Gen Y - Retire Rich!

Post #71 - Inflation affects your portfolio returns

Post #71

Part 3: Money and Investing (continued)

Inflation affects your portfolio returns
When people talk about the rate of return you get from your investments, they are normally referring to “total return” as opposed to “real return”.  Real return is the total return minus the inflation rate.   See: Real Rate Of Return.

The inflation rate is the general increase in the price of goods and services over a period of time.  If the inflation rate is 2% this year, one dollar will buy 2% less a year from now than it can buy today.  If your portfolio return is 8% in a given year and the inflation rate is 2%, your real return is 6%.  Real return is more important than total return, because it’s a better reflection of whether you are winning or losing the money battle.

Economists predict the future inflation rate all the time, but they are really gazing at their navels when it comes to figuring this stuff out.  Don’t pay too much attention to them.  Nobody can tell you ahead of time what the inflation rate will be over the next ten to forty years.  It’s much easier to look back and see what inflation has been than look forward and guess what it will be.  Here is a look back at the monthly inflation rates:  Current Inflation.

You should assume that inflation will be around for the foreseeable future.  I quote from Warren Buffet’s Op Ed piece that was referenced in post # 64:

"Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts."

This does not mean that the inflation rate will immediately jump.  In fact, with oil prices coming down in early November, there is a case to be made that we will be seeing some deflation (the opposite of inflation).  Check this article: Deflation lurks as global demand declines.

If we do experience deflation, I think it will be short lived.  I’m gazing at my own navel when I say this, and I’m not even an economist.  Who knows what will happen with prices?  I just can’t imagine that they will stay down for very long.

So my target asset allocation is 60% equities and 40% bonds/cash.  In April I will have to rebalance to get back to that.  This gives me an edge during slightly inflationary times, and won’t kill me if we experience deflation.  I just don’t want to take too many risks any more.

Post #70 - What about buying Individual Bonds, instead of a Bond Fund?

Post #70

Part 3: Money and Investing (continued)

What about buying Individual Bonds, instead of a Bond Fund?

NO!

There, I’m glad I got that off my chest.

What, you want an explanation?  OK. 

• When you buy individual bonds, if you are investing less than $1 Million at a time, you will get hosed on the bond markup that the broker secretly adds into the transaction (that’s how he makes his money).  A Vanguard bond fund has a low annual expense ratio, which winds up being a much less expensive way to own these things.
• A Vanguard bond fund gives you great diversification.  You would not be able to give yourself the same diversification buying individual bonds.
• All bonds (Except US Treasury Bills, Notes, and Bonds) have a risk that the bond issuer might default and not pay back your money when the bond comes due.  Your risk of losing a lot of money if one of the bonds in an index fund defaults is very low.  On the other hand, if you buy ten individual bonds and one of those defaults, your spouse will make you sleep with the pet iguana for a few months.

Post #69 - Short Term Bond Fund or Bank CD?

Post #69

Part 3: Money and Investing (continued)

Short Term Bond Fund or Bank CD?
If you have paid attention to the last two posts, you might be asking yourself, “Why don’t I just forget investing the bond portion of my portfolio in a Short Term Bond Fund and put the money in a Bank CD?"

After all, today (November 3) a one year Corus Bank CD yields 4.45%, while the Vanguard Short Term Bond Index Fund yields 3.59%.  The Vanguard Short Term Investment Grade Bond Fund yields 5.93% (mainly because it has decreased in value by more than 5% so far this year).  If you were deciding on which option you should use for the “bond” portion of your portfolio, your thought process might go like this:

“The Investment Grade Fund has a nice yield, but it’s already lost more than 5%.  What if it goes down some more?”

“That leaves me two choices.  I’ll take the one year CD.  It’s safer and has a better yield!”

I don’t subscribe to that thinking, but I can see why it might occur to you.

My main objection is that if you put your “bond” money into a CD, what happens when it comes time to rebalance?  You have to wait until the CD matures before you can do it.

If the one year bank CD offered 10% and the bond funds yielded 4%, I would be tempted.  Right now, I would stick with the bond funds for the “bond” portion of your portfolio.

By the way, a few years from now, when rates are higher, you should be looking at moving your “bond money” into the Total Bond Market Index Fund.  The fund holds bonds that have longer maturities than the short term bond funds.  When rates are higher, it offers better returns at slightly higher risk.  This should be your bond mantra as you go through life “When rates are high and about to decrease, buy the Total Bond Market Index Fund.  When rates are low and about to increase, buy the Short Term Bond Index Fund.”  However, if you don’t want to worry about following interest rates, then stick with the Short term Bond Fund for maximum safety and decent returns.

Post #68 - My bond fund recommendation has lost value

Post #68

Part 3: Money and Investing (continued)

My bond fund recommendation has lost value
My bond fund recommendation, Vanguard Short Term Investment Grade Bond Fund (VFSTX), has lost more than 5% this year, while the Vanguard Short Term Bond Index Fund has made about 1.46%.  The Vanguard Total Bond Market Index Fund has lost 1.9%.

So, which short term bond fund is better for the next few years?

