Gen Y - Retire Rich!

Post #75 - How Long Until you get your Money Back?

Post #75

Part 3: Money and Investing (continued)

How Long Until you get your Money Back?
It takes an average of 3.5 years to get your money back after a market decline.    That’s assuming you don’t sell out and you rebalance your positions yearly.   For markets that have gone down by more than 40% (like this one), it takes about 5 years.

During the last few months of 2008, we all got officially whomped!  We may continue to be mini-whomped for a few more months or years.  Nobody can predict the future.

If you have not panicked yet, please continue to stick with your asset allocation strategy.  Eventually, you will be back in the plus column.  Will it be 5 years from now?  Who knows?  I’m guessing ten years, as a worst case scenario.  But that’s just a guess.  In the meantime keep saving and investing per your plan.  You will be buying equities while they are down, which means that you will get a big boost when the market rebounds.  You are in a much better position than I am.  I don’t earn any money, so I can’t invest new money into a down market.

Even when the market doesn’t go into free fall, most investors still don’t do as well as they should.  Jason Zweig is the personal finance columnist for the Wall Street Journal.  Prior to that, he wrote for Money Magazine.  He’s also written a couple of books about investing.  Here is a quote from one of his articles about people who invest with mutual funds.

Stunningly, while the average fund generated a 5.7% annualized total return over the four years, the average fund investor earned just 1%. In every category except two (equity income and utilities), investors earned less than their funds did.

That’s just crazy.  Sounds impossible.  If you invest in a fund, and the fund returns an average of 5.7% over a four year period, how can you screw up so badly that you wind up with just 1%?   The main reason is that you are impatient.  You don’t hold the fund for the whole four years.  You keep switching your money around from one fund to another, chasing last year’s good performer or next year’s sure winner.

Here is an over-simplified version of how you can screw up your pile of money by switching back and forth between two funds.  Assume a starting balance of $10,000. 

As you can see, if you keep switching it will hurt your portfolio’s performance.  I didn’t consider taxes or fees, which would make things even worse.

So the moral is to have a plan and stick with it.  Don’t make silly fund switches or change your allocations from one year to the next.  It will only hurt your performance.

Post #74 - How come every asset class is going down?

Post #74

Part 3: Money and Investing (continued)

How come every asset class is going down?
The reason for allocating your assets among different asset classes is to diversify your portfolio.  In that way, when one asset class is going down, the other asset classes may be going up.  This is a way of reducing risk.  Modern Portfolio Theory tells us this, and MPT works.

Well, it obviously doesn’t work all of the time.  Because right now, everything sucks.

So what is happening during this meltdown?

• Money market funds are yielding piddly.    
• Most bond funds are either even or down a little bit.  But the reason you bought bonds was because they wouldn’t go down in a crisis.  So they are not doing the job you hoped they would do.
• US equities are getting hammered.  This includes small cap, mid cap and large cap funds.
• International equities are getting hammered.
• Emerging markets are getting double-hammered.
• REITs are getting hammered.

The only good news about your diversification is that bonds are not getting hammered as badly as everything else.  So the 20% or 30% or whatever part of your portfolio that is invested in these asset classes is treading water or slightly down.  Everything else stinks.

By the way, gold is also down, as are commodities, as are every other conceivable asset class.  Further diversification would not have helped in this crisis.

I was reading in USA Today that in this meltdown, everyone is looking stupid, which doesn’t make me feel any better.

We have proved one thing.  Your single most important decision, the one that makes all the others pale by comparison, is what percent of your portfolio is in equities vs. what percent is in bonds/cash.  

If you started this crisis 80% in stocks, you got hammered a lot worse than those who were 50% in stocks.  How much you had in international versus small cap versus large cap has been almost immaterial compared to how much you had in stocks versus how much you had in bonds.  That has been the real determinant of how much you have lost so far.  Since I was at 60/40, I probably am doing better than most Gen Y people who are more aggressive.  

I’m not saying you should have been 60/40.  You guys are young and should have been more aggressive than I am.  When stocks come back, those who are 80/20 or 70/30 will do better than me.

All we can do at this point is understand a few basic things:

• Diversification is still important.
• During incredibly bad times (and this is one) diversification isn’t going to matter a whole lot.  You are still going to get hammered.
• During the rest of the time, diversification helps.
• Bonds, US stocks, and International stocks are essential.
• REITs are not, but they are good diversifiers.
• Eventually, the bad times will pass.  I can’t prove this other than by saying that every other bad time has passed.
• The big mistake is to sell at the bottom and give up on equities.  Over the long haul, investing a portion of your portfolio in equities will give you a larger pile of money.

Q&A #18 - Can my parents serve as my emergency fund?

Question & Answer #18

Q: Can my parents serve as my emergency fund?
A: If your parents are really and truly financially secure, and are absolutely willing to give you $20,000 if things go south in your life, go ahead and use them as an emergency fund.  This does not mean that you should invest 100% of your own money into equities.  You still need to keep at least 20% in cash/bonds.  Why?  So you don’t panic in a crisis (like the one we are wading through right now).  You always want at least 20% in cash/bonds.  I know that I’m conservative here.  Other people say that if you are young you can commit 90% or 100% to equities.  I just don’t believe that’s a good idea. 

