal (“common”) stocks.

The idea of preferred stock is that dividends (based on the preferred stock’s stated coupon rate) must be paid to preferred stockholders before any dividends can be paid to common stockholders.

And because preferred stock typically has a much higher yield than common stock, it’s thought to be an “income” investment, much like a bond.

But Nothing is Guaranteed

But to be clear, nothing is guaranteed with preferred stocks. They are nowhere near as safe as CDs.

The dividend payment is not guaranteed. If the company chooses not to pay dividends to common stockholders, they don’t have to pay dividends to preferred shareholders either. (Though if the preferred stock is “cumulative preferred stock,” there is a slightly higher degree of protection because the company would have to pay dividends in arrears to make up for each of the missed preferred dividend payments before any dividend can be paid to common shareholders.)

And the market value isn’t guaranteed either. For example, the following chart from Morningstar plots the price of iShares S&P U.S. Preferred Stock Index Fund (PFF, in blue) against the price of Vanguard Total Stock Market ETF (VTI, in yellow) from 3/30/2007 through 4/2/2012. As you can see, preferred stocks can lose market value just like common stocks.

Finally, if a company goes out of business, shares of its preferred stock are considered an equity position rather than a creditor position — meaning all creditors would have to get every dime they’re owed before preferred stockholders would get anything.

In short, preferred stocks have a high yield — making them bond-esque investments in that regard. And if everything is going well and the company is paying dividends, a preferred stock will have a predictable rate of return. But nothing is guaranteed — neither the dividend payment, nor the market value of the stock.

Researching Funds on Morningstar

While I’m a big fan of Vanguard funds, there are plenty of reasons why investors might want (or need) to use funds from a different company — the most common reason being that many investors don’t have the choice of Vanguard funds in their 401(k).

So what do I do when somebody asks me for an opinion regarding a fund I’m not particularly familiar with? I turn to Morningstar.

Things to Check for Every Fund

When researching a fund, the first thing I check is the fund’s expense ratio. As a rule of thumb, unless there’s no way around it (e.g., in an employer-sponsored plan with no low-cost funds), I rule out any fund with an expense ratio greater than 0.30%. If you have your choice among funds (in an IRA, for instance), there are several options in each asset class with costs below that point.

Next, I click over to the “portfolio” tab on Morningstar to check out the fund’s overall asset allocation. How much does the fund have in:

  • U.S. stocks,
  • International stocks,
  • Bonds, and
  • Cash?

This question is important because you cannot implement an asset allocation plan without first knowing the underlying asset allocation of the funds you’re using.

You’ll want to pay particular attention to the amount of cash that stock and bond funds hold. In general, the less cash a fund holds the better. Cash is a perfectly reasonable thing to hold in a portfolio, but there’s generally little benefit to paying a fund manager to hold it for you.

Researching Stock Funds

The next thing I do (still on the “portfolio” tab) when researching a stock fund is check out the tic-tac-toe-looking “holdings style” breakdown. This is important because you can’t always tell from the name of a fund whether it’s more heavily weighted toward value stocks or growth stocks. In fact, even if the fund has “value” or “growth” in the name, that doesn’t necessarily mean much. Better to actually check the numbers.

As an example, here’s the information for Fidelity’s Spartan Total Market Index Fund:

This tells us that the fund is very evenly split between value and growth stocks and that it’s primarily a large-cap fund, with modest mid-cap and small-cap holdings. In other words, it’s exactly what you’d expect from a “total market” stock index fund.

If I’m researching an international fund, the next thing I check is the breakdown between developed and emerging markets (at the very bottom of the “portfolio” page). There’s no right or wrong answer here, but it’s important to check so that you know what level of risk to expect from the fund. (The larger the allocation to emerging markets, the greater the risk.)

Finally, I take a quick glance at the “Sector Weightings” of the fund. I do this simply to make sure that it’s not super-heavily weighted in just one or two sectors (e.g., healthcare), because you can’t always tell from the name.

Researching Bond Funds

When researching a bond fund, after checking out the expense ratio and asset allocation, I check two things (again, both on the “portfolio” tab) to get an idea of the risk-level of the fund:

  • The average duration, and
  • The credit quality breakdown.

As we’ve discussed before, the duration of a bond fund is an important indicator of its risk level because the longer the duration, the more the fund’s price will fluctuate as a result of changes in market interest rates.

Credit quality is important for obvious reasons. Personally, I prefer to look at the actual breakdown (how much in AAA, how much in AA, etc.) rather than just looking at the average credit rating because averages can be deceiving.

Other Points of Note

If the fund in question is going to be held in a taxable account, I make sure to look at two additional metrics: the “tax cost ratio” (on the “tax” tab) and portfolio turnover (on the “quote” tab), both of which can give an idea of the fund’s tax efficiency. (In both cases, a lower figure suggests better tax efficiency.)

Finally, you may have noticed that I didn’t mention checking performance at all. That’s because I often don’t. Past performance really is a poor indicator of future results. If I check a fund’s performance at all, it’s usually just to visually compare it to the performance of another fund to get an idea of the funds’ similarity to each other.

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