Archive for the ‘Stock Investing Series’ Category

Ah, no.  Index investing is for people who want the best possible results.

Over the last year or so some of my investing ideas have drawn comment on other blogs and forums.  Lately I’ve noticed that even those folks seeking to compliment me sometimes frame my position on Vanguard and index funds as sound advice only for average people who don’t want to work very hard at investing.  The idea being that with a little more effort in the selection of individual stocks and/or actively managed funds smarter, more diligent folks can do better.

Rubbish!

bruce-lee-flip

I can’t do this. Can you do this?

I can’t pick winning individual stocks and you can’t either. It is vanishingly difficult, expensive and a fool’s errand.  It will erode your returns in such a fashion as to make planning your withdrawal rate a much dicier proposition.

Take a look at this video clip from a few months back and consider Apple, then most valuable company in the world:  http://video.cnbc.com/gallery/?video=3000116834&play=1

These are very smart people being interviewed, with analytical tools us individual investors can only dream about. Apple was trading at 700, clearly on its way to 1000. The interviewer pushes to get even a hint of possible concerns, and good on him for it. But they were absolutely convinced Apple was cheap and a buy at 700. Their reasoning was sound. Yet here it is opening at 442 today. Oops.

Will it go higher from here? Possibly. That’s why people are willing to buy at this level. Will it go lower? Possibly. That’s why an equal number of people are willing to sell at this level. Never lose sight of the fact that anytime you buy or sell a stock, no matter how careful your research and sound your thinking, there is someone on the other side of that trade just as convinced you’re wrong.

As you may know there is a school of thought that suggests that even the super-star investors, think Warren Buffet, are simply lucky.  Even for a hard-core indexer like me, that is tough to wrap my head around.  Yet here’s research that suggests that only the very top-tier of money managers out perform and that when they do it is almost impossible to distinguish skill from luck:   Luck v. Skill in Mutual Fund Performance

Many years ago I had a martial arts instructor who was talking about effective street fighting.  On the subject of high kicks he had this to say:  “Before you decide to use kicking techniques on the street ask yourself this question:  ‘Am I Bruce Lee?’  If the answer is ‘no’ keep your feet on the ground.” Good advice when you’re playing for keeps.

Bruce-Lee

Are you Bruce Lee?

The point is this:  As cool and effective as kicks look in the movies, tournaments and in the dojo, on the street they are very high risk.  Unless you are both very skilled and significantly more skilled than your opponent (something unknowable in street fighting or investing) they are likely to leave you exposed and vulnerable.  Even, and this is critical, if you’ve had success with them before.

So too with investing. Before you start trying to pick individual stocks and/or fund managers ask yourself this simple question:  “Am I Warren Buffett?”  If the answer is “no,” keep your feet firmly on the ground with indexing.  (If the answer is “yes,” it’s nice to have you here, Warren.)

So let me take a moment to be absolutely clear.  I don’t favor indexing just because it is easier, although it is. Or because it is simpler, although it is that too.

I favor it because it is more effective and more powerful in building wealth than the alternatives.

I’d happily put in more effort for more return. More effort for less return? Not so much.

For more:

https://jlcollinsnh.wordpress.com/2012/01/06/index-funds/

https://jlcollinsnh.wordpress.com/2012/01/02/magic-beans/

https://jlcollinsnh.wordpress.com/2011/12/27/dividend-growth-investing/  

Addendum:

Here’s Jack Bogle on the Market. Bogle is the best thing that ever happened for us small investors. Listen to this five minute interview and take the concepts to heart. On Market Timing: “I’ve been in this business 61 years and I can’t do it. I’ve never met anybody who can do it. I’ve never met anybody who’s met anybody who can do it.”

Ok, so you’ve read the Smoother Path to Wealth and thought,  “Aww man.  Three funds?  And I gotta rebalance them every year?  That’s too much to keep track of!”

Picard aww man

But then you hit the link and went to the Simple Path to Wealth.  As you read, you thought, “This is more like it.  Only one fund.  This I can handle.”  But then you got to the part where, maybe 40 years from now as you start looking at retirement, you’re going want to add a couple more.  “Aww man!”

jlcollinsnh hears your pain.  You need the simplest of all possible paths.  You need to be able to buy just one fund and own it till your dying day.  Any asset allocation crap should be handled for you.  You have bridges to build, nations to run, great art to create, diseases to cure, businesses to build, beaches to sit on.  Motorbikes to ride.  I’m here for you bunkie.

