Alpaca's 401K - More Developments

Two days ago I wrote a post about Alpaca's new 401K plan and about how we chose the ROTH 401K option for her. A comment by one of my anonymous readers changed my mind. He directed me to this post by the Finance Buff, which is extremely informative and well written. I thought that most of the arguments offered against ROTH 401K, while valid, did not apply to Alpaca and I. However, one specific argument hit right home: AMT...

The darn stealth tax. I didn't think about that when we looked at the ROTH 401K option. In 2008 we were caught by its nasty snare. In 2009 I think we will narrowly escape its grasp since Alpaca was unemployed for much of the year and worked as a part time contractor for much of the rest. However, if both Alpaca and I remain employed this year (keep those fingers crossed, people), AMT is pretty much assured. We have 3 kids, make a decent living and live in California - a high tax state. These are all crimes and misdemeanors that justify a fat fine under the American tax code. Damn it. I knew I should have opened an investment bank or mortgage company. That way we could have been getting all that taxpayer money instead of being actual... taxpayers...

Anyway, no more ROTH 401K. This morning Alpaca switched her contributions to a traditional 401K. This anonymous reader probably saved us a nice chunk of change. Thank you, anonymous. Watch the skies for that Bat Signal, in case we need you again! I guess writing this blog has some value after all... :-)

In other (good) news, Alpaca received notice today that her 401K plan was changing its fund line-up, and will from now on include an international index fund (FSIIX) with an impressively low expense ratio of 0.2%. Consequently, Alpaca will dump her previous international fund choice (allocated at 10%), reduce her Total Market Index contribution from 70% to 50% of her allocation, and will allocate 30% of her contributions to the new international index fund. This will bring Alpaca's 401K contributions more or less inline with our overall portfolio asset allocation.

Next week my own Fidelity 401K representative will be visiting our office, and I intend to make a vocal case for the inclusion of the same international index fund in our own plan.

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New Job, New 401K & Benefits

My readers know that after several months of searching for a job in a horrible job market, Alpaca has recently landed a new job. With a new job, comes a new 401K and other benefits. Here's a quick run down:

401K - like my own company's 401K, Alpaca's company uses Fidelity to run their 401K plan. One of the benefits of this is that Fidelity is one of a few providers out there that is Quicken friendly, something which I appreciate very much. The plan offers no matching - is it just me or are employers completely walking away from the whole matching thing? And it offers only a small number of investment options, most of which are dismal. The only good option, as in my own plan, is a low cost total market index fund. No other index options whatsoever. Because of this severe lack of desirable options, 70% of Alpaca's retirement savings will go into that index fund, with the rest split evenly between mediocre and expensive international, bond and real-estate funds. Readers take-heart, I will make the necessary adjustments to the rest of our portfolio to ensure that our asset allocation remain appropriate.

The biggest benefit in Alpaca's new 401K plan is that it offers a ROTH 401K option, which is the option that Alpaca and I chose for her. Our adjusted gross income is too high to allow us to invest in a ROTH-IRA, but through the stupidity of the government a ROTH 401K has no income limits.

Can someone explain to me why it is that the government is only choosing to give certain tax benefits to employees whose employers choose to offer a ROTH 401K option? Why should this option not be available to me just because my employer has crappy benefits?

ESPP - Alpaca's new company is publicly traded and offers an employee stock purchase plan. Alpaca signed up for this free money at the maximum amount permitted by her company, which is 10% of salary. As I previously wrote in this blog, we treat ESPP as a short term savings plan with excellent guaranteed results. We sell the stock immediately after it is purchased (once every 6 months) and pocket the minimum 15% guaranteed return.

Flex Accounts Galore - childcare flex accounts, medical flex accounts, we signed up for both at the maximum level. Once again, my gripe with the government remains. Why would the government give a tax advantage only to those employees whose employers offer flex accounts?

Generally speaking decent benefits. Regardless, it's great that Alpaca has a well paying job and even better that so far things seem to be going well for her in her new position. It's all about happiness at the end of the day.

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Stocks Are A Lot Less Risky Than You Think

The following is a guest post from Rob of A Rich Life. Rob is a long time reader of this blog and a prolific and passionate writer. The “RobCasts” section of his web site contains over 180 podcasts in which Rob describes the Valuation-Informed Indexing investing strategy, an approach to indexing which according to Rob greatly reduces the risks of stock investing by having investors lower their stock allocations at times of insanely dangerous valuations.