First, remember that the most important consideration is: What percentage of your portfolio is invested in bonds/cash?  This has a far greater affect on your ultimate pile of money than the individual fund you pick.  If you don’t believe this, go back and re-read my posts on Modern Portfolio Theory.

Having said that, I’m annoyed that I seemed to have picked the wrong fund.

The Short Term Investment Grade Fund is a reasonable fund to own.  It’s been around twice as long as the Short Term Bond Index fund and it’s twice as big.  Unfortunately, it is more a corporate bond fund, while the index fund is more a TreasuryBond/US Government Agency fund.  It owns bonds that are slightly more risky and provide slightly better yield.  When everyone panicked this year, they piled into Treasury Bonds and Government Agency Bonds.  Higher demand equals higher price.  The Investment Grade Fund went down and the Index Fund went up.  The Investment Grade Fund now has a substantially higher yield, because it went down.

Keep in mind that when a bond index fund decreases in value, it still won’t result in a loss to you unless you sell the fund.  Why?  Because the fund managers will hold the bonds until maturity.  The bonds will mature at the exact bond price, even though the current value of the bond is priced lower than that by the “market”.  This does not necessarily apply to managed bond funds, where the managers might be wheeling and dealing, selling under priced bonds, and buying different ones.  Technically, the Short Term Investment Grade Fund is a managed fund, but the managers are not wheelers and dealers.  So the -5% performance this year will go away by the time all of the current holdings mature (average time for this is a little less than 2 years).

This is what I think (with emphasis on the word “think”):

• The Short Term Investment Grade Fund managers will hold their under priced corporate bonds until maturity, and thus the -5% performance you see now will be eliminated within the next 2 years.  There might be a slight loss if some of the corporate bonds default, because a default means the bonds don’t get paid.  Since the vast majority of the portfolio is high quality bonds, you shouldn’t see any defaults.  But there could be some.  Nothing is guaranteed.
• The index fund is marginally safer (less corporate bond exposure) and it has a slightly lower annual expense ratio. If you are worried, switch to the index fund.  But if you do this, understand that you are locking in a loss of 5% that will probably disappear within 2 years if you don’t sell.
• If you haven’t started investing in bonds yet, use the Short Term Index Fund when you start investing.  Simply because it is a little bit safer.
• Don’t worry too much about this particular decision, because it is small potatoes next to the much more important decision of “What percentage of my portfolio should be in bonds/cash?”

Post #67 - Money Market Fund Yields are Really Low

Post #67

Part 3: Money and Investing (continued)

Money Market Fund Yields are Really Low
The Vanguard Prime Money Market Fund yield is low compared to bank money market funds, bank CDs, and some bank savings accounts. 

This does not mean that Vanguard is having a problem.  All fund company Money Market Fund rates are very low.

Vanguard has joined the Treasury Guarantee Program to give you some assurance that if something crazy happens, your deposits in their money market funds as of September 19 are safe.  Here is a link that explains things more clearly.  Vanguard money market funds participate in Treasury Guarantee Program.

This means that anything that you had in the money market funds on September 19 is guaranteed until December 19.  Then they re-evaluate the program.  But if you added money after September 19, the new money is not guaranteed.

I am not worried about Vanguard’s Money Market Funds losing money.  First, because I don’t think a fund company the size of Vanguard will have any problems.  And second, because the Treasury Guarantee program will protect all balances you had as of September 19.  But I am worried about the low yield.   I recommend that you put your emergency fund money and house fund money into a bank.

Look at money market accounts, CDs, and savings accounts offered by banks that have FDIC insurance.  The FDIC insurance is $250,000 per depositor through December 31, 2009.  And the rates are higher than you can get at Vanguard (or Fidelity, or T. Rowe Price, or any other fund company) right now.  Check with your local bank, or on-line at Corus Bank or ING Direct.

This is an interim move.  You can put your money back in the Vanguard Money Market Fund when rates get better.  I don’t know when that will be but I will let you know when it happens.

I know.  At the start of this blog, I said we would keep things simple.  I never anticipated back in March that I would recommend something like this.  Unfortunately, life intervened.

Post #66 - When someone sells a stock, someone else has to buy it

Post #66

Part 3: Money and Investing (continued)

When someone sells a stock, someone else has to buy it
You might think that everyone is getting out of the stock market.  Au contraire, mes amis.  Some people are buying.

Here is a really simple explanation of how selling shares of stock actually works.  Pardon me if I am insulting your intelligence with this explanation.  I just want to make sure we are all on the same page.

• I decide to sell my holding of stock XYZ.
• I tell the broker to sell the stock at a specific price, let’s say $25 per share.
• If nobody is willing to pay $25 per share, the stock does not get sold.  I still own it. 
• Eventually, I realize that $25 per share is too high, so I tell the broker to sell the stock “at the market”.
• The broker goes out and says, “Will anyone buy this stock, and what price are you willing to pay?”
• Someone puts in an order to buy shares of XYZ at $20 per share. 
• My broker sells the stock at $20 per share.
• $20 per share becomes the new market price for XYZ shares. 
• If the previous transaction for XYZ had been at $30, then the market price of XYZ just plummeted by 33%.  Everyone who owns XYZ shares just lost 33% on paper.