More importantly, so is Vanguard with a series of 11 Target Retirement Funds.* For that matter, so are other mutual fund companies, but as you know Vanguard is the primo choice around these parts so we’ll be talking about these. If your 401k or similar plan offers only one of the others, what is said here (excepting expense ratio costs) applies.

*(For some reason this link doesn’t stay set to just the Target Retirement Funds.  To bring them up when you get to the page, look at the left hand column.  Under Asset Class chose Balanced.  Under Fund Minimum be sure only $1000 is checked.  Under Management chose Index.  That should bring them up.  Then you can simply click on each to check out the specifics.)

If you click on the link you’ll see that these eleven funds range from Target Retirement 2010 to Target Fund 2060.  The idea is you simply pick the year you plan to retire and that’s your fund.  Other than adding as much as you can to it over the years and arranging for withdrawal payments when the time comes, there is nothing else you need ever do.  It’s a beautiful and elegant solution.

Let’s peek under the hood.

peek under the hood

Megan Fox wants to….

Each of these Target Retirement Funds (TRF) is what is known as a Fund of Funds.  That just means that the Fund holds several other funds, each with different investments.  In the case of Vanguard, the funds held are all low-cost Index Funds.  That’s a very good thing.  The TRFs ranging from 2020 to 2060 each hold only three funds:

  • Total Stock Market Index Fund
  • Total Bond Market Index Fund
  • Total International Stock Market Index Fund

To those three the TR 2015 fund adds:

  • Inflation-Protected Securities Fund

To those four the TR 2010 fund adds:

  • Prime Money Market Fund

As the years roll by and the retirement date chosen approaches the funds will automatically adjust the balance held, becoming steadily more conservative and safer over time.  You needn’t do a thing.

The expense ratios range from .17 to .19, depending on the fund.  Excellent.

What are the short comings?

Some people say the funds get too conservative too soon. Others complain that they are too aggressive for too long. For my money, I think Vanguard gets it pretty close to spot on.  Maybe a bit conservative for me personally, but then I’m on the aggressive side.  This is easy to adjust for.  If you want a more conservative (greater percentage of bonds) approach, choose a date before your actual retirement.  The earlier the date the more conservative the asset allocation.  If you want more aggressive (greater percentage of stocks), just pick a later date.

In deciding, be sure to remember what we learned looking at the Trinity Study in our discussion of withdrawal rates:  A strong dose of stocks is critical to a portfolio’s survival rate, especially once you begin drawing money out.

BTW, other fund companies use differing allocations for differing retirement dates. If those are what’s offered in your 401k or 403b plan, you’ll need to take a look and then decide. But the same principles apply.

So why doesn’t jlcollinsnh recommend them?

I do, actually, and am with this post.  They are an excellent choice for many, maybe most people.  They will certainly over time out perform the vast majority of active management investment strategies.

But I do have a slight preference for…

…the Smoother Path to Wealth and the Simple Path to Wealth.  Here’s why:

  • The expense ratios are even lower than those of the TRFs.
  • The TRFs all hold the Total International Stock Market Index Fund.  While this is an excellent fund, I don’t feel the need for additional international coverage beyond that found in the Total Stock Market Index Fund.
  • REITs are not part of the TRF mix. Held in VGSLX, these provide dividend income and, more importantly, serve as my inflation hedge.  Of course, you could easily just add VGSLX to your TRF of choice.
  • With separate funds, I can keep my bonds and REITS in my tax-advantaged accounts, protecting the dividends and interest from taxes.

Where are you likely to find Target retirement Funds?

looking under a rock

Painting by Ted Dawson

Target Retirement Funds have become very popular as options in the 401k and 403b retirement plans offered by employers. The thinking is (and it is sound) that most people really have very little interest in investing.  TRFs provide an effective, simple and well-balanced “one decision” solution.  Plus, because such retirement plans are tax sheltered, the interest from the bonds and the dividends from the stocks go untaxed.  Of course, when the funds are withdrawn in retirement taxes will be due.

What should you do?

If your 401k (or the like) offers TRFs or low-cost equivalents from another fund company, they are well worth your consideration.

If you want as simple as possible and still effective, TRFs are for you.

TRFs:  They come with the jlcollinsnh….

Seal-of-approval

In Part XII: Bonds, reader Chronicrants commented:  “I’d love to see more on deflation. I’ve always been confused about it and about it’s consequences. It seems like it would be a good thing, and yet….”  Great point, and what better topic, I thought, for unlucky number 13 in this series!

lucky 13

Unfortunately, I forgot that was my plan and Withdrawal Rates got spot #13.  Sigh.  It’s tough getting old.

