Calculate Your Diversification Benefit

So how does diversification really impact the long-term return of your portfolio? I had the same question, so I set out to create a realistic model (which you can play with below).

To create this tool, I selected 5 asset classes: the S&P500 Index; the Russell 2000 Index; the Dow Jones Industrial Index; real estate assets as represented by Vanguard's Total REIT Index Fund (VGSIX); and global stocks as represented by Vanguard's Total International Index (VGTSX). To create this tool I selected the period starting on March 1, 1997 and ending on March 1, 2008 (for no particular reason). I downloaded from Google Finance the value for each asset class on the 1st calendar day of each month within the period.

To use the calculator, enter your starting portfolio value, allocate funds to each of the five asset classes using the sliders - note that the asset classes can amount to more or less than 100% of the portfolio. The tool will graphically display your portfolio's total period risk vs. return compared to each of the asset classes.

The benefits of diversification should be pretty clear. For example, a portfolio comprised of 50% in the S&P and 50% in the REIT index has an expected return which is higher than that of a portfolio of 100% stocks, while exhibiting a lower risk profile than either asset class on its own (as measured by the standard deviation).

Finally, two caveats: there are clearly two major asset classes missing from this calculator - cash and bonds. The reason for this is that the methodology I used made it too cumbersome to factor interest into my calculations. Please also note that dividend payments are missing from the tool for all asset classes.

Enjoy, and as always, let me know if there are any other calculators that you would like to see.

Check out some of my other calculators:
Latte Factor Calculator
Cross Over Point Calculator
Value of Savings Over Time
Retirement Savings Goal Calculator

Want to Know What Everyone in Your Company is Making?

Earlier this week I received via e-mail an Excel file that I needed for a project that I am working on. When I opened the Excel, I noticed that it contained many more tabs than I was expecting, and one of those tabs listed the salaries of EVERYONE in my company, including every executive and the CEO.

Could you resist taking a look? I couldn't. Here is what I found out: I am the lowest paid executive in the company, which is not surprising given that this is my first executive position. What surprised me was the fact that the difference between my pay and that of the highest paid executives (other than the CEO) was fairly small - about 25%. Interesting.

I also found out that some of the engineers in the company make about the same salary that I make. Once again, this does not surprise or dismay me. Some of these guys are very, very experienced and fill positions that are in extremely high demand. The only discovery that really surprised me was that a particular individual - who the CEO last week proposed to add to my team - is making more than me. If he does end up on my team, and I would officially be told his compensation package, I wonder how the CEO is going to explain the fact that one of my team members is more highly paid than me.

The real benefit of getting this information is the fact that per my employment conditions my salary will be reviewed in 5 months from now. I now know exactly what compensation I should be negotiating for. If you are about to ask for a raise or enter into salary negotiations, and do not gain such serendipitous access to internal documents, check out this post about how to find out what your market value is.

Do you think I crossed an ethical line by looking at the document?

The U.S. Tax System is Screwed Up

Before I start down this path, let me say that I consider myself very fortunate. What follows is meant as a critique of the U.S. tax code, and should not be read as a personal complaint, although, I must say that I do find this situation both frustrating and perplexing.

Today is tax day. Yesterday our returns were finally completed by our tax advisor (the reason that they were so late is another story which I will cover at a later time), and it turns out that we owe... wait for it... over $12,000. Yikes. So how could this be? A number of reasons but here is the biggy: Alternative Minimum Tax. Good ol' AMT.

Yes, in absolute terms my wife and I make a very good living. Most people in this country would trade places with us pretty quickly. In other parts of the country our income would certainly make us wealthy, however, here in Silicon Valley we are not even close to wealthy. As readers of this blog know, I have written many times against buying a house as an investment. My wife and I rent. However, on Sunday we went to see a model house in a new development in our neighborhood. Let me put things in perspective. The house, while new and nice, was a three bedroom townhouse, with no yard. The cost? $1.3 million. Let me be very direct here: there is no way on earth that we can afford to pay that price for a house (or for anything else), and this was NOT a fancy house.

So here is the way I see it. We cannot afford to buy even a modest house in the town in which we live - in my mind that means that we are not wealthy. However, because we have three kids and live in a state with high income taxes (California), the Federal Government considers us wealthy and hits us with the penalty rich man's tax.

In my business travels, I spent much time in South Carolina, Ohio and other places around the country. If we made anywhere near our income level elsewhere in the country (with the exception of Manhattan), we would be able to afford very nice houses, and could legitimately be considered wealthy. However, here in Silicon Valley we are simply middle class.