When there are lost of sellers and only a few buyers, the buyers try not to be dumb.  They offer low ball bids for stock.  If the sellers accept these bids, the stock price drops to that level.  You can see how prices of individual stocks can drop through the floor if everyone is trying to sell in a panic.  But understand that for every share sold, someone is buying.  You can’t sell a share if nobody is willing to buy it.

This means that despite the current panic and the ever mounting paper losses, someone is out there buying each and every share sold.  And they are getting the shares for significantly lower prices than they would have paid one year ago.   Some people see great value in the shares that most people are dumping.

Who is doing most of the buying?  I don’t know.  Day traders are probably doing a lot of buying, and then selling the same shares a few days later when a little rally hits the market.  Similarly, hedge fund managers are probably buying at low points, waiting for a rally, and dumping the shares.  This explains the see saw action of the markets to some degree.

Should you be buying?  Sure, when you rebalance.  I mentioned in an earlier post that if you are really aggressive, you can rebalance early to try to get in on the low prices while they last.  However, the prices may go lower.  Nobody can predict the short term swings of the market.  Nobody can tell you if the market will bottom tomorrow or in two weeks or in two months or in two years.

Should you temporarily change your asset allocation from a stodgy 60/40 to 80/20 because you think that the market will rebound?  No!!  You stick with your plan.  You can’t keep changing allocations because you have a feeling about the market.  I guarantee your feelings will be wrong most of the time.

All I can say for certain is that the world is getting to be a better place to live, and will continue to get better.  That’s the one big assumption of this blog.  If you believe this, then you can be secure in knowing that the markets will be higher in the long term.  Follow my recommendations and you will enjoy the gains of the market.  You will also outperform the majority of private and professional investors, who don’t have the discipline to do things the right way.  Plus, you won’t need to spend a lot of time and effort matching the gains of the market.  My recommendations are easy to implement and easier to follow during the course of the years.

If you don’t believe the world is continuing to be a better place to live, then you shouldn’t be in the market, ever.  Build a bunker in your back yard and stock it with lots of provisions.

Notice how I keep repeating the same things in this blog.  As I said early on, investing is easy.  There aren’t a lot of tricks.  But staying the course, especially in tough times, is really hard.  Which is why I keep repeating the main points.  So you don’t waver.

Post #65 - Is Dollar Cost Averaging a Good Strategy?

Post #65

Part 3: Money and Investing (continued)

Is Dollar Cost Averaging a Good Strategy?
Let’s recap what we are doing:

• Saving 20% of our gross annual salary.
• Creating an asset allocation plan that puts 80% of our investments into equities and 20% into bonds and cash.  This is for the most aggressive investors.  Everyone else should have a plan of 75/25 or 70/30 or 65/35 depending on how well you can handle incredible panics like the one we are still working through.
• Using a minimum of three low cost index funds, Vanguard Prime Money Market Fund, and a checking account to implement the plan.  We can use a few more funds if we want to get a little fancier, and it still won’t be a lot of work to maintain the portfolio.
• Setting up an emergency fund.
• (Optional) Setting up a house fund or a fund for any purchase we know we have to make in the next 5-10 years, like a new car.
• Investing in the 401K plan at work, an IRA plan we set up ourselves, a taxable account, or any combination of the three.
• Putting the money into our investments as we save it, which means we are dollar cost averaging.
• Rebalancing our portfolio every year.

Click on the link to get the official definition of Dollar cost averaging.  This is a fine strategy, because you are putting your money to work as you save it. 

But what if you get a big chunk of money from Grandma Skinflint?  Should you dollar cost average that money into your portfolio?

The answer is NO!

Statistically, it is better to invest the whole amount right away rather than slowly.  That’s because historically, the market goes up more days than it goes down.  I bet you didn’t know that!!

Of course, statistics aren’t guarantees.  I can’t absolutely guarantee that you will be better off if you invest everything at once.  All I can tell you is that that there is a higher probability you will be better off. 

Many brokers and investment sales people will tell you that you should invest the money by dollar cost averaging.  

The reason they tell you to dollar cost average is because they know you are worried about investing the whole chunk at one time.  They figure (and they are probably right) that you would be more willing to invest a little bit at a time.  It’s a psychological thing.  They want to make the sale, and the best chance they have is to offer you something that you would be more ready to accept.  They won’t tell you that statistically, this is the wrong move. 

If you feel more comfortable with investing a large bag of money via dollar cost averaging, go ahead.  If it gives you more peace of mind, that’s fine with me.  Don’t worry about the fact that it may not be the best play to make.  It’s the only one that you are psychologically prepared to make and it’s much better than no play at all.  But statistically, it’s better to put all the money to work at once. 

Some of you may be new to this blog.  If you want more detail about anything I am talking about, just re-read my earlier posts.  The blog is designed like a book.  If you start at the beginning and read forward you will get everything you need laid out for you on a platter (or in this case a fancy computer screen).