Archives for June 2014

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More to Risk Tolerance Than Just Age

A reader writes in, asking:

“One thing I don’t understand about target date funds is the implicit assumption that the only thing that should determine your asset allocation is how old you are. Doesn’t this seem like an obvious mistake?”

I’m not sure I’d say it’s a mistake how target date funds are constructed. But I absolutely agree that there’s more to risk tolerance and asset allocation than just the year in which you plan to retire.

For example, how stable is your income? A person with a secure, steady-paying job can take on more risk than a person with a job that could be lost at any minute or a person with a job that pays entirely based on commission.

What other assets do you have? If you have a very large emergency fund that you’re not counting as part of your portfolio, you can take on more risk in the portfolio than somebody with a smaller emergency fund.

What other assets would you have access to, if the need arose? Consider two young investors. One comes from a poor family and knows with 100% certainty that she wouldn’t be able to get any sort of financial assistance from friends or family if she lost her job. The other comes from an upper middle class background and knows that the Bank of Mom and Dad would chip in (at least to some extent) if a financial emergency came up. All else being equal, these two investors have very different levels of risk tolerance.

How much investing experience do you have? Have you been through a bear market before? Until you’ve experienced one, you should assume that it will feel worse than you’d naturally expect. If your portfolio is small relative to the size of your total available assets and you can therefore afford to make a mistake (e.g., sell out at or near the bottom in the event that you can’t handle the stress), then go ahead and build a high-risk portfolio. But if selling out would be a problem and you’ve never been through a bear market, you should probably consider a less risky allocation.

Do you have any need for the higher expected returns that come from a risky portfolio? For example, author/advisor Larry Swedroe has often written that he has a “low marginal utility of wealth” (marginal utility being the additional happiness you would get from more of the item in question), meaning that he has little to gain from a high-risk portfolio. Or, as Bill Bernstein puts it, “if you’ve won the game, why keep playing?”

Target Retirement Funds and Risk Tolerance

Due to all of the above factors, an investor might want an allocation that doesn’t vary solely with age. For example, for a young investor who has a relatively low risk tolerance and who doesn’t expect that risk tolerance to change any time soon, a fixed 60% stock, 40% bond allocation may be a good fit. But the Target Retirement funds don’t offer that option. For investors who want an allocation that doesn’t vary with age, and who still want the simplicity of an all-in-one fund, Vanguard’s LifeStrategy funds can be a good fit.

3 Bad Reasons to Claim Social Security Early

Administrative note: My wife and I are moving this week, from St. Louis, Missouri to Manitou Springs, Colorado. As a result, there will be no articles this upcoming Friday (6/20) or Monday (6/23). Also, please be patient with me if I’m slower than usual in replying to emails.

There are many perfectly good reasons to claim Social Security early. For example:

  • You need the cash flow right now,
  • You are unmarried and have a shorter than average life expectancy,
  • You’re the higher earner in a married couple, and both you and your spouse have significantly shorter than average life expectancies,
  • You’re the lower earner in a married couple and either you or your spouse has a shorter than average life expectancy,
  • Inflation-adjusted interest rates are high, making the “take the money and invest it” strategy likely to work out well, or
  • You plan to take the money early and invest it in risky assets, you understand that there’s a significant possibility that you’ll end up worse-off as a result of that decision, and you can afford such an unfavorable outcome.

Unfortunately, people frequently claim Social Security early for reasons that don’t make a great deal of sense. Three especially common not-so-good reasons for taking Social Security early include:

  1. You want to spend more money in early retirement than in later retirement,
  2. You don’t want to work until age 70, and
  3. You want to leave behind money to your kids.

One way to assess the when-to-claim decision is to calculate the break-even point between two different strategies. For example, how long do you have to live for claiming at 70 to be a better strategy than claiming at age 62? As it turns out, if inflation-adjusted interest rates are below 2% or so, the break-even point occurs prior to age 83 (age 83 being the total life expectancy for an average 62-year-old).

Stated differently, unless investors can safely earn inflation-adjusted investment returns of 2% or more (not possible at the moment, given current TIPS yields), most people (specifically, most unmarried people and higher earners in married couples) can maximize the total number of dollars they’ll have available to them over their lifetimes by claiming Social Security at 70 rather than at 62.

The key insight here is that maximizing the total dollars you have available to you over your lifetime isn’t the same thing as maximizing your standard of living in late retirement only. If you prefer, you can use that increased amount of lifetime wealth to spend more in early retirement. Or, if you prefer, you can simply accumulate those dollars and leave them to your heirs.