This post is one of several guest posts I am publishing while my family and I are living the good life on our family vacation in Costa Rica. I will resume publishing my original articles after the first of the year. Here is the post:

Most people have mixed feelings about stocks. They love the high return. They are not so crazy about the high risk. Stocks without risk -- that would be the middle-class investor’s dream!

The dream is available to us today. That’s my take.

There is nothing inherently risky about stocks. Many of us make stocks risky by believing crazy things about them. But it’s not fair to blame the investment class for that. That’s us. It’s our investing beliefs that make stock risky, not anything to do with the asset class itself.

When people say that stocks are risky, what they mean is that prices jump around a lot. One year you might see a 30 percent price increase. Another year you might see a 20 percent price drop. Volatility scares us. It’s because stock prices are volatile that we have come to view stocks as a risky asset class.

But you know what? The price volatility of stocks is an illusion. It’s not real. Change how you react to it and it goes away. Stop taking volatility seriously and it goes “Poof!”.

You’ve probably heard that the average return on U.S. stocks is 6.5 percent real. That’s because that’s the return justified by the productivity of the U.S. economy. When you buy a share of an index fund, what you are really buying is a share of U.S. productivity. So long as the U.S. economy remains roughly as productive as it has been for a long, long time, your reward for owning a share of an index fund is going to be a return something in the neighborhood of 6.5 percent real.

There’s no volatility in that reality, is there? You buy stocks, you get a 6.5 percent real return. Simple. Safe. Nice.

What causes us to perceive volatility where it doesn’t really exist is the newspaper and television reports that tell us that stocks are up 30 percent or down 20 percent. What if we tuned out the noise? Would that bring an end to volatility and risk? It would.

We have historical data on U.S. stock returns dating back to 1870. There’s a neat thing that happens if you work through the historical returns year by year, subtracting from the reported return to bring it back down to 6.5 percent real whenever the nominal number is higher than that and adding to the reported return whenever it is lower than that. If you take that step, you will see that stocks don’t just provide a return of 6.5 percent on average but each and every year. Yes, stocks provide the same return every year -- so long as the effect of volatility is ignored.

Volatility is not real. Volatility is an illusion. We should be making that adjustment in our returns each year. U.S. stocks have always paid a return in the neighborhood of 6.5 percent real, never more and never less.

Some will say this is crazy talk. They will point out that, if you sell stocks after they go up 30 percent, you really will obtain the higher price for them. That’s so. In this short-term sense, returns higher or lower than 6.5 percent are “real.”

However, the price that applies for a few months or a few years is immaterial to the long-term investor. So long as you have no immediate plans to sell, what practical difference does it make to you if stocks are temporarily selling for a price 30 percent higher than their true value or 20 percent lower than their true value? What matters to you is what your investment is really worth. Your investment is worth 6.5 percent more than it was worth 12 months earlier. That’s always so. Regardless of the current-day selling price.

How do I know?

I know from looking at the historical data that the stock price always returns to what it would be if stocks increased in value each year by 6.5 percent real like clockwork. Price changes that do not last are not real. Price increases greater than 6.5 percent real never last. And price changes less than 6.5 percent real never last. No matter how much crazy volatility we experience in one direction or the other, we always end up with that 6.5 percent number coming through for us in the long run.

That cannot be an accident. The reason why the 6.5 percent number always holds is that that number is the return that the productivity of the U.S. economy supports. You can count on earning 6.5 percent real from your stock investment each year. Any gains greater than that or less than that are a mirage that should be ignored for financial planning purposes.

When you see a gain of 30 percent, you should count 6.5 percent as the real gain and 23.5 percent as a mirage gain. When you see a loss of 20 percent, you should count 6.5 percent as the real gain and 26.5 percent as a mirage loss.

If you did this, volatility would disappear from your stock investing experience. You would enjoy all the benefits of owning stocks but not need to endure any of the downside. You would get gains without volatility, returns without risk. It’s the best of all worlds for the middle-class investor.

You would also come to think about stocks very, very differently than you think about stocks today. Do you remember January 2000, when stocks were selling at a price three times their fair value? Most investors continued buying stocks even at those insane prices, prices at which the chance that stocks could provide a solid long-term return were virtually nil. Those of us who see through the nonsense volatility did not make that mistake. We lowered our stock allocations dramatically when prices went to the moon and thereby avoided most of the pain of the recent price crash.

