In my role as a member of my company's 401K committee, I have recently had conversations about the topic of 401K asset allocation with a number of people in my company. I discovered that people don't really know how to invest their retirement money. Below are some of the poor investment strategies that I have heard about:
Pretend Diversification - one employee told me that his investment strategy is to split his contributions between all available fund options. Since we offer our employees a total of 15 funds, he essentially puts 6.7% of his funds in each of them. What a horrible strategy. Essentially this employee believes that whatever it is we put in front of him is worth spending money on, regardless of cost or performance. That's not diversification, it's laziness. Such laziness makes me want to roll up a newspaper, smack that guy on the nose and yell, "No! Bad investor!" This is probably the second worst 401K investment strategy that I have heard about. Here is the worst:
Putting Your Money in the Safest Investment - one employee puts most of his money in the stable value fund offered in our plan. He thinks he is doing himself a favor by playing it ultra conservative. This is a poor strategy. A 401K is a very long term investment. Arguably it is the longest term investment most people make. That being the case, the daily, monthly and even annual ups and downs of the market are not relevant. All the matters are the long term trends, and in the long run stable value funds barely keep up with inflation. Try to be too conservative with your money and you are bound to end up with a cash stash too small to support you comfortably in retirement.
Over Confidence - more than one employee told me that they are investing their money in only one or two funds. Unless you are talking about a lifestyle fund, or a couple of very broad based index funds, you are probably not going to get the diversification you need from such a small number of funds. You may feel confident about the hotshot international equity fund you picked, but without sufficient diversification you'll be sorry when the next international melt down hits.
Not Paying Enough Attention to Cost - few employees demonstrated to me an understanding of the costs associated with the investments that they picked. That's too bad for them. Costs can have a critical impact on your portfolio. Let me give you an example: let's say that your equity fund generates an average return of 8% a year. If your fund charges an expense ratio of 2%, you are essentially paying a commission of 25% on your profit! And don't think I am exaggerating either. Our 401K plan has more than one fund that carries that expense ratio. That's partly the reason that we are switching 401K plan providers.
So how should you invest your retirement money? Here are a few tips:
1. If You Don't Know Ask - ask your plan's sponsor or call a financial advisor directly. Better yet, go online and read some personal finance blogs for some hints. Go to the library, get a few books and read. Whatever you do, educate yourslef before you commit to any investment strategy.
2. Consider the Costs - very few investment options are worth 2% per year in fees. I am a big proponent of index investing. If your 401K plan offer a broad index fund, check it's expense ratio and consider investing some of your money in that option. Generally speaking, if you are given the choice between two funds that cover the same asset class, you probably want to pick the one with the lower cost. Studies have shown a negative correlation between investment fees and investment returns: the more you pay, the less you get for your payment. What a scheme.
3. Diversify for Real - Don't just select multiple funds. Select funds that cover different asset classes. Get a broad exposure to the domestic stock market, the international stock market and to the bond market. If you can add a small exposure to the real estate market, that might not be a bad option either.
4. Consider Lifestyle Funds - lifestyle funds are an excellent option for investors who feel that they don't know enough to invest for themselves or that don't want to deal with the hassle. All it takes is for you to pick your retirement date, put in your money and the fund invests your assets in a mixture of stocks and bonds that gets progressively more conservative as you age.
5. Stay Out of the Money Market Fund or Stable Value Funds - such funds are great if you are building an emergency cash reserve or saving for your summer vacation, but if your investment time horizon is long, putting your money in such vehicles is a poor decision.
Friday, September 21, 2007
Thursday, September 20, 2007
Finances in Your 20's
A few days ago an anonymous reader left a detailed comment regarding the "Finances in Your 20's" series of posts I did a couple of months ago. I thought it would be interesting to post the full text of the comment and share my thoughts about it.
Here is the comment in full. I added emphasis in a number of places:
Let me comment on some of the points the reader made:
My anonymous reader is clearly well on his way to financial security. He seems to have made many smart decisions, and he understands the trade off between spending and saving. He has taken those first steps to financial stability a decade or more before most of his contemporaries will start to think about issues of financial planning. Kudos!