By the way, don’t assume your parents will help you out.  Ask them if they will provide money for you to live on during emergencies.  This should be a serious discussion where you:

• Define the word “emergency”. 
• Decide on whether interest will be charged.
• Decide on the terms of paying back any money they give you.
• Decide on whether or not you need to sign a contract with them.  Some parents may insist on a contract, others won’t care.

Even without a “contract”, it’s still a good idea to put everything in writing, so nobody says they don’t remember the terms.

If you have at least one sibling, or step sibling, the answer is more complicated.  Especially if you have a good for nothing sister who your parents wouldn’t give a dime to.  She would be royally annoyed if they agreed to help you out.  If you don’t want a war with your sister down the road, maybe you should set up your own emergency fund.

Of course, your siblings might already be mooching like crazy from your kind, good-hearted parents.  If you’re the only kid who is responsible and working and saving and investing, I’ll bet you resent your parents slipping a couple hundred to your sister every month so she can meet the rent on an apartment that she really can’t afford because she works part time as a fact checker for a start up newspaper in SoHo.  But she always has money for parties and getting her hair done, etc., etc.  Did I hit a nerve?  The point is that money makes family relationships crazy sometimes, so be careful about asking your parents to be your emergency fund.  Your siblings might look at you as the moocher, even before you have a true emergency and actually need the money.

One more note about emergency funds.  You can withdraw your contributions (not the earnings) to a Roth IRA at any time, with no penalties or tax payments.  Now that I’ve told you this secret, I also tell you “Don’t do it!”  You don’t want to have the attitude that you can raid your Roth IRA in a pinch.  Once you start thinking that way, it’s easy to move away from your savings goals.  You start hitting up the Roth every time you need something that costs more than $200, and there goes your retirement.

But if your back is to the wall, and your parents can’t help, this is your final source of emergency cash before you go to Frankie the Fingerchopper for a loan.

Post #73 - Bond Fund – Summary of Information I’ve Given You

Post #73

Part 3: Money and Investing (continued)

Bond Fund – Summary of Information I’ve Given You
In the last five posts, I’ve talked a lot about bond funds.  I’ve given you too much information.  Your head is probably spinning.  What should you do? 

• Remember that the most important decision is what percentage of your portfolio you should put into bonds versus equities.  The decisions I talk about in the following bullets are minor by comparison.
• For now, put your bond money into a Short Term Bond Fund.  I gave you two choices, and I’ll let you pick which one.
• I don’t think we’ll see any inflation in the very near future.  Heck, look at how quickly oil prices have come down.  This is deflationary.  But Warren Buffett thinks that the policies the government is employing to combat our current problems will eventually prove to be inflationary.  Warren is usually right about these things.  So you might want to convert some of your short term bond fund to TIPS somewhere in the future.  Remember that TIPS usually offer lower yield, but they provide protection against inflation. 
• When rates are high and about to decrease, buy the Total Bond Market Index Fund.  That’s because the Total Bond Market Fund buys bonds that have longer maturities than the Short Term Bond Fund.  You will lock in the higher rates for a longer period of time.  When rates are low and about to increase, buy the Short Term Bond Market Index Fund.  It owns bonds with shorter maturities, and as these short term bonds mature, it will be able to pick up higher yielding bonds more quickly.
• If you do not want to track inflation and interest rate trends, just go with the Short Term Bond Fund 100% of the time.  It’s easier, and over the last 50 years short term bonds have given investors decent returns with little risk.  This is what I prefer to do.  But if you are willing to take on a little more risk, go with the Total Bond Market Fund and stick with it during all cycles.  Your returns will be slightly higher than the short term bond fund.

Hey, that last bullet sounds good!   Use one bond fund for your portfolio, and stick with it through low rate periods and high rate periods.  It’s the simplest option and it works!   I recommended the short term bond fund in earlier posts, because it is a little more conservative.  But the Total Bond Market Fund is just fine for those who want a little more return.

One last note about bonds and other “fixed income securities”.  At this point you know almost nothing.  There is tons more to learn.  Trust me, it ain’t worth it.  You’ll do just fine using this post and the previous five to decide on your strategy.  Don’t let some fast talking stock broker try to sell you more complicated stuff.  My way is easy, doesn’t take much time to implement, and it works.

Post #72 - Are TIPS Good Investments?

Post #72

Part 3: Money and Investing (continued)

Are TIPS Good Investments? 
Treasury Income Protected Securities (TIPS) are lower yielding bonds designed to protect you against inflation.  See this link for a good definition: Treasury Inflation-Protected Securities (TIPS).

As of November 3, the Vanguard Inflation Protected Securities Fund yielded 2.89% and had lost 7.43% in 2008.  Many experts think that half of your bond holdings should be TIPS, just in case inflation sneaks back.  Nobody recommends trying to figure out when inflation will hit.  You can’t do that.  So they tell you to put half of your bond holdings into TIPS forever, grit your teeth and live with the lower yield, and offer praise to Buddha if inflation hits and TIPS save you with their magic.

I don’t own TIPS.  I’ll take my chances using short term bond fund when rates are lower and the Total Bond Index Fund when rates are higher.  That’s all the calculating I want to do.  However, if you are worried about inflation, then sink half your bond money into the Vanguard Inflation Protected Securities Fund and keep it there forever.