We saw something that Buy-and-Hold investors did not. We saw that stocks always provide a return of 6.5 percent real. And that, when you pay three times fair value, you are obtaining stocks with only one-third of the money you are putting out; the rest goes to buying cotton-candy nothingness. What you want to buy is stocks, not the hot air created by deceptive volatility. Learn how to see through volatility and you can obtain far higher returns at far less risk. For the first time, you will be seeing stocks as they really are, not as The Stock-Selling Industry (which spends millions promoting Buy-and-Hold Investing) wants you to see them.

The investor who gives up the belief that crazy price increases are real (any price increase beyond that justified by economic productivity is crazy) gains the ability to avoid falling into the traps that cause him to suffer crazy price drops on the other side. The way to avoid the pain of bear markets is to understand the phoniness of bull markets.

If you think 6.5 percent real is a good enough return on your investing dollar (and I sure do), you are set. Just ignore all the volatility junk and it can no longer bother you. For you stocks will carry only a fraction of the risk experienced by investors who follow the Buy-and-Hold model.

[Shadox - I agree with Rob on many things including the fact that indexing is the way to go where stocks are concerned. I also strongly disagree with him on others such as his assertion that stock investing is essentially risk free. I recently wrote a post about stock market volatility. While that particular post discussed daily price volatility, in a coming post I will try to extend the concept to the longer time horizons to which Rob is referring]

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Guest Post: A Critique of Value Informed Indexing

A few weeks ago I published a guest post by Rob of A Rich Life. In doing so, it appears that I inadvertently stumbled into the middle of a religious war. Schroeder, a critic of Rob's has asked me to post the critique which follows, and having read it, I thought I would share it with my readers and let you all make up your own opinions. This critique is broader than a direct response to the guest post on Money and Such. With this, I think that I will gracefully bow out of what appears to be a larger dispute between these two thoughtful writers. I am sure that Rob will respond in detail in the comments below. The guest post.

This is a critique of Rob Bennett's "Valuation Informed Indexing" or VII for short. Here is Rob's claim:

"Valuation-Informed Indexing always provides better risk-adjusted long-term returns than Passive Indexing. If you take the same portfolio as the Coffeehouse Portfolio or the Wellington Fund and instead of following a rebalancing strategy you adjust your stock allocation in response to big price changes, you will achieve higher risk-adjusted returns. I am not able to imagine how there could be any exception to this general rule." [Shadox - this quote is taken from Rob's comment (#24) to this post on Get Rich Slowly]

Adjusting your stock allocation in response to big price changes" is the key phrase and defines Rob's VII. And the claim is that if you adjust your stock allocation in response to big price changes, you will achieve higher returns than sticking with a static, never-changing stock allocation.

In order to compare VII versus a static, never-changing stock allocation, we need decision rules that tell us how to implement VII. Rob provides us VII decision rules here:

"A Valuation-Informed Indexer might go with a stock allocation of 50 percent at times of moderate prices (a P/E10 level from 12 to 20), a stock allocation of 75 percent at times of low prices (a P/E10 level below 12) and a stock allocation of 25 percent at times of high prices (a P/E10 level above 20)."

How do we determine P/E10 levels? P/E10 data is contained in an Excel spreadsheet on Robert Shiller's website. Here is the link.

So if you were a VII investor and followed Rob's guidelines, you would have maintained a normal stock allocation of 50% when the P/E10 level ranged between 12 and 20. This was the case up to 1992. However, you would have switched to 25% stocks in 1993 when P/E10 first went above 20. P/E10 stayed above 20 for the next 16 years before dropping below 20 in October 2008.

Now that we have defined Rob's VII, we can take the next step and test Rob's claim. Repeating what Rob wrote above:

"If you take the same portfolio as the Coffeehouse Portfolio or the Wellington Fund and instead of following a rebalancing strategy you adjust your stock allocation in response to big price changes, you will achieve higher risk-adjusted returns."

I will choose the Coffeehouse Portfolio because the returns are tracked on Bill Schultheis' website:

Year Return

1991 23.55%

1992 9.57%

1993 15.64%

1994 -0.58%

1995 22.89%

1996 14.53%

1997 17.95%

1998 6.88%

1999 8.30%

2000 7.25%

2001 1.88%

2002 -5.55%

2003 23.56%

2004 14.18%

2005 5.97%

2006 15.002%

2007 2.91%

2008 -20.25%

Annualized 17 Year Return 8.61%

Rob says that a VII investor would have reduced their stocks to 25% when P/E10 went above 20. This occurred in 1993. And since the Coffeehouse Portfolio is 60% stocks, we need to add a bond fund to make the valuation-adjusted stock allocation equal 25%.