Regarding the purchase of a house while you are in your 20's. I have written a number of posts about why I don't think that real estate is a good investment, and particularly why I don't think it is a good investment for people in their 20's. However, if you are buying your house because you want to move out and own your own place - and not as an investment - there is absolutely nothing wrong with it. I completely understand that some people really need the emotional attachment, convenience and perceived security of owning a home. However, I always find it strange when people refer to renting as throwing away money. I have many points to make on this topic and will address them in a future post. For now, I will share only one important thought: by renting I am able to take the large chunk of cash that would otherwise be tied in bricks, and invest it in highly diversified, high yielding investments. I am not throwing away money on rent, what I am doing is the equivalent of taking out a low cost loan to invest in a highly profitable opportunity. Somebody else's capital is tied up in the house I live in.
One a different note, there are two financial errors I think that the commenter is making. The first is owning a large number of shares in his own company stock. To find out why I think this is a big error, see my post on the subject. I also think that the reason the commenter is accumulating shares is his company's ESPP which allows him to purchase shares at a discount. Purchasing the shares is the right move. Hanging on to them is not. Once the shares are purchased at a discount, it is probably a good idea to sell them and pocket the difference. More about my proposed ESPP strategy in this post.
Although the commenter does not say so explicitly, I am getting the sense that he thinks he is not diversified. If that is the case, this is a serious financial error. To diversify your portfolio you don't need to have a lot of money, and you don't need to to pay through the nose to achieve diversification. Here is a good way to take a step in the right direction: when you sell your company shares, use the proceeds to purchase a diversified index fund, such as Vanguard's Total Market Index Fund. Diversification is a sound financial strategy that will pay off in the long run.
The reader is clearly doing almost everything right financially, but he appears to be paying a high personal cost for some of his decisions. For example he mentions that he is no longer taking "fancy vacations". To me it's all a question of happiness. I used my 20's to travel the world. Yes, it cost a lot of money, but I don't regret that expense for a second. Let me tell you something: as a mid-career professional, taking large chunks of time off to go traveling is not very feasible. Doing it with three small kids is pretty much impossible. So, yes, plan for your financial future but make sure you don't fixate on the money. Enjoy your youth. Your memories will last a lifetime and the money is very well spent.
Regarding the after hours start-up and giving back to the community, all I can say is "more power to you!"
As you can see, I read every comment left on my blog, and respond to pretty much all of them. So, keep 'em coming. Let me know what you think about my posts and let me know if there are any topics you would like me to tackle. I will be glad to do so.
Here is the comment in full. I added emphasis in a number of places:
First of all, what an awesome comment to receive. I really enjoy writing this blog, and it's nice to know that my readers find my articles useful. Thank you very much for taking the time to write such a detailed comment."Thanks for the great series. I read it very carefully as I AM in my 20's, fell into a GREAT job, and realize there is great financial potential if I make the right choices now. Everyone says "start young" or "don't make mistakes when you're young" or "I wish I would have... when I was young." But not very many people offer practical advice of what to do WHILE you're young, have a great paying job, and need to know what to do with all that disposable cash.A few
Points of reaction:
1. House. I bought one. The housing market where I live was far too tempting not to, I couldn't stand living with family a second longer, and I wasn't about to throw away thousands in rent. I think if you're planning on staying with your current job for at least 5 years, and you are in a strong growth area, you can't do any harm purchasing a house. It also helps TREMENDOUSLY at tax time, since I have no dependents to claim on my return.
2. Savings: I currently contribute 6% to the company 401k and my company kicks in an extra 4% (yay for free money), but having non-taxable savings seems VERY attractive. I will definitely look into the ROTH IRA. I hadn't considered IRAs, since I have pretty much maxed my current paycheck out.
