Save and Conquer

I was talking to my wife the other day about our investments. Our overall holdings are what would be termed a moderate asset allocation of stocks and bonds using low-cost index mutual funds and ETFs. Somehow it came to light that she had a little over $10,000 in cash sitting in her Roth IRA. I think these were the last two year’s contributions that she just never got around to investing.

Because my wife is younger than me, her retirement accounts will not be available to us without penalty when we actually retire. Because of this, I have recommended that she invest all of her Roth IRA funds in the total stock market as soon as new funds are added.

I tend to look at our joint and my retirement accounts about once a week. That is probably too often, but as long as I do no more than look, it doesn’t hurt anything. My wife apparently doesn’t much look at her accounts.

Many studies say that looking at retirement accounts too often can be detrimental because you will tend to want to do something as the market swings up or down. They say that men are “more prideful and overconfident, tend to take too much risk, and they over-trade.” Women are better able to control their emotions, look for less risk, and thus often have better returns. Talking about emotional investing, John Bogle of Vanguard fame often says, “Don’t do something, just stand there.”

On the other hand, I am concerned that my wife doesn’t look at her investments often enough. She missed earning $2,500 over the last two years. Of course she was not happy when I pointed that out.

I would say that everyone should look at their retirement accounts at least once a year, and rebalance their asset allocation if necessary. You may want to look more often, such as once a month, to make sure new funds are going into the asset class that has gone out of balance. This will help to rebalance your asset allocation using new savings with no need to sell and buy from one asset class to another.

Nolo press provides many self-help resources that can save you lots of money. Most people do not actually need a lawyer to write a simple will or health directive. You can do it yourself using forms and instructions from Nolo Press.

Nolo recently published a book that I have to disagree with, though. It is called “Fight Your Ticket & Win in California.” The main method the book propounds to fight a ticket is to insist on a jury trial and hope that the ticketing officer does not show up at court. This is a very risky strategy. If the officer does show up, you will almost certainly have to pay the maximum fine plus lawyer fees.

A better strategy is to try to lower the penalty for a ticket by asking the judge at the initial hearing if you may attend traffic school. You may also come out ahead if you admit to your guilt and ask for a reduced fine.

An even better word of advice is to avoid the ticket in the first place by obeying the law. Don’t speed and always stop at stop lights and stop signs.

Be respectful if you are pulled over. Address the police officer as “Officer.” Admit to nothing but be as professional and friendly as you can be. Roll down your window and keep your hands in view on the steering wheel until asked to provide your license, registration, and proof of insurance.

If you are speeding and you see a police officer, reduce your speed and move over as quickly and safely as possible into the slow lane. Travel the speed limit or even a bit below. You want to appear as cooperative and non-threatening as possible.

Bottom line: avoiding a ticket is a much better strategy than hoping to bottle up the court system with a jury trial.

I probably listen to too many podcasts, but have found quite a few entertaining ones on iTunes that are free. I may be stating the obvious, but you do not need an iPod or iPhone to listen to podcasts. You can also listen directly through iTunes on a Mac or Windows computer.

My all-time favorite podcast is History According to Bob. From his website, “Professor Bob loves to tell stories of the real people behind the often sterile descriptions found in history texts. His conversational style, filled with anecdotes, quips, and humor, will bring to life the characters of history.”

Other free podcasts that I subscribe to are the NPR Science Friday, In Our Time, and A Way With Words.

There are many learning resources on iTunes that are also available for free. There’s MIT, Stanford, Yale, Virginia Tech, and University of California to name a few. “Open University” has many courses that are tailored to people that are not necessarily trying to earn a degree, but are just looking to enhance their lives with knowledge. Click on the iTunesU tab within the iTunes store to access most of these courses for free.

Free books are available in the iTunes store by clicking on the Books tab, and then clicking on the “Free Books” link on the righthand side of the page. Note that iTunes will not display books. The iTunes store says, “Books can only be viewed using iBooks on an iPad, iPhone (3G or later), or iPod touch (2nd generation or later).”

The quickest way to find free stuff on iTunes is to go to the iTunes store and look for a link on the righthand side that says “Free on iTunes.”  Click on that and you will be presented with a “featured” selection of free music, movie clips, TV shows, apps, books, and podcasts. This page does not show anywhere near all the free stuff that’s available, but it is a good starting place.

Suze Orman has a segment of her show where she advises people over the telephone whether or not they can afford an expensive purchase they have in mind. The callers provide their assets and debts as well as the cost of the item. People she denies are often surprised when Suze says they cannot afford the item.

In most of her denials, the problem is that the person has not saved much for retirement, holds a large amount of debt, or wants to use debt to purchase the item.

What is wrong with these people? What happened to saving before making a purchase. And even with enough savings to purchase an item, the cost should be a small fraction of a person’s savings. The only time it makes sense to go into debt for a purchase is when purchasing something that will appreciate or at least not lose value over time, such as a house. Even then, you have to be careful in how much debt you take on. From Investopedia,

“A good rule-of-thumb to calculate a reasonable debt load is the 28/36 Rule. According to this rule, households should spend no more than 28% of their gross income on housing expenses (including mortgage payments, home insurance, property taxes, and condo fees), and a maximum of 36% on total debt service (i.e. housing expenses + other debt such as car loans and credit cards).