To achieve a 25% stock allocation with the Coffeehouse Portfolio, we would need to add a bond fund such as the Total Bond Market (TBM). By my calculations, you would place 58% of your money in TBM and 42% in the Coffeehouse Portfolio.

So for example, if you had $10,000 and only want $2500 in stocks (25%), you would put $5800 in TBM and $4200 in the Coffeehouse Portfolio (CH). How much do you now have in stocks?

$4200 * 60% = $2520

Which is close enough to $2500.

We now have almost all the information to test Rob's claim that when you take the Coffeehouse Portfolio and instead of following a rebalancing strategy, you adjust your stock allocation in response to big price changes and thus, you will achieve higher returns. The only piece missing is the returns for the Total Bond Market. That data can be found at this website:

Year TBM

1991 15.25%

1992 7.14%

1993 9.68%

1994 -2.66%

1995 18.18%

1996 3.58%

1997 9.44%

1998 8.58%

1999 -0.76%

2000 11.39%

2001 8.43%

2002 8.26%

2003 3.97%

2004 4.24%

2005 2.40%

2006 4.27%

2007 6.92%

2008 5.05%

So with a little spreadsheet work, we can apply Rob's VII guidelines and produce valuation-adjusted returns for the Coffeehouse Portfolio. The left column represents the unmodified Coffeehouse (CH) and the right column represents the Coffeehouse modified using Rob's VII guidelines:

Year CH VII

1991 23.55% 23.55%

1992 9.57% 9.57%

1993 15.64% 12.18%

1994 -0.58% -1.79%

1995 22.89% 20.16%

1996 14.53% 8.18%

1997 17.95% 13.01%

1998 6.88% 7.87%

1999 8.30% 3.05%

2000 7.25% 9.65%

2001 1.88% 5.68%

2002 -5.55% 2.46%

2003 23.56% 12.20%

2004 14.18% 8.41%

2005 5.97% 3.90%

2006 15.00% 8.78%

2007 2.91% 5.24%

2008 -20.25% -5.58%

Coffeehouse (CH) 18-year annualized return = 8.52%

VII 18-year annualized return = 7.93%

So it appears that adjusting the stock allocation for the Coffeehouse Portfolio in response to big price changes did not produce higher returns. The valuation-adjusted returns were 7.93% annualized over the 18 year period from 1991 through 2008. This is lower than the unmodified Coffeehouse annualized returns of 8.52% over the same period.

To repeat, the Coffeehouse Portfolio maintained a static, never-changing stock allocation of 60% over the full period. By contrast, the valuation-adjusted Coffeehouse added TBM in response to big price changes as occurred in 1993 and thus reduced its stock allocation to 25% and maintained that lowered stock allocation from 1993 through 2008.

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Reader Question: Selecting 401K Investments

Recently I received the following question from one of my long time readers:

"I have a question about how to select among the funds offered in a 401k/403b plan. My employer offers several funds for each fund category (international, large cap, mid cap, etc...). Every so often new funds are being introduced and I'm not sure whether the new fund would be a better one in that category than the one I have. So how does one choose? By always picking the lowest cost fund? By comparing the fund performances over the past 5 or 10 years? By comparing against an index? (and then which one?)

Florin"

First of all, I want to thank Florin for sending me the question. I love getting e-mail - questions, comments or ideas - from my readers. That's a large part of why I blog. I respond to each one of my readers (not so much to commercial solicitations), and if you send me a question and include your website, chances are I will respond to your question on this blog and include a link to your site. Anyway, I already responded to Florin via e-mail, but here is a more detailed answer to his question:

What Florin is facing is the reason that when we redesigned our 401K plan at my previous company our advisers advised us to select a relatively small number of funds, that covered the necessary asset classes. By his questions Florin is clearly a financially literate person, yet such decisions are not easy ones to make and many feel confused or overwhelmed by them. 

When selecting funds for my own 401K, I follow a pretty straight forward process that may work for others as well:

Decide on an asset allocation - simply described, an asset allocation is the mix of assets (stocks, bonds etc.) that you own. The way you allocate your assets should be based on two main factors: your investment horizon and your willingness to accept risk. Here is a more detailed post on asset allocation for additional background. 