3. Stock: I have several thousand shares of options in my company, and have just started participating in the company stock purchase program which allows me to purchase stock every 6 months at 85% of the lowest market value. I am maxed out at 10% of my gross in that program.
4. Charitable donations. This is one you didn't mention that I think you should have. Young people, no matter how poor, should get in the habit of giving back. I give between 10-12% to my church and other charitable organizations. It helps at tax time and it's the right thing to do. If you wait to be "rich enough" give back, you will wait forever.
I wish I could do more... like start a ROTH, or diversify my portfolio, but I'm pretty maxed out. I had to give up my glamorous vacations to start doing the stock purchase program. Now I just go home for the holidays. I have to constantly evaluate my life/money balance, and certain things like gym memberships and cable TV have all met the chopping block.
Also, I really liked your post about investing in yourself/career; spending the extra time and effort while you don't have attachments. I spend my evenings doing work on my own start up company, and while it gets tiring, I'm hoping it will all pay off in financial independence in the future.Any ideas, feedback, suggestions are welcome... "
Let me comment on some of the points the reader made:
My anonymous reader is clearly well on his way to financial security. He seems to have made many smart decisions, and he understands the trade off between spending and saving. He has taken those first steps to financial stability a decade or more before most of his contemporaries will start to think about issues of financial planning. Kudos!
Regarding the purchase of a house while you are in your 20's. I have written a number of posts about why I don't think that real estate is a good investment, and particularly why I don't think it is a good investment for people in their 20's. However, if you are buying your house because you want to move out and own your own place - and not as an investment - there is absolutely nothing wrong with it. I completely understand that some people really need the emotional attachment, convenience and perceived security of owning a home. However, I always find it strange when people refer to renting as throwing away money. I have many points to make on this topic and will address them in a future post. For now, I will share only one important thought: by renting I am able to take the large chunk of cash that would otherwise be tied in bricks, and invest it in highly diversified, high yielding investments. I am not throwing away money on rent, what I am doing is the equivalent of taking out a low cost loan to invest in a highly profitable opportunity. Somebody else's capital is tied up in the house I live in.
One a different note, there are two financial errors I think that the commenter is making. The first is owning a large number of shares in his own company stock. To find out why I think this is a big error, see my post on the subject. I also think that the reason the commenter is accumulating shares is his company's ESPP which allows him to purchase shares at a discount. Purchasing the shares is the right move. Hanging on to them is not. Once the shares are purchased at a discount, it is probably a good idea to sell them and pocket the difference. More about my proposed ESPP strategy in this post.
Although the commenter does not say so explicitly, I am getting the sense that he thinks he is not diversified. If that is the case, this is a serious financial error. To diversify your portfolio you don't need to have a lot of money, and you don't need to to pay through the nose to achieve diversification. Here is a good way to take a step in the right direction: when you sell your company shares, use the proceeds to purchase a diversified index fund, such as Vanguard's Total Market Index Fund. Diversification is a sound financial strategy that will pay off in the long run.
The reader is clearly doing almost everything right financially, but he appears to be paying a high personal cost for some of his decisions. For example he mentions that he is no longer taking "fancy vacations". To me it's all a question of happiness. I used my 20's to travel the world. Yes, it cost a lot of money, but I don't regret that expense for a second. Let me tell you something: as a mid-career professional, taking large chunks of time off to go traveling is not very feasible. Doing it with three small kids is pretty much impossible. So, yes, plan for your financial future but make sure you don't fixate on the money. Enjoy your youth. Your memories will last a lifetime and the money is very well spent.
Regarding the after hours start-up and giving back to the community, all I can say is "more power to you!"
As you can see, I read every comment left on my blog, and respond to pretty much all of them. So, keep 'em coming. Let me know what you think about my posts and let me know if there are any topics you would like me to tackle. I will be glad to do so.
Wednesday, September 19, 2007
How to Play the Fed Rate Cut
To much fanfare and cheers from Wall Street the Fed cut interest rates by 0.5% yesterday. The markets were virtually certain that the Fed would cut rates, but pundits were arguing whether the cut would be a moderate 0.25% or an aggressive 0.5%. Well, the Fed is trying to signal that it means business and that it will not let the economy sink into recession without a fight.