So if you earn $50,000 per year and follow the 28/36 Rule, your housing expenses should not exceed $14,000 annually or about $1,167 per month. Your other personal debt servicing payments should not exceed $4,000 annually or $333 per month.”

Some of the callers to Suze Orman seem to have trouble recognizing that their retirement savings should be their priority. Fidelity Investments published guidelines for how much a person should have saved for retirement at particular ages.

• At age 35, you should have saved an amount equal to your annual salary.
• At age 45, you should have saved three times your annual salary.
• At 55, you should have five times your salary.
• When you retire at age 67, you should have eight times your annual pay.

Personally, I think these are a little low. We are aiming for twelve times our annual salary to be saved when my wife and I retire.

Several interesting articles point out that passive investing in index funds will always beat active investing due to cost.

Indexed Investing: A Prosaic Way to Beat the Average Investor, By William F. Sharpe

“Indexed investing is a strategy designed to match a market, not beat it. Done properly, it can be cheap and tax-efficient. After costs and taxes, an indexed investor in a market can beat the average active investor. Many investment vehicles, both mutual funds and the more recently introduced exchange-traded funds, make it possible for individuals to invest some or all of their assets in indexed strategies. This talk elaborates on these points, describes some of the more attractive funds and shows how indexed investing can be used to help obtain a globally diversified portfolio.”

The Arithmetic of Active Management, By William F. Sharpe

“Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement.”

Three Challenges of Investing, By John C Bogle

“As a group, active managers will fall short of the index return by the exact amount of the costs that they incur. The central fact of investing, then, is this simple proposition: Investment success is defined by the allocation of financial market returns—stocks, bonds, and money market instruments alike—between investors and financial intermediaries. Gross return minus cost equals net return. If the data we have available to us do not reflect that self-evident truth, well, the data are wrong.”

The Case For Indexing, Vanguard Research

“Indexing has experienced tremendous growth since its beginnings in the 1970s. This Vanguard research paper explores both the theory behind indexing as an investment strategy and the evidence to support its use in investor portfolios. The research compares actively managed funds with unmanaged benchmarks weighted by market capitalization. It shows that the average U.S.-domiciled actively managed fund has underperformed a style benchmark with greater volatility over long time periods. The paper also finds that reported performance statistics can change markedly once survivorship bias is accounted for, and that persistence among past winners is no more predictable than the flip of a coin.”

Reading Room (Passive vs. Active) contains a plethora of links to research papers. Some are listed above. In all cases, the authors make the case that passive index funds beat active funds due to cost.

Many people are worried that now is a bad time to invest. The Dow Jones Industrial Average and the S&P 500 Average are setting all time highs. Treasury bond yields are at all time lows. Ten year Treasury Inflation Protected bonds are paying a negative real return (when inflation is subtracted from the yield). What is an investor to do?

The answer is to continue adding money to stocks and bonds in your desired asset allocation (AA). Of course, with the recent run-up of the market, it may make sense to rebalance into bonds. For example, if your AA requires 60/40 percent stocks/bonds and your portfolio is at 70/30, you should sell stocks and purchase more bonds.

No one knows the future. If the markets had no volatility, stocks would always be setting new highs. And bond yields would remain constant.  Market highs are not necessarily a bad thing. Waiting for a correction may seem like the smart thing to do, but trying to time the market is a loser’s game. There is no telling how long you will have to wait before the next correction. It could start next week. Or the market could keep going up for years. Holding cash while waiting for a correction just loses money to inflation.

From Jeremy Siegel’s book, Stocks for the Long Run,

“Many investors, although convinced of the long-term superiority of equity, believe that they should not invest in stocks when stock prices appear high. But this is not true for the long-term investor. The after-inflation total return over 10-, 20-, and 30-year holding periods after the eight major stock market peaks of the last century is shown in Figure 2-2.

A number of ‘market timers’ have boasted that they yanked all their money out of stocks before the 1987 stock crash or the 2000 bear market. But in 1987 many did not get back into the market until it had already passed its previous highs. And many of the bears of the most recent decline are still out of the market, despite the fact that most market averages have hit all-time highs. In the long run, getting out of the market at the peak does not guarantee that you will beat the buy-and-hold investor.”

According to the dictionary, a windfall is a sudden, unexpected piece of good fortune or personal gain. Very often, it is money from an inheritance.

There are several things that can be done with a windfall.

• Spend it
• Pay off debt
• Save it
• Invest it
• Give it away

The best use of a windfall is a combination of the above. Emotions are usually high when a windfall is received. Often, a loved one has just passed on. The best thing to do in that circumstance is nothing. Place the money in a high-interest savings account (or accounts if the value is higher than the FDIC limit) for several months while grieving the passing of the loved one.

Eventually, the windfall should be used to erase high-interest debt. There is no reason to carry debt if you have the means to pay it off. Investing the remainder of the windfall should then be considered.

