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Why Are Bonds a Useful Diversifier?

A reader writes in, asking:

“I graduated in May and immediately started contributing to the 401k at my new job. Fidelity runs the 401k. I am using the Spartan 500 Fund, the Spartan U.S. Bond Fund, and a small amount in the Total International Equity Fund.

I thought my portfolio was diversified. But the Spartan 500 fund went way down last month and the U.S. Bond fund barely went up at all. I’ve read that ‘bonds zig when stocks zag’ but that doesn’t seem to be working. Do you have any suggestions?”

The problem doesn’t appear to be with the portfolio. A portfolio of those 3 funds would be reasonably well diversified. The problem is that you’re expecting too much from your bond holdings.

Historically in the U.S., bonds have typically had a positive correlation to stocks. (See Figure 2 in this paper from Vanguard.) In addition, the correlation between stocks and bonds varies dramatically over time. (See Figure 1 in this article from Rick Ferri.)

In other words, the reason bonds are a successful diversifier is not that they have negative correlation to stocks and that you can expect bonds to rise reliably when stocks fall. Sometimes it works out that way, and it’s very convenient when it does. But you can’t count on it.

The primary reason that bonds work well as a diversifier is simply that they are less risky than stocks. That is, when stocks are falling, it’s entirely possible that bonds will be falling too. But as long as you’ve stayed away from very high-risk bonds (e.g., junk bonds or bonds with very long durations), it’s very unlikely that your bonds will fall as much as your stocks.

For example, the following chart (made using the Morningstar website), shows the returns of Vanguard Total Stock Market Index Fund (in blue) and Vanguard Total Bond Market Index Fund (in orange) over the last three months.

Screen Shot 2015-09-27 at 8.48.22 AM

As you can see, the stock fund fell quite noticeably around the middle of August. The bond fund didn’t shoot upward when the stock fund fell, but it didn’t decline precipitously either. That’s pretty much what you should be hoping for from a bond fund. It delivers boring, low-risk performance, even when stocks are performing poorly.

If you’re hoping that your bond holdings will reliably offset any stock losses that you experience, thereby allowing your portfolio to climb steadily upward without any bumps, you’re going to be disappointed.

Where, When, and How to Buy Mutual Funds

A reader writes in, asking:

“I am just getting into investing. It would be very helpful for folks like me, if you can write about where to buy, how to buy, when to sell and how to sell.

I have read few investment related books and searched online but could not find this kind of information. Most of them talk about what to buy. For example, from your site I understood what kind of funds to buy but I do not know where to buy them from, when to sell them and how often should I buy them, is there a good time to buy them as they too have price fluctuations like stocks.”

Where to Buy Mutual Funds

As far as where to buy different funds, I think it’s usually just a question of finding a place where you can buy them without having to pay commissions. For example, if you want to use Vanguard mutual funds, it usually makes sense to open an account at Vanguard and buy them there. Or if you want to use Fidelity’s “Spartan” index funds, Fidelity is probably the best place to do that.

With ETFs, there may be more options. For example, you could purchase Vanguard ETFs commission-free at Vanguard. But many of the most popular Vanguard ETFs are also available commission-free at TD Ameritrade.

In some cases, if there is a specific service that you want from a brokerage firm, and you know that it is only available at certain places (e.g., you’re looking for a firm that offers solo 401(k) accounts that allow both incoming rollovers and Roth contributions), it may make sense to use a firm with non-zero commissions. But you will usually know if you’re in such a situation.

When to Buy (or Sell) Mutual Funds

As far as when to buy and sell funds, there’s some disagreement on the matter. Personally, I follow a “strategic asset allocation” approach, which means that I do not adjust my asset allocation based on market valuations, predictions about interest rates, or anything of that nature. Instead, my portfolio only changes when a) something in my life changes such that I can afford more or less risk or b) a new product becomes available that allows me to meet my desired allocation with less work or lower expenses.

For people following such an approach, the question of when to buy and sell is very easy.

  • Buy when you have money to invest,
  • Sell when you need to take money out of the account (either to spend it or to satisfy required minimum distributions from a retirement account), and
  • At specific intervals (e.g,. once per year) buy and sell as necessary in order to rebalance (i.e., to bring your overall portfolio back to the desired allocation).**

In contrast, some investors prefer to use a “tactical asset allocation” approach, in which you shift your allocation in one direction or another based on various market conditions. Personally, however, I have never been convinced that such methods reliably result in anything other than an increased workload.

How to Buy Mutual Funds

As far as how to buy, with traditional open-end mutual funds, there’s nothing to it really. You simply log into your account and place a buy order. With ETFs, there are some additional considerations with regard to what type of order to place (e.g. market order, limit order, etc.) and what time of day to place a trade. (See this paper from Vanguard for a more thorough explanation.) But those considerations can be sidestepped completely, if you desire to do so, simply by using traditional open-end mutual funds.