What does the rate cut mean for the average investor and what is the correct reaction? Frequent readers of this blog know that I am a "steady as she goes" kind of investor. I do not let the ups and downs of the market change my carefully planned investment strategy and asset allocation. Having said this, the rate cut is likely to effect different asset classes in different ways:
1. Money Markets and CD's - even before the cut experts have been talking about the fact that yields on CDs and money market funds were destined to go lower. With the turmoil in the market, many investors were panicking and moving their investments to safer investment vehicles. With more money being thrown into CDs and money market accounts, financial institutions could reduce the yield that they offered.
What does the rate cut mean for the average investor and what is the correct reaction? Frequent readers of this blog know that I am a "steady as she goes" kind of investor. I do not let the ups and downs of the market change my carefully planned investment strategy and asset allocation. Having said this, the rate cut is likely to effect different asset classes in different ways:
1. Money Markets and CD's - even before the cut experts have been talking about the fact that yields on CDs and money market funds were destined to go lower. With the turmoil in the market, many investors were panicking and moving their investments to safer investment vehicles. With more money being thrown into CDs and money market accounts, financial institutions could reduce the yield that they offered.
The rate cut will certainly cause the yields to decline. If not tomorrow, then in the next few weeks. This means that if you are planning to keep a cash position as part of your portfolio, you may want to look into the option of locking some of that money in CD's at the current higher rate.
2. International Investments - with the yield on the Dollar going down, and the international economy still expanding, the chance for a further decline in the Dollar vs. other major currencies has increased. This means that investments denominated in foreign currency will be worth more in Dollars, and that companies that do business abroad or rely on exports to a large degree will be seeing their income increase when converted back into Dollars. If your portfolio is short on foreign investments, now may be a good time to boost that portion of your investments.
3. The Domestic Stock Market - the stock market loves interest rate cuts. The reason? When interest rates go down, the yield on safer investments becomes less attractive and people move into the stock market to find higher returns. With a greater demand for stock, their price climbs. In addition, companies find it easier to borrow money to expand their operations, and find it cheaper to pay their obligations. Both factors tend to support earnings.
Is the bull market coming back with a vengeance? I have no clue, and neither does anyone else. However, if I were a betting man I wouldn't put my money on it quite yet. The economy is not out of the woods. No by a long shot. In fact, I think we may just be starting to walk into them. If that is the case, the stock market is going to see some choppy water before any celebrations can begin. I am guessing volatility will continue at least for several more months.
4. Bonds - Have you gotten tired of seeing the bond portion of your portfolio stagnate for the past several years? I know I have. Many a time I thought about dumping my bonds and doing something productive with the money, but prudence won out. I stuck to my asset allocation plan. Now come the better times for bonds. As yields on the money market drop and as interest rates continue to decline, bonds start to look better and better for those conservative investors that don't want to jump into the stock market. An environment of interest rate cuts is typically one in which bonds show some muscle. That would be nice.
5. Real Estate - remember the woods I mentioned a couple of paragraphs ago? These are the woods I am referring to. The Fed cut interest rates, and that's good. The cut may mitigate some of the pain and save some homeowners from foreclosure. BUT I am not rushing out to buy a house, or to increase my exposure to the real estate market. There are too many darn houses on the market. Those are still there whether or not the Fed cut the rate. Let's face it. We just came through a major real estate bubble and prices have a ways to go before they return to sanity. They can either drop outright, or they can stagnate while inflation catches up. Either way, real estate has had its day in the sun, and I think it will be a while before we return to the crazy day of the flipper.
6. Commodities - the Fed cut is likely to boost economic activity and with more activity comes the need for more raw materials. We have seen crude oil prices break records two days in a row, and I suspect high commodity prices will last. Am I investing in metals, corn futures or oil? Nope, but until economic activity cools down substantially, I think we will continue to see high commodity prices. In fact, I wouldn't be surprised to see commodity prices holding at current prices or higher for years to come.