Beware of salespeople in the guise of financial advisors. They seem to sense when a person has come into a lot of money without the expertise to invest it. It may be OK if they mention investing in low-cost diversified index funds or ETFs. It may also be OK if they suggest purchasing a Single Premium Immediate Annuity (SPIA) which will give you a monthly income payments for life. Run the other way if they suggest investing in variable annuities, though. The main reason they will suggest this is to earn a large fee from the underlying insurance company for themselves. You will eventually pay this fee, as well as other expenses over the life of the annuity. Again, do not trust anyone trying to sell variable annuities, no matter how knowledgeable or nice they seem to be. They are not acting in your best interest.

If you are looking for a “safe” investment, I-bonds are hard to beat. Up to $10,000 per tax ID (SSN or trust ID) may be invested in I-bonds each year. These are the most conservative federally-insured investment that will remain above inflation. I-bonds are purchased from the Treasury at treasurydirect.com. After that, a mixture of low-cost index funds of stocks and bonds should be purchased at an appropriate asset allocation (AA). John Bogle often uses a rule of “age in bonds” for a measure of the correct percentage of bonds in one’s AA. Some people use a more aggressive AA of stocks equal to 110-age. No matter what AA you use, your portfolio should be invested in low-cost index funds for both stocks and bonds. Vanguard, Fidelity, and Schwab all offer very low-cost index funds or ETFs.

Dr. N. Gregory Mankiw, professor of economics at Harvard, wrote an article in the NY Times in which he stated that if he could pick just one stock for someone to buy, it would be the Vanguard Total World ETF.

According to Vanguard, the Total World ETF

• Invests in both foreign and U.S. stocks.
• Seeks to track the performance of the FTSE® Global All Cap Index, which covers both well-established and still-developing markets.
• Has high potential for growth, but also high risk; share value may swing up and down more than U.S. or international stock funds.
• Only appropriate for long-term goals.

This is another admission by a preeminent economist that no one can predict the market. The only thing we do know is that diversification is important and necessary.

I sometimes watch a show on CNBC called American Greed. It has been running for 7 seasons. Wikipedia has a good description of the show:

“The program focuses on the stories behind some of the biggest corporate and white collar crimes in recent U.S. history (e.g., WorldCom, HealthSouth and Tyco). In addition, stories about common financial crimes that affect scores of everyday citizens (Ponzi schemes; real estate and other investment frauds; bank robbery; identity theft; medical fraud; embezzlement; insurance fraud; murder-for-hire; art theft; credit card fraud; and,money laundering) are also featured. Other topics have included the story behind Nevada’s infamous Mustang Ranch, and rise-and-fall pieces on highly successful, high-profile businesspeople (e.g., boy band impresario Lou Pearlman, and Mark Dreier. The series has also produced specials on subjects like Bernie Madoff’s life behind bars, and how organized crime groups (including the U.S. mafia) earn money. In season four, the show covered stories including high-profile cases such as Raffaello Follieri, Marcus Schrenker, and Sholam Weiss.”

I recently watched the episode that featured Lou Pearlman. Many people may recall that he was the creator of many “boy bands” in the ’90s. He put together the Backstreet Boys and *NSYNC, among others. He had a good thing going with his recording company. He could have lived a comfortable life and made many people happy. Unfortunately for him and his investors, he was very greedy and spent much more than his endeavors earned. He was sued by all the bands for not paying what he owed them. He also ran several ponzi schemes where he bilked investors and many large banks out of nearly $300 million. As with all ponzi schemes, his eventually collapsed and he ended up sentenced to 25 years in prison. Investors were compensated with pennies on the dollar.

I feel very sorry for the people who are taken in by the scams shown on American Greed. In many cases they lose their entire life’s savings. Most episodes prove the old adage that if something seems too good to be true, it usually is.

My takeaway from American Greed is that I will never invest in a “sure thing” and will stick to low-cost index funds run by well known firms like Vanguard or Fidelity.

For anyone who has an investment fund, be it a retirement account like an IRA or 401(k), or investments in a taxable account, there’s a very interesting short article at Vanguard’s website about how much investment fees accumulate over time. One example is that a fee of 1% will have cost you more than 25% of your total investment after 30 years.

Stopping the silent killer of returns

The annual fees are generally given as the expense ratio (ER) of the fund. Many actively managed mutual funds have an ER of around 1%. Most index funds and ETFs have ERs of 0.1% or less. The Vanguard article was a real eye opener.

The weighted average ER for all holdings in my wife’s and my combined portfolio is 0.12%. I would like it to be lower, but the only bond funds in our 401(k) have ERs of 0.45% and 0.46%. Still, 0.12% is much better than the typical actively-managed mutual fund ER, which averaged 1.12% in 2012.

The equation from the Vanguard article shows that after 30 years with an ER of 0.12%, we will have only paid 3.53% of our total accumulated investment value to the brokerage firms, rather than 28.4% from an ER of 1.12%.

I would rather keep more of our own money than let the brokerage firms have it. Just something to keep in mind.