When deflation has come up in my previous posts it has been the ugly escort bringing Depressions to the Ball.  Indeed here in the USA we have had four depressions since our founding in 1776:  1818-21, 1837-43, 1873-96 (the duration record holder) and the one we think of most often:  The world-wide depression of 1930-33.  In each case deflation was there, walking side-by-side holding depression’s hand.

So what the heck is deflation anyway?  Simply put, it is the lowering of prices and the increasing of the value of money.

Hmmm….  As Chronicrants says, “It seems like it would be a good thing…”  In many cases, it is.  Let’s take a closer look.

Good Deflation.

One of the dynamic benefits of our economic system is the steady lowering of prices thru technological innovation and increased productivity.  Perhaps the clearest example of this in recent decades is the rapid fall in prices and improvement of products in the electronic/tech world.  The laptop or TV that was $2000 a few years back can be had now for $500.  People never tire of pointing out that we carry more computing power in our phones than that on the Apollo moon missions.

Apollo

Apollo Launch

Not Apollo, but here’s also a great sound track/video of a Space Shuttle launch.

As a percent of average earnings, the cost of food, housing and transport are all lower today than 50 years ago.  Yet thru innovation and productivity gains, the companies that provide these things are doing better as well.  Our money buys more of all these things and is thereby worth more than it was.  This is deflation, and it is a good thing.

Ugly Deflation.

Deflation turns ugly when prices drop for reasons other than increasing innovation and productivity.  This occurs during economic downturns.  At first, this too can be a good thing, but the danger is slipping into a Deflationary Spiral. It looks something like this:

Unemployment rises — Demand for goods slows — Prices come down — Profits drop — Companies cut production — Unemployment rises faster — Demand for goods slows further — Prices fall — Profits drop — Companies cut production — and on.  A few cycles of this and companies start folding and bread lines start growing.  The cycle can start with any of these points along the line.  It becomes a vicious circle that’s very tough to break.

Bowery-Bread-Line

Bowery Bread Line

Photo from:  Old Photo.com

The collapse of our housing bubble a few years back brought us to the edge of this abyss.  The antidote is a nice healthy dose of inflation and that’s exactly what the Federal Reserve has been trying to reignite.  It does this by lowering interest rates (now effectively zero) and pumping cash into the system.  The idea is this will break the cycle and get companies ramping up and people spending again.  It is an attempt to reverse the psychology.

The Psychology of Deflation.

Franklin Delano Roosevelt, the 32nd President of the United States (1933–1945), famously said, “The only thing we have to fear, is fear itself.”  He was talking about the psychology that threatened to mire the country in its deflationary depression.  Our housing crisis gives us an excellent tour of this in action.

Let’s suppose you were in the market to buy a house in 2005.  Prices had been rising for years and the pace was accelerating.  Every where you turned those who had bought were bragging about their gains.  If you waited, a year from now you might be paying 10-20-30% or more for that same house.  That not only raises your cost, it represents lost profit in your mind.  You are filled with an urgency to ink a deal.

Of course, you are not alone in this thinking.  Every time a house goes up for sale, scores of other people, driven by the same psychology, are competing with you for the privilege of buying it.  Meanwhile sellers, also realizing that their house is increasingly more valuable, become more reluctant and scarcer.  Up the prices go.  Endlessly, or so it seemed.

What we had was an Inflationary Spiral.  Just like with tulip bulbs in 1637, this bubble expanded till it burst.  Then, on a dime, the psychology reversed.

At a certain point, people just couldn’t afford to buy houses at the price levels they’d reached.  In fact, in this case with all the easy money that had been lent, many new owners couldn’t afford to own them in the first place.  Suddenly, houses went up for sale and no buyers showed up.  Prices softened.  Owners started to see their values drop.  They became more willing to sell, hoping to get out before prices dropped further.  Fewer houses sold, even as more came on the market.  Supply quickly outpaced demand.  Prices dropped again.

Potential buyers, of course, also saw this happening.  It didn’t take long to realize that now waiting to buy paid off. The house you looked at today would still be for sale tomorrow and for less.  Fewer people were able to buy and those that were, effectively got paid to wait.  If you’ve been wondering why real estate brokers are so eager to declare home prices are rising again, it is this.  Until buyers start to believe prices will be higher next year they’ll hesitate to buy now. Until then, housing is locked in this Deflationary Spiral.