In other words, even if you:

  1. Want to retire at age 62 or earlier,
  2. Want to spend more in the early stage of retirement than in later retirement, and
  3. Want to leave behind money for the kids…

…there’s still a good chance that delaying Social Security until 70 is the best strategy.

Want to Learn More about Social Security? Pick Up a Copy of My Book:

Social Security cover Social Security Made Simple: Social Security Retirement Benefits and Related Planning Topics Explained in 100 Pages or Less
Topics Covered in the Book:
  • How retirement benefits, spousal benefits, and widow(er) benefits are calculated,
  • How to decide the best age to claim your benefit,
  • How Social Security benefits are taxed and how that affects tax planning,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"An excellent review of various facts and decision-making components associated with the Social Security benefits. The book provides a lot of very useful information within small space."

A Look at Vanguard’s Global Minimum Volatility Fund

This week, a reader wrote in asking about the Vanguard Global Minimum Volatility Fund that was launched in December 2013 — what it’s supposed to do, what it owns, and so on.

The fund is an actively managed stock fund. The fund’s investment strategy is to select stocks based on their individual volatility levels and correlation to each other, with the goal of delivering less overall volatility than a typical indexed stock portfolio.

What’s in the Portfolio?

Vanguard has stated that the plan is for the fund to have roughly half of its assets in U.S. stocks, and half in international stocks. And indeed, the fund currently has an allocation very close to that target.

The Global Minimum Volatility fund currently holds 241 stocks. While that’s not exactly a small number, it’s still far fewer than would be included in a typical broadly diversified index fund. For instance, a combination of Vanguard Total Stock Market Index Fund and Vanguard Total International Stock Index Fund would currently  include more than 9,000 stocks.

How Risky is the Fund?

On their “Risk Potential” meter, Vanguard rates the Global Minimum Volatility fund at 4/5, which is the same rating that they give the Vanguard Total Stock Market Index Fund. In other words, despite the low-volatility goal, it’s not as if Vanguard expects the new fund to be as safe as a bond fund. John Ameriks of Vanguard put it this way:

“You should not expect this fund to protect your principal in times of market downturns. We take a dim view of any stock fund that makes claims of safety from market loss or full downside protection. The objective of the fund is to deliver the least volatility that we can, subject to reasonable constraints on other important aspects of the portfolio. Zero volatility in times of market stress is not a reasonable expectation.”


The fund has an expense ratio of 0.30% (or 0.20% for Admiral shares, with a $50,000 minimum). There’s no ETF version of the fund.

My Personal Opinion

Given that we continue to be very happy with our simple one-fund solution, we won’t be adding the Global Minimum Volatility Fund to our portfolio.

But, frankly, even if we weren’t using an all-in-one fund, I still wouldn’t be inclined to add this fund to our portfolio, due to my general degree of pessimism about the value of active management. If I wanted to slightly reduce the risk level of my portfolio, I would simply adjust my stock/bond allocation slightly rather than moving a portion of my stock holdings into an actively managed stock fund that hopes to achieve lower levels of volatility than basic stock index funds.

That said, if I ever were to place a bet on active management, I would want to find a fund with rock-bottom costs, so as to minimize the hurdle that the fund managers have to overcome. And the cost of active management for this fund is much lower than that of most actively managed stock funds.

Last Day of New Book Sale (Microeconomics Made Simple)

My apologies for the unusual Wednesday post. I just wanted to give readers a brief reminder that today is the last day to download a Kindle copy of the new book, Microeconomics Made Simple, for just $0.99.

Also, if you’d like to tell any friends about the book (e.g., via forums, Facebook, or Twitter), today would be the day to do it, so that they can get the lower price as well.


We’ll return to our regularly scheduled investing-related material on Friday.

New Book: Microeconomics Made Simple

Microeconomics Book CoverOf my books, the one that sells the most copies each month is the one that has the least to do with personal finance: Accounting Made Simple. I wrote the book with small business owners in mind, but it has turned out to be very popular with business students who are struggling in their accounting courses.

Over the last few years, many readers of that book have asked whether I would consider writing a similar book about microeconomics. While that seemed like a great idea, there was one obvious problem: I’m not an economist. My training in economics consists of just a handful of undergraduate classes.

So, last year, I turned to somebody I know who is an economist (and an excellent writer) — Austin Frakt — to see if he would be interested in partnering up on such a book. For those of you who aren’t familiar with him, Austin is the founder of the health policy blog The Incidental Economist, as well as a regular contributor to The New York Times. (He’s also a Boglehead.)