When building my asset allocation plan I do so for my entire portfolio, not just for my 401K - taking into consideration all the different accounts and my wife and I own. It doesn't make sense to optimize my 401K allocation unless the strategy fits our portfolio as a whole. Generally speaking, I try to put my tax inefficient funds in a tax deferred account (e.g. REITs that keep throwing off dividends that would otherwise be taxed, can be sheltered by a 401K).

By the way, our own target asset allocation is approximately 45% US stocks, 30% international stocks, 15% bonds, and 8 - 10% real estate (through REITs). For reference, my wife and I are in our late thirties and are fairly tolerant of risk, i.e. we don't sell our equity positions in a down market...

Find Funds that Fit the Planned Asset Allocation - here's the trick: since we do our asset allocation across the entire portfolio, if I don't find a fund that I am happy with for a certain asset class in our 401K plan, I don't sweat it. I simply buy the appropriate fund in another one of our accounts and balance my 401K allocation appropriately. This is important because many 401K plans offer limited or unacceptable fund choices for one or more asset classes. 

Selecting Between Similar Funds -  If there are several funds in a given asset class, I typically choose between them according to the following priority: 

(i) index funds first - as I explained in my very first post on this blog, I am a big believer in index investing; 

(ii) comparing expense ratios - look, the expenses and fees that you pay for investing in a mutual fund may not always be the most important thing about investing, but I have found few exceptions; 

(iii) comparing morning star ratings - if we are talking index funds that's not relevant, but if an index is not an option, checking up on the fund rating is a good idea; 

Florin also asks a very prudent question: which index should you compare the performance of a fund against to determine the fund's success? 

Investors should understand that they can frequently gain a higher return by accepting a higher degree of risk (you can read about this in my advanced portfolio building series). So the fact that a certain fund generates a higher rate of return than a broad stock index does not necessarily mean that it is an appropriate investment for you or that it is actually out-performing the relevant index. To measure the true performance of a fund, measure it against the return of an index that more or less covers the same asset class. For example, a large cap fund can be measured against the S&P 500 while a fund investing in small caps would be better measured against the Russell 2000 index and a real estate fund may be better compared against Vanguards Total REIT index fund or similar real estate benchmark.

Finally, if you feel confused by the range of options offered by your 401K plan - there is nothing wrong with selecting a target date or lifestyle fund that will do the asset allocation for you.

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Rolling Over My 401K to Vanguard

I recently left my old job for a brand new and exciting one, and as I have previously written, I am a big believer in rolling-over my 401K as soon as feasible after I leave a job. There are many reasons to roll-over a 401K into an IRA, but some of the biggest are the high-costs and limited transparency of typical 401K plans and the relatively limited investment options.

Being the devoted index investor that I am, I rolled my 401K money into my traditional Vanguard IRA. The process itself was smooth and painless. First, I logged into my 401K account online. There I chose to terminate my account and to take my money in the form of a direct roll-over. Note that if you choose to withdraw your cash instead of rolling it over, you may be subject to a 10% tax penalty, and to an immediate 20% withholding. ADP - my now former 401K plan provider - asked me to enter the name of the institution into which I will be rolling over my account, and presto - a week later a check arrived in the mail made out to Vanguard, for the benefit of your humble blogger.

This morning I called Vanguard - whose service center closes at 5 PM Pacific for some strange reason. The representative was very friendly and informative and simply asked me to identify myself, which account the money will be rolled into and how I would like my money invested. I chose to invest my hard earned $46,000 as follows: 15% Total REIT Index (VGSIX) - I have been beefing up my investments in that fund recently to offset declines over the past year; 40% in Total International Stock Index Fund (VGTSX); 35% in Total Market Index Fund (VTSMX) and the remaining 10% in Vanguard's Extended Market Index Fund (VEXMX). The whole process took me about 10 minutes. I mailed the check to Vanguard today, so with any luck my money will be back in the market within a few short days.

On a (little) sad note, when I left my employer after almost three years, I left behind 50% of my employer matching funds, which were not yet vested. This amounted to a few thousands of dollars, but if you get a good career opportunity, you don't give it up for some short term gains. Still, I am never happy when I need to leave money on the table.

Battle of the Stock Indexes

Following yesterday's post, I decided to take a closer look at several broad stock indexes and try to calculate the average return that they offered to investors over the course of their entire existence. For this little exercise, I selected the following indexes: Dow Jones Industrial Average; S&P 500; NASDAQ Composite Index; Wilshire 5000; and Russell 2000.