That's my take on the economy and the likely outcomes of the Fed rate cut. Unfortunately, I am no prognosticator. I wish I had a functioning crystal ball, but lacking one I think I will stick to my tried and true asset allocation strategy. I go through this analysis as an intellectual exercise, but I don't typically act on my own advice. I don't recommend you act on it either.
Tuesday, September 18, 2007
Recommended Articles
It's Tuesday, which means it's time for my weekly blog Carnival review. So here goes:
The Carnival of Personal Finance was hosted by Money, Matter and More Musings this week. My article titled "The Real Estate Market is About to Get Worse" was included in the Carnival.
FILAM Personal Finance has an article about how utility companies are now offering rebates for consumers who purchase energy efficient appliances. At least in Northern California this is certainly true. PG&E is also offering consumers the option to pay a variable rate on their electric usage depending on the time of day. For most folks that's not a great deal, but my in-laws used to own an electric vehicle, and saved a bundle by using this option and re-charging the car at night.
Limeade over at Fiscal Musings has a post about how he and his wife enjoyed an outing to McDonald's at a very low cost. He especially liked the fries. OK. The reason I am mentioning this article is that I am wondering if the cost of the dinner includes the cost for the Cardiologist visit. The last time I ordered fries at McDonald's was the time I read on the menu the nutritional value of the food I was eating. My large order of fries had 8 grams of trans fat in it. They should hand out bottles of Lipitor with those fries. It's a sad statement about our society that the cheapest and most easily available food is also the most harmful from a health perspective.
The Festival of Stocks was hosted by Trading To Go this week. My article To Time or Not to Time the market was selected Editor's Choice. Sweet. I must say that the Festival had some excellent articles this week. Check it out. Here are a couple of examples:
Ask the Advisor, ranks the 25 most influential investing blogs. For any of you guys that just stumbled on my humble blog but are not familiar with some of the titans of our PF blog community, check out this list and visit some of these excellent websites. Many of these blogs are also featured in my blogroll (check out the left column on this page).
The Agonist has a smart and detailed article about the sad state of the U.S. political system and the connection between "business political contributions", which I fondly refer to as bribes, and stock appreciation of the contributing companies. This is highly recommended reading. In the name of freedom of speech, companies are being allowed to buy influence and favors in Washington. From my perspective, freedom of speech is a basic human right that should be reserved for individuals. Corporations, which are fictitious legal entities should not enjoy this right, at least as far as political contributions go.
Adventures in Money Making takes an unpopular position, with which I tend to agree. Better a relatively small recession now than a much bigger and more painful recession later. He also thinks that we are already in recession.
Another Carnival that is up this week is the Stock Market Carnival published by The Investor's Journal. I haven't had a chance to read any of the articles and may add some recommendations later.
The Carnival of Personal Finance was hosted by Money, Matter and More Musings this week. My article titled "The Real Estate Market is About to Get Worse" was included in the Carnival.
FILAM Personal Finance has an article about how utility companies are now offering rebates for consumers who purchase energy efficient appliances. At least in Northern California this is certainly true. PG&E is also offering consumers the option to pay a variable rate on their electric usage depending on the time of day. For most folks that's not a great deal, but my in-laws used to own an electric vehicle, and saved a bundle by using this option and re-charging the car at night.
Limeade over at Fiscal Musings has a post about how he and his wife enjoyed an outing to McDonald's at a very low cost. He especially liked the fries. OK. The reason I am mentioning this article is that I am wondering if the cost of the dinner includes the cost for the Cardiologist visit. The last time I ordered fries at McDonald's was the time I read on the menu the nutritional value of the food I was eating. My large order of fries had 8 grams of trans fat in it. They should hand out bottles of Lipitor with those fries. It's a sad statement about our society that the cheapest and most easily available food is also the most harmful from a health perspective.