**If your portfolio includes taxable brokerage accounts, there may also be tax-related reasons to buy and sell funds (e.g., tax-loss harvesting or tax-gain harvesting).

Why I (Still) Like All-in-One Mutual Funds

A reader writes in, asking:

“You haven’t written about how you feel about the LifeStrategy funds in light of current market events. Are you still using one? Are you happy with it?”

The short answer is that:

  • Yes, we’re still using the Vanguard LifeStrategy Growth Fund for all of our retirement savings,
  • Yes, we’re still super happy with it, and
  • Neither my investment strategy nor investment tactics change as a result of market conditions, so that’s not really playing a role (in either direction) regarding my level of satisfaction.

All-in-One Funds Are Low-Stress, Low-Maintenance

One of the primary reasons I’ve enjoyed using the LifeStrategy fund is that it is a very low-hassle way to invest. When I sign into the Vanguard site to make a contribution, I don’t have to spend any time figuring out how much to buy (or sell) of each fund in order to maintain our desired overall allocation across accounts. Nor am I spending any time or energy considering adjustments to our asset allocation. All I’m doing is entering the amount of the contribution I want to make, confirming the transaction, and signing out.

If you use an all-in-one fund, you will want to make a point of staying informed about changes made to the fund (for example, Vanguard recently increased the international allocations in their all-in-one funds), because it’s possible that the fund company could change the underlying allocation in such a way that it’s no longer appropriate for your needs. But, at least with Vanguard, such changes don’t happen especially often, so the amount of work (and thought) involved is minimal.

All-in-One Funds Help Reduce the Likelihood of Mistakes

A second reason I like using an all-in-one fund is that it reduces the likelihood that I’ll tinker with our portfolio in a way that will ultimately be detrimental to performance.

Morningstar research has consistently shown that investors tend to underperform the funds that they use, because they switch between funds at the wrong times. (This is generally the result of buying immediately after a period of good performance and selling after a period of poor performance.) Interestingly, in research from earlier this year*, Morningstar found that investors in target-date funds have actually had better performance than the funds themselves over the 10-year period ending 12/31/2014.

But They’re Not for Everyone

Despite the benefits mentioned above, all-in-one funds have their limitations. Last time I gave an update on using the LifeStrategy fund, I wrote the following, which I still think is true.

All-in-one funds are not a perfect fit for everybody. There are plenty of reasons why any given investor might be better off taking the DIY-allocation approach. For example:

  • The fund-of-funds structure is tax-inefficient, which is relevant if you have assets in a taxable brokerage account.
  • Some people will not be able to find an all-in-one fund with an asset allocation that suits their needs (e.g., because they need to underweight U.S. stocks in their IRA in order to make up for the fact that they’re overweighting U.S. stocks in their 401(k) because their retirement plan’s only decent choice is a U.S. stock fund).
  • Some people will prefer to implement a strategy that “tilts” the portfolio in some way (most commonly toward small-cap value stocks or REITs).
  • Some people don’t mind the modest work involved in managing a portfolio, are completely confident they will not do any detrimental tinkering, and want to take advantage of the slightly lower costs of individual index funds or ETFs.

*A free Morningstar account is required to view the article.

Self-Publishing FAQs

Mike’s note: This article was originally published in February of 2012. But there has been an increase in questions from readers about self-publishing lately, so I’m updating the article and republishing it with current information. For readers with no interest in the topic, don’t worry, I have no intention of discussing book publishing on a regular basis.

Aside from the usual financial planning-related questions, the most common thing readers ask me about is self-publishing — how to do it, how to get a book on Amazon, which printing company to use, how to market books, etc.

What follows are the answer to the questions I’m asked most often. If you have any questions left unanswered, feel free to ask via email.

Of note, this article is written from the perspective of a writer whose goal is to publish a book as an entrepreneurial endeavor. If your goal is simply to publish a book, and you have no goal of any financial reward, you can read the first FAQ below and ignore everything else.

Print Publishing

Which printing company do you use?

CreateSpace. Their costs are low, and they’re easy to use.

I also have printing set up with a second company (Lightning Source), so that the books are still available while they are being updated. (I update 3-5 books each year. And while a book is being updated with a given printing company, it must be taken out of distribution with them.)

But for most writers though — especially anybody just getting started — I’d suggest sticking with CreateSpace alone.

What do you have to do to get a book selling on Amazon?

If you’re using CreateSpace, it’s easy:

  1. Create an account,
  2. Send them a pdf of the cover and a pdf of the interior,
  3. Order a proof copy and check it over,
  4. Submit necessary revisions,
  5. Repeat steps 3 and 4 as necessary, then
  6. Approve the proof.

After you’ve approved your proof copy and checked the box for distribution via Amazon, it will automatically be available for sale within a few days.

How much money do you make from a book sale?