Before I tell you the results of my inquiry, I would like to point out that I had some difficulty finding the year in which some of these indexes were first introduced, as well as some of the base values at which they were introduced. In the end, I think I got the correct numbers, but if anyone can spot a mistake, please let me know so I can correct it. Also, I would like to point out that the numbers are approximate, since I did not account for the fact that 2007 has not yet ended.

Without further delay here is what I have found:

Dow Jones Industrial Average
Year of Introduction: 1896
Base Line Value: 40.94
Average Annual Return (Sept 11, 2007): 5.35%

S&P 500
Year of Introduction: 1957
Base Line Value: 44.06
Average Annual Return (Sept 11, 2007): 7.27%

NASDAQ Composite Index
Year of Introduction: 1971
Base Line Value: 100
Average Annual Return (Sept 11, 2007): 9.47%

Wilshire 5000
Year of Introduction: 1980
Base Line Value: 1404
Average Annual Return (Sept 11, 2007): 9.12%

Russell 2000
Year of Introduction: 1984
Base Line Value: 100
Average Annual Return (Sept 11, 2007): 9.35%

These results are very interesting. First off, as I commented yesterday, the return on the Dow since its introduction is dismal. The S&P is the second oldest of the indexes I examined, and it too offers lackluster performance, although it is certainly more attractive than the Dow. The remaining three indexes are all substantially newer and all offered significantly better returns.

What do these results mean? Are the low returns on the Dow an artifact of the much less developed financial markets of the late 19th and early 20th centuries? Or are the higher returns exhibited by the Wilshire, NASDAQ and Russell simply the result of a fluke that has allowed them to so far escape from a protracted bear market? Am I simply making an error or overlooking something basic? Once again, I think I will continue to look at this question I stumbled across, and will keep you informed of my findings.

Here's Why You Don't Pick Stocks

According to Wikipedia, the Dow Jones Industrial Average was first introduced to the world on May 26, 1896, just over 111 years ago. The original Dow components were:

American Cotton Oil Company
American Sugar Company
American Tobacco Company
Chicago Gas Company
Distilling & Cattle Feeding Company
Laclede Gas Light Company
National Lead Company
North American Company
Tennessee Coal, Iron and Railroad Company
U.S. Leather Company
United States Rubber Company; and
General Electric

I don't know about you, but the only name that rings a bell in that entire list, and the only one of the original list that is still on the Dow to this day, is General Electric.

Here is the lesson that I am taking away from this change in the Dow: given enough time, even the bluest of blue chips fail and disappear. I have to ask myself whether investors in the stocks that faded into obscurity saw the change coming and bailed out and how many of them lost a bundle by betting on these stocks.

When the Dow was first introduced it stood at 40.94. When the market closed yesterday the Dow ended at 13127. So while the index itself soared over 32,000% over its existence, many of the underlying stocks disappeared. This is not exactly a scientific case for index investing, but if you are into stock picking this should make you pause and ponder for a while.

Incidentally, in writing this post I ran a quick calculation based on the numbers I quote above, and it appears that over its entire existence the Dow averaged a return of about 5.4% per year. Does that not strike you as unnervingly low? I think I will dig into that a little bit more. I'll let you know what I come up with.

Beating the Market or Faking It?

Here is a story I heard a while back (I have no reason to believe that it's true): a new financial advisor moves into town and wants to drum up some new business. He buys a mailing list and drafts a marketing letter. In the letter he talks about stock XYZ. In 50% of the letters he praises the stock and forecasts that the stock price will go up in the following two weeks. In the remaining 50% he explains that the stock price will go down during the same period.

He mails the letters, waits two weeks and repeats the process, but this time he only sends marketing letters to the 50% of residents who got the version of the original document which turned out to be true, i.e. if the stock went up only the ones that received the positive remarks about the stock receive a new letter, and vice-versa.

If the financial advisor repeats the process four times, each time using a different stock as the subject of his fraudulent letter, at the end of the period 1/16 of the town's population will be convinced that the new financial advisor is a stock picking genius, having guessed the short term performance of four separate stocks correctly with a 100% success rate.

Of course, there are many reasons why this scam would not work. For example, some of the residents could compare notes and realize that conflicting advice was being sent to them. However, this is not the point of the story. My point is that residents who received the correct predictions would have no way of knowing whether the advisor was providing insightful advice or whether he was merely lucky four times in a row. After having received four correct predictions, many of the residents would probably hire the services of the scheming advisor, even though in reality he did not add any real benefit to their investment decisions.