The danger is, of course, that housing is a huge part of the economy.  When housing sales slow it spills into the sales of lumber, appliances, furniture, windows, HVAC, flooring, garden equipment and a raft of other stuff, along with the jobs related to them.  As those drop, other segments of the economy dependent on them and the folks that work for them get pulled down.  If enough get caught in their own whirlpools, the entire economy enters the deflationary spiral.  Next thing you know….

introductions

…Mr. Deflation is introducing you to Ms. Depression.

Deflation winners and losers.

As we’ve already seen, we all win thru the deflation of prices thru technological innovation and increased productivity.  And it’s not hard to see the losers in a deflationary spiral:  Companies fold, people get thrown out of work, investments collapse.  But even these ugly deflations have winners.

Remember, deflation is the lowering of prices and the increasing of the value of money.  Deflationary spirals simply accelerate this process.  You win if:

  • You hold cash.  This is why your depression era grandparents (or great grandparents) hoarded cash.  Deflation means cash buys more, it increases in value.
  • You hold bonds.  As you know from Part XII: Bonds, when you buy bonds you are lending your money. Deflation means that your money buys more when you get paid back at a later date.  Providing, of course, the bond issuer survives the depression and has the money to pay.  Default risk.
  • You are on a guaranteed fixed income.  Those on Social Security and fixed pensions would benefit as their income buys more goods and services.  Interestingly, Social Security has provisions to raise benefits in response to inflation, but none to lower them in times of deflation.  Same is true of most pensions.

Now before you go out and sell everything and stuff the money in your mattress, it is worth noting the Federal Reserve is working overtime to reignite inflation.  There is an old saying on Wall Street:  “Don’t fight the Fed.”  It is good advice.

4%.  Maybe more.

So, you’ve followed the jlcollinsnh big three:

You’ve avoided debt

You’ve spent less than you’ve earned

You’ve invested the surplus

eggs

Eggs

by Sergey Gusev

Now you’re sitting on your stash and wondering just how much you can spend each year and not run out.  This could be stressful, but it really should be fun. You might even be cheeky enough to ask, “What percent of his own stash does jlcollinsnh spend?”  We’ll get to that.

You don’t have to have read far in the retirement literature to have come across the “4% rule.”  Unlike most common advice, this one holds up to our beady-eyed scrutiny pretty well, even though it is really very little understood.

Back in 1998 three professors from Trinity University sat down and ran a bunch of numbers.  Basically they asked what would happen at various withdrawal percentage rates to various portfolios, each with a different mix of stocks and bonds, over 30 year periods depending on what year the withdrawals were started.  Oh, and both with adjusting withdrawals for inflation and with not adjusting withdrawals. Whew.  Then they updated it in 2009.

Out of the scores of options, the financial media seized on just one of these models:  The 4% withdrawal rate, 50/50 stock/bond portfolio, adjusted for inflation.  Turns out, 96% of the time, at the end of 30 years such a portfolio remained intact.  Put another way, there was just a 4% chance of this strategy failing and leaving you destitute in your old age.  In fact, it failed in only two of the 55 starting years measured:  1965 & 1966.  Other than those two years, not only did it work, many times the remaining money in the portfolio had grown to spectacular levels.

Think about that for a moment.

What that last line means is that in most cases the people owning these portfolios could have taken out 5, 6, 7% per year and done just fine. In fact, if you gave up the inflationary increases and took 7% each year you would have done just fine 85% of the time.  Most of the time taking only 4% meant at the end of your days you left buckets of money on the table for your (all too often ungrateful) heirs.  Great news were that your goal.  Also great news if you anticipate living on your portfolio for longer than 30 years.

But the financial media knows that most people don’t like to think too hard.  By reporting the results at 4% they could report on just about a sure thing.  Roll it down to 3% and we have as sure a thing as we’ll ever see short of death and taxes.  Oh, and that’s giving yourself annual inflation increases.

While 1965 & 1966 were the last and only two years where 4% failed, remember that more recent start years have not yet had their own 30 year measurable runs.  My guess is that if you began your own withdrawals in 2007 and the early part of 2008 just prior to the recent collapse, you will have hit upon two more years in which the 4% plan is destined to fail.  You’ll want to scale back.  On the other hand, if you started with 4% of your portfolio’s value as of the March 2009 bottom, you’re very likely golden.