Today, after many months of work, the book is finally available:

Austin and I would encourage you to pick up a copy of the book if:

  • You never learned microeconomics and yearn for a basic intro that won’t take much time or make your brain hurt,
  • You learned microeconomics, but so long ago that you’re rusty and want to brush up,
  • You’re a student with a microeconomics course in your future and you want to get a jump on the basic concepts,
  • You’re taking a microeconomics course right now, but it’s going too fast for you and you want a simple way to review the fundamentals, or
  • You find yourself puzzled by some discussions of markets, profits, opportunity cost, or other microeconomic concepts and want a way to get up to speed.

Temporary Price Discount

As I’ve done with prior book releases, this book will be temporarily discounted for the first few days of publication. Specifically, from today through Wednesday (June 4th), the Kindle price will be discounted from $4.99 to just $0.99. As a reminder, Kindle books can be read on a plain-old PC or Mac — no need for an actual Kindle device. You can download the free Kindle software here:

Also, for anybody interested, the Kindle version of Accounting Made Simple will be discounted as well during that same period.

What’s In The Book?

This book is in two parts. In Part One, we discuss several of the most basic concepts of economics, such as utility, supply, demand, market equilibrium, and some ways in which governments intervene in markets. In Part Two, we focus on the degree of competition in different types of markets, as well as the outcome of that competition. Market structures considered include: perfect competition, monopolies, oligopolies, and monopolistic competition.

A detailed chapter-by-chapter table of contents is available on Amazon.

Sample Excerpts

For those curious to see what the book is like, Austin and I have published a few brief excerpts:

To give a good sampling, these excerpts come from both earlier and later sections in the book. Naturally, the topics are somewhat easier to understand within the full context of the book.

So, please go check it out and pick up a copy if you have an interest in the subject matter:

Microeconomics Made Simple: Basic Microeconomic Principles Explained in 100 Pages or Less

PS: Special thanks go to Wade Pfau and Julian Jamison for contributing their time and expertise for technical editing.

Calculating Consumer and Producer Surplus

The following is an adapted excerpt from my book Microeconomics Made Simple: Basic Microeconomic Principles Explained in 100 Pages or Less.

“Consumer surplus” refers to the value that consumers derive from purchasing a good. For example, if you would be willing to spend $10 on a good, but you are able to purchase it for just $7, your consumer surplus from the transaction is $3. You’re getting $3 more value from the good than it cost you.

We can use a chart of supply and demand to show consumer surplus in a market.

EXAMPLE: The following chart shows the perfectly competitive market for oranges. The market is in equilibrium at the price PE and the quantity QE. As we know, the demand curve indicates consumers’ willingness to pay. In the chart, the amount that consumers actually are paying is PE — the equilibrium market price for oranges. Therefore, for each transaction that occurs up to QE, consumer surplus is achieved in an amount equal to the distance between the demand curve and PE. As a result, the shaded area in the chart indicates the total consumer surplus achieved in the orange market.

Consumer and Producer Surplus in Perfect Competition

Consumer and Producer Surplus

To calculate the total consumer surplus achieved in the market, we would want to calculate the area of the shaded grey triangle. If you think back to geometry class, you will recall that the formula for area of a triangle is ½ x base x height. In this case, the base of the triangle is the equilibrium quantity (QE). And the height of the triangle is the amount by which the y-intercept of the demand curve (i.e., the price at which quantity demanded is zero) exceeds the equilibrium price (PE).

“Producer surplus” refers to the value that producers derive from transactions. For example, if a producer would be willing to sell a good for $4, but he is able to sell it for $10, he achieves producer surplus of $6.

Like consumer surplus, producer surplus can also be shown via a chart of supply and demand. This time, however, the surplus from each transaction is represented by the distance between the supply curve (which denotes the lowest price suppliers would be willing to accept) and the market price. The total producer surplus achieved in the orange market would be represented by the dotted area in the chart.

The area of the dotted triangle (representing producer surplus) is calculated as ½ x base x height, with the base of the triangle being the equilibrium quantity (QE) and the height being the equilibrium price (PE).

“Total surplus” refers to the sum of consumer surplus and producer surplus. Total surplus is maximized in perfect competition because free-market equilibrium is reached. That is, if a quantity less than the free-market equilibrium quantity were transacted, total surplus would be less, because there would be beneficial transactions that are failing to occur (i.e., transactions where consumers’ willingness to pay is greater than the lowest price suppliers are willing to accept). And if a quantity greater than the free-market equilibrium quantity were transacted, total surplus would be less, because transactions that cost more to producers than consumers would be willing to pay would occur.

Want to Learn More about Microeconomics? Pick Up a Copy of the Book:

Microeconomics cover Microeconomics Made Simple: Basic Microeconomic Principles Explained in 100 Pages or Less
Topics Covered in the Book:
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