With CreateSpace, your revenue per unit (for a black and white book) will be calculated as follows:
60% of the book’s list price (which you set), minus
$0.85, minus
$0.012 per page.

So, for example, for a book with 150 pages and a $15 list price, you’d receive:
$9.00 (60% of $15)
$1.80 (150 pages x $0.012 per page)
$6.35 profit margin per book

How much money can I make by self-publishing a book?

There’s no way to know ahead of time how much a given book will make. I’m happy to share some information though, because I know it’s helpful to at least have some idea. For the twelve months ending 7/31/15, five of the eight books in the “…in 100 pages or less” series generated revenue of between $10,000 and $20,000. One book generated less revenue than that, and two books generated more revenue than that.

From what I’ve heard from other financial self-publishers, that range is fairly typical, subject to the following caveats:

Caveat #1: If you make a book about a topic that very few people have an existing interest in, or if you don’t bother putting in the time to market your book, your sales will probably be much lower.

Caveat #2: These figures include both a print edition and a Kindle edition for each book. For the last 12 months, Kindle sales were responsible for 26% of my sales revenue. (This figure grew quickly from 2010-2011, but has since leveled off.)

How much does it cost to get started?

With CreateSpace, the cost is negligible. Setting up a book is free. Each proof copy costs about $20 including shipping. That’s it.

If you want to sign up with Lightning Source, there are more upfront costs involved. Plan on spending a few hundred dollars to get the book into distribution.

You may also want to buy an ISBN for the book rather than using one from your printing company. This will allow you to choose your own publisher name. (Otherwise, the printing company will appear as the publisher.) In the U.S., one ISBN costs $125. A block of ten costs $295.

That’s it as far as costs for the actual printing. However, I’d definitely encourage you to budget for professional editing services (both regular editing and technical editing) as well as cover design.

Why sell a book on Amazon rather than direct-selling ebooks to visitors?

The primary reason is that you get to take advantage of Amazon’s millions of visitors. This allows you to be successful with less of your own traffic, and without having to get other bloggers to promote your book.

Also, once the Amazon marketing engine starts promoting your book, it generally continues to do so. (My understanding is that with the direct-sales model, sales tend to decline dramatically after the first couple months of promotional effort.)

Finally, there’s no need to handle any sort of customer interaction at all. It’s passive income once the book is selling.

That said, those are just the advantages. There are disadvantages too. For example, you’re unlikely to get away with charging $50 for a book on Amazon. In addition, you’re not in control of what people say. If people don’t like your book, you’ll end up with negative reviews on the book’s sales page.

Do you have to keep a lot of inventory on hand? Is it a hassle to mail books out all the time?

You don’t have to do anything involving inventory or shipping. Amazon and the printing company handle all of it.

Kindle Publishing

How do you make a Kindle book?

For the most part, a Kindle book is just plain old HTML. However, rather than create the Kindle files yourself, it likely makes sense to outsource the conversion process. Because conversion from a Word document to an HTML document is a commodity-esque task, you can get it pretty cheap. (It’s easy to find people who will do a good job for less than $200 per book.)

How much do you make per Kindle book sale?

If you set the list price for your Kindle book between $2.99 and $9.99, your margin per book will be 70% of the list price, minus a “delivery fee” for the cost of transmitting the data. This fee is quite small. ($0.05 is typical for my books.)

If you set the list price for your Kindle book below $2.99 or above $9.99, your margin per book will be 35% of the list price, minus the data delivery fee.

Book Marketing

What’s your most important marketing tip?

Make a book that satisfies a need that people already know they have.

My most successful approach for book creation and marketing has been to:

  1. Find a specific question that people are asking. (Even better: Check your blog’s analytics to see what questions you’re already getting traffic for.)
  2. Answer that question as a chapter in a book.
  3. Answer several related questions as your other chapters. (Bonus points if you’re already getting traffic for these questions too.)

How do you promote your books on your site?

For me, by far the most successful spot for book promotion has been right at the bottom of each post. I simply have a paragraph that says, “for more information about [topic of book], consider picking up a copy of my book: [title].” Then it has an image of the book cover and several links to the sales page on Amazon. (See the bottom of this post for an example.)

I also use a widget that promotes my most-related book in the sidebar of every post. But it gets a much lower conversion rate than the end-of-post promo.

How do you get book reviews?

It depends which type of review you’re talking about.

In my experience, reviews from independent bloggers (as opposed to people writing for larger publications) are usually only of minor importance. It would be typical for a very positive review to sell just a few copies of your book.

Conversely, positive customer reviews on Amazon are tremendously helpful. My most successful method of getting customer reviews has been to include a prominent section at the front of the book requesting feedback from readers. When you get compliments, thank the person, and ask if they’d be so kind as to copy/paste the compliment into a review on Amazon.

Again, if you have other questions, please feel free to ask.

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