Although this story sounds far fetched, in reality it is something that happens every day. However instead of happening with a single financial advisor, it happens with a hoard of financial planners, brokers, fund managers and so forth. Some say a stock will go up, some say a stock will go down. Some happen to be right. Some will happen to be right four times in a row. Because there are hundreds of thousands of professionals in the financial services industry, some will happen to be right dozens of time in a row. In many cases their success will be based on pure coincidence. The laws of statistics virtually guarantee that some advice givers will be correct a seemingly implausible number of times by pure coincidence.

I concede that there may be a select few whose success is based upon knowledge and expertise rather than luck, but the real question is:

HOW WOULD YOU KNOW WHICH IS WHICH?

So what remains? Index funds. Don't try to out-guess the market. Don't try to outperform the rest of the population. Simply aim for average returns and reduce your costs. Academic studies have repeatedly shown that using this seemingly lackluster strategy will yield a higher than average return.

Return of the Bond Investment?

Don't look now, but it looks like bonds are finally begining to generate some reasonable returns. An index investor such that I am, I hold the bond portion of my portfolio in Vanguard's Total Bond Market Index (NASDAQ: VBMFX).

The sad news is that over the past few years, with interest rates on the upswing, returns on this investment have been dismal. To be more specific, the average annualized returns before taxes on distributions was 3.47% over the past 3 years. The technical term: URGGHHH, comes to mind.

It looks like there may be some light at the end of this tunnel. In the past year, the fund has returned 5.93%, which is still below its 10 year average annual return, but is at least respectable. Much of this increase in returns has happened in the past two months (1.42% year to date), and with people now talking about the Fed cutting interest rates, are bonds getting ready to stage a big rally?

Who knows? Quite frankly, who cares? I am an index investor that follows a strict asset allocation straetgy. I am not buying, selling or timing the market. So why am I talking about this? Well, while I don't trade, it's still fun to think about these things and to observe the market. While I control my urge to trade, controlling my urge to talk is somewhat more difficult.

Diversifying into International Markets

My personal asset allocation goal is to keep approximately 25% of our assets in international stocks. With the recent correction in many of the international markets, I think that now may be a good time to slowly increase exposure to this asset class.

To make it clear, I don't advocate playing the Chinese stock market, nor dumping your nest egg into Brazilian penny stocks. While I believe that emerging markets offer some attractive opportunities in the long run, many emerging market stocks have seen oversized returns in recent years, and may be ripe for some bumps and bruises. No, when I talk about investing in international stocks, I am talking about indexing. My chosen international index is Vanguard's Total International Stock Index (NASDAQ: VGTSX). I picked this fund for its broad diversification: it holds shares in Vanguard's European, Pacific and Emerging Markets indexes, which together give me exposure to much of the global economy.

I am a proponent of international investing for a number of reasons: first, international diversification helps to mitigate single country risk. For example, if the U.S. economy falls into recession, it is likely that other global economies will continue to chug along, thus dampening the impact of U.S. stock market declines on our portfolio.

Second, it is well established that emerging market economies tend to grow at a faster rate than those of developed countries. Companies that invest in those economies have a better chance of seeing a faster profit growth and faster stock price appreciation. Of course, emerging markets are a higher risk investment as they are more prone to cycles of boom and bust (remember the Russian default? the Thai economic meltdown? etc.)

Third, with the growing trade deficit and with the Federal budget deficit, I think it likely that the dollar will continue to decline against world currencies. By investing in foreign stocks, or at least in companies that obtain much of their income in foreign currency, I am protecting us against the adverse effects of a weak dollar. As the dollar falls, an investment denominated in foreign currency will be worth more in USD.

I believe that any well balanced portfolio should contain a healthy dose of international diversification. However, it is important not to over do it, since with the potential for higher returns come bigger risks and a potential for some additional sharp corrections after the rapid stock price increases in recent years. Additionally, if you are thinking of investing in international markets, make sure you are doing it for the right reasons. That is, do not try to chase hot international funds in the hope (or delusion) of striking it rich. Rather, if you invest internationally, do so for the added benefits of diversification and exchange rate risk protection, and be prepared for what may be a bumpy ride.

6 Reasons to Roll-Over Your 401(k)

After leaving their job for a new one, many people leave their old 401(k) with their former employer. They do so for a variety of reasons: they forget to move it; they are too lazy; they think their old 401(k) is a good deal etc. However, I am of the opinion that once you leave your employer, your retirement savings should leave as well.