Why is the Federal tax code not indexed for cost of living in the various states? Why are citizens living in expensive parts of the country being penalized?

Late Payment on AmEx - Happy Resolution

Every few months, for whatever reason, we forget to pay one of our credit cards on time. Usually our payment is just a few hours late or at worst a day or two, but this time my wife only remembered to pay-off the card after I told her Quicken was showing a late fee of $38 and finance charges of $43. That's a total of $81 for a payment late by approximately one week. We really had no good excuse this time.

Luckily, because our mistakes happen infrequently, and usually not on the same card, we are usually able to reverse the charges. This time was no different and American Express refunded our money. Nevertheless, we really need to stop making those silly mistakes.

Stupid Financial Advice Revisited

Back in November 2007 - a mere 5 months ago - I wrote a post about some really stupid financial advice that I heard a financial commentator utter on TV. The advice related to Google stock, which at the time crossed the $700 mark. The commentator advised her viewers that even though Google stock was expensive, buying a single share of Google stock was a better investment than buying many more shares in "weaker companies".

Let's see how that clear case of performance chasing advice panned out. On November 4, the day this brilliant piece of advice was inflicted on the population at large, Google stock hit an intra-day high of $730 per share. As of the market close yesterday, the same stock was worth $457. It turns out that if you had taken that steaming pile of financial advice you would have lost 37.4% on your money within a few short months.

What does this story teach us? Well, here are a few lessons:

1. Don't trust financial advice from unqualified sources - there are plenty of people spewing financial advice left and right (this blog included). Don't trust it. If you want serious financial advice look for reliable sources and do your own research.

2. Don't chase performance - the reason the illustrious TV commentator graced us with her disastrous piece of financial wisdom is that Google stock has been on a tear for months prior to the date of the recommendation. Not being a particularly bright individual, the commentator simply extrapolated the past trend into the future. Well, if it has gone up this quickly in the past, shouldn't it continue to climb indefinitely? Nope.

3. Performance tends to regress to the mean - if an asset class did really well in the past, and is now becoming the common wisdom, "can't go wrong" investment (see real estate until last year), chances are that it is about to take a major tumble at some point. Don't get cocky, however, irrationally buoyant asset price increases can last long after the rational voices start calling a bubble. If you try to bet against a bubble you may well find yourself losing money hand over fist, before the bubble eventually pops.

I am sticking to my index funds, thank you very much.

Time to Jump Back Into Stocks and Real-Estate?

As I have previously written, I have been gradually putting more money into the stock market over the past several months. Now, however, I am getting a feeling that the bad news has finally been priced into the stock market. Even Bernanke is finally talking about a recession, and even the clueless National Association of Realtors is finally admitting that housing is in decline and that recovery may be a ways off. With all this negative talk it seems to me like the stock market may actually be ready to start a gradual bounce-back over the next several months.

Don't get me wrong. I expect volatility to continue for some time to come, as yesterday's dramatic gain in the markets clearly demonstrated. However, it is possible that the long term trend may be about to turn positive. Since I am not a believer in hunch investing or in market timing, I will continue my disciplined and deliberate approach of regularly investing the same amount of money on the 15th day of every calendar month, regardless of what the market is doing.

What is new for me is the sense that real estate may actually be turning into a reasonable investment. And, even though I have previously written at length in praise of renting vs. owning a house, I am now, for the first time ever, toying with the idea of buying a house. Even here, in the most expensive part of the San-Francisco Bay Area, prices seem to have mitigated somewhat and the number of houses on the market has increased substantially. It used to be that the asking price was a mere starting point for a furious bidding war. This seems to be a thing of the past, at least for now. My wife and I have noticed houses staying on the market longer, and a larger number of open houses in our neighborhood are held not just on Sundays but on Saturdays as well. Even more intriguing is the fact that a house on our street was recently sold below its asking price. Am I still living in Northern California? Is this a sign of the end of days? (repent!)

For now, prices in this area have not declined siginificantly, but I have a hunch that we may be seeing some declines in the near future. Our current lease will be up for renewal in October. Would this be a good time to jump into the real estate market? Should I abandon my long held beliefs in diversification and in the long term supremacy of the stock market and sink our hard earned savings into bricks and mortar? I don't know, but for the first time in a very, very long time, I am starting to think that this may be a sane option. What do you think? I am interested in hearing from everyone, but especially folks from the Bay Area.