The Festival of Stocks was hosted by Trading To Go this week. My article To Time or Not to Time the market was selected Editor's Choice. Sweet. I must say that the Festival had some excellent articles this week. Check it out. Here are a couple of examples:
Ask the Advisor, ranks the 25 most influential investing blogs. For any of you guys that just stumbled on my humble blog but are not familiar with some of the titans of our PF blog community, check out this list and visit some of these excellent websites. Many of these blogs are also featured in my blogroll (check out the left column on this page).
The Agonist has a smart and detailed article about the sad state of the U.S. political system and the connection between "business political contributions", which I fondly refer to as bribes, and stock appreciation of the contributing companies. This is highly recommended reading. In the name of freedom of speech, companies are being allowed to buy influence and favors in Washington. From my perspective, freedom of speech is a basic human right that should be reserved for individuals. Corporations, which are fictitious legal entities should not enjoy this right, at least as far as political contributions go.
Adventures in Money Making takes an unpopular position, with which I tend to agree. Better a relatively small recession now than a much bigger and more painful recession later. He also thinks that we are already in recession.
Another Carnival that is up this week is the Stock Market Carnival published by The Investor's Journal. I haven't had a chance to read any of the articles and may add some recommendations later.
Monday, September 17, 2007
Lies Brokers Will Tell You
Personal financial advisers will tell you many lies. Some of them will tell you that you'll be better off investing in actively managed funds, some of them will explain that there is a reason to invest in load funds that charge you a fee for the pleasure of buying their shares. I will not speak about these big lies. Instead I'd like to speak about a small lie that I find harmless but annoying.
You must have heard at least a dozen versions of this lie, but here is the most recent version that I have heard. The following quote actually comes from a good article that I quoted from a few days ago, taken from Charles Schwab "On Investing" Magazine . It goes like this:
"...I showed a chart highlighting that if you missed the top 40 best single market days (less than 1.6 of trading days) over the past 10 years, your annualized return plunged to -6.4% versus the S&P 500's +8.4%."
So what's wrong with this statement? It's very simple. This statement assumes that you missed the top 40 days, but were somehow able to hit every single one of the worst days. Well, if by some black magic you were able to accomplish this feat, you would be the person with the worst luck who has ever walked the face of the planet. In fact, if you are able to do this, stay away from me, because there is a good chance you will be hit by a meteor and a lightning bolt on the same day. Reality is that if you are out of the market, you will miss both the good days and the bad days in equal measure. Removing only the good days from the calculation vastly overstates the problem.
So called financial advisers frequently use this lie to push people into putting their money in the market even in bad times. I completely agree with their underlying goal: people should systematically continue to invest in the market, regardless of whether the market is having a good year or not. However, there is no reason to overstate the facts or come up with impossible scenarios to encourage them to do so.
You must have heard at least a dozen versions of this lie, but here is the most recent version that I have heard. The following quote actually comes from a good article that I quoted from a few days ago, taken from Charles Schwab "On Investing" Magazine . It goes like this:
"...I showed a chart highlighting that if you missed the top 40 best single market days (less than 1.6 of trading days) over the past 10 years, your annualized return plunged to -6.4% versus the S&P 500's +8.4%."
So what's wrong with this statement? It's very simple. This statement assumes that you missed the top 40 days, but were somehow able to hit every single one of the worst days. Well, if by some black magic you were able to accomplish this feat, you would be the person with the worst luck who has ever walked the face of the planet. In fact, if you are able to do this, stay away from me, because there is a good chance you will be hit by a meteor and a lightning bolt on the same day. Reality is that if you are out of the market, you will miss both the good days and the bad days in equal measure. Removing only the good days from the calculation vastly overstates the problem.
So called financial advisers frequently use this lie to push people into putting their money in the market even in bad times. I completely agree with their underlying goal: people should systematically continue to invest in the market, regardless of whether the market is having a good year or not. However, there is no reason to overstate the facts or come up with impossible scenarios to encourage them to do so.
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