Here are 5 reasons why you should make the effort:

1. Your 401(k) May Be a Bad Deal - it is truly amazing how many bad 401(k) plans are out there. I intend to cover the topic in a future article using what I learned as a member of my company's 401(k) plan management team. Some plans impose attrocious expense rates, wrap charges and other needless costs. Why bear these costs if you don't have to?

2. Expand Your Investment Options - most 401(k), even the good ones, restrict their participants to a few investment options. In many companies those investment options are selected by the HR team... a team qualified for this task mainly by... nothing. Worse yet, in some companies the investment options are chosen by a broker, who may or may not be giving your company impartial advice. Roll your money out and make your own plans.

3. Consolidate Your Accounts - how annoying is it to get 17 different statements from several different financial institutions? By consolidating your old 401(k) plans into a single IRA you can manage your portfolio in a single account and get complete picture of your investments all in one place. Even more importantly, by rolling out several accounts into one you can sometimes save on expenses. For example, The Vanguard Group offers substantially lower expense ratios for accounts that pass a certain size threshold (these are even lower than their already low fees).

4. Avoid the Money Market Trap - in some cases, if your former employer is unable to make contact with you and your previous investment choices in your 401(k) are no longer available, your investments may be placed in some sort of stable principal fund, i.e. the place where money goes to die. If you forget to follow up, it may be years before you realize that your hard earned retirement investment is earning 2% a year. Seriously, just take your money and run.

5. Tracking Your Money - the funds in my company's current 401(k) plan, like those in many similar plans, do not use ticker symbols and are not easily trackable. In many cases this is true for companies whose 401(k) plans are managed by an insurance company (ING, Hartford etc.) By rolling-over your 401(k) into an IRA you will be able to invest your money in funds for which a public price is posted on a daily basis. You know, like one of those things that people actually want to invest in...

6. Index Investing - it is amazing that after all this time, most 401(k) plans offer only minimal index fund investment options. My own company's 401(k) plan offers none. I am stuck with a choice of only actively managed funds. Even those plans that offer some indexing options don't offer enough of them. For example, when speaking with Fidelity on behalf of my company last week, I was told that their 401(k) platform does not include any international indexing options. As many of you know, a majority of actively managed funds underperform their stock market benchmarks. Yes, that's what we like: paying more for less performance... Why would you want to be stuck with that?

Convinced yet? Well if you're not, stay tuned. I will be writing a lot more about the problems with 401(k) plans and how an ordinary employee can drive a change in his company's retirement plan.

It's Great to be Average!

For my first post on this new blog, I want to relate a conversation I had with a friend earlier today. My friend recently invested in shares of EMC (NYSE: EMC), and did so based on information that the company is about to spin off their VMWare division. Although EMC may be a good investment (I don't know), I am questioning the wisdom of buying and selling individual stocks.

The typical investor gets most of his information from the mainstream news media. This information is widely known, and in all likelihood the same information is known to professional traders, brokers, investment bankers and research analysts (unless you are using illegal insider information). If the "big boys" have access to the same information they have probably acted on it and the price you will pay for the stock already reflects the good or bad information you are using to make your trading decision. In other words, the information you plan to use is probably already priced into the stock.

What strikes me as amusing is that in every stock transaction there is a seller and a buyer. The seller sells the stock because he thinks the price of the stock is about to drop. Of course, the buyer buys because he believes the opposite. If you trade a stock you are essentially betting that you understand the market better than the guy on the other side of the deal. However, the guy on the other side of the deal is probably a professional or institutional investor who gets paid to know the market and who specializes in a narrow group of target companies.

While most people never dare to claim that they can beat a professional tennis player in a 1:1 tennis match, and most sane individuals will not try to beat a professional race car driver at his own game, many think they can beat the professional investors at stock picking. Can anyone tell me why that is?

Now the punch line: research shows that most people can achieve better returns on their investments than can a professional investor. The strategy for success is simple: invest in an index fund and don't trade. This strategy essentially guarantees you a return equal to the average market return. Most professional investors under perform the market.

In summary: if you are both picking stocks, the professional investor has an advantage. He has more information and investing is his day job. Even armed with all this research and information, the typical professional investor will under perform the market. You as a private individual have an even smaller chance of beating the market by picking stocks, but by indexing you can assure yourself of average market returns.

Here's to being average.