Here’s the Trinity Study Update.  The prose is a bit dry, it is written by PhDs after all, but don’t feel you need to read it closely.  What you should take a close look at are the very cool charts showing how differing scenarios play out.  If you want a detailed answer to the question of what percent works for you and your own unique situation and attitudes, you can figure it out here.  Plus, you’ll need to refer to those charts to follow along in the rest of this post. So go ahead. Take a look. I’ll wait.

Here’s the Cliff Notes version:

    • 3% or less is a near sure bet as anything in this life can be.
    • Stray much further out than 7% and your future will include dining on dog food.
    • Stocks are critical to a portfolio’s survival rate.
    • If you absolutely, positively want a sure thing, and your yearly inflation raises, keep it under 4%.  Oh, and hold 75% stocks/25% bonds.
    • Give up those yearly inflation raises and you can push up towards 6% with a 50% stock/50% bond mix.
    • In fact, the authors of the study suggest you can withdraw up to 7% as long as you remain alert and flexible. That is, if the market takes a huge dive, cut back on your percent and spending until it recovers.

When you look at the article you’ll see it has four charts.  The first two look at how various portfolios performed over time and at various withdrawal rates.  The difference is the second one assumes you increase your dollar withdrawal amount each year to account for inflation.  So if you look at Chart #1 and at the 50/50 mix with a 4% withdrawal rate, you see you have a 100% chance of your portfolio surviving 30 years.  Chart #2 tells you that if you take those same parameters but give yourself inflation raises, your portfolio’s chance of survival drops to 96%.  Makes sense, no?

Charts 3 & 4 tell us how much money remains in the portfolios after the 30 years have passed and this, to me, is really compelling stuff.  Again, Chart 3 assumes a straight percentage withdrawal and Chart 4 assumes giving yourself inflation raises.  Let’s take a look at some examples.

Assume a 4% withdrawal rate on a portfolio with an initial value of $1,000,000.  Here’s what you’d have left (median ending value) after 30 years:

Chart 3:

  • 100% stocks = $15,610,000
  • 75% stocks/25% bonds =  $10,743,000
  • 50% stocks/50% bonds= $7,100,000

Chart 4:

  • 100% stocks = $10,075,000
  • 75% stocks/25% bonds =  $5,968,000
  • 50% stocks/50% bonds = $2,971,000

Very powerful stuff and it should give you a lot to feel warm and fuzzy about as you follow The Simple Path to Wealth.

As you look over these charts, one thing that should become very clear to you is just how powerful and necessary stocks are in building and preserving your wealth.  This is why they hold center stage in my Portfolio Ideas.

What is likely less obvious, but every bit as important, is the critical importance of using low-cost index funds to build your portfolio.  When you start paying 1-2% or more to active mutual fund managers and/or investment advisors all these cheerful assumptions wind up in the trash heap.  Blogger Wade Pfau in this article says it best:

“For an example of this, the 50-50 portfolio over 30 years with 4% inflation-adjusted withdrawals had a 96% success rate without fees, 84% success rate with 1% fees, and 65% success rate with 2% fees.”

In other words, using the Trinity Study projections with portfolios built from anything other than low-cost index funds is invalid.

So, now to answer that question:  What withdrawal percent do I personally use in my retirement?  I confess I pay so little attention it took a few moments to figure it out and even then it’s not exact.  But this year my best guess is it is running somewhere north of 5%.  If you are a regular reader, this casualness probably surprises you.  But there are mitigating circumstances:

1.  I have a kid in college.  That is a huge annual expense, but in 1.5 years it goes away.  The money for it is figured into my net worth, but it is also earmarked as “spent.”

2.  Since my retirement, my wife and I have accelerated our travels and the related spending has spiked sharply. Not to be morbid, but at my age I am more worried about running out of time than money.  If the market were to tank in a major way, this is an easy expense to adjust.

3.  Sometime in the next few years we will have two nice new income streams coming on-line in the form of Social Security.

4.  Most importantly, I know I’m well under the 6-7% level that requires close attention.

Within that 3-7% range, the key to choosing your own rate has less to do with the numbers than with your personal flexibility.  If as needed you can readily adjust your living expenses, find work to supplement your passive income and/or are willing and able to comfortably relocate to less expensive places, you will have a far more secure retirement no matter what rate you choose.  Happier too I’d guess.

If you are locked into certain income needs, unwilling or unable to ever work again and your roots go too deep to ever seek out greener pastures, you’ll need to be much more careful.  Personally, I’d work on adjusting those attitudes.  But that’s just me.

My pal, Mr. Money Mustache, did a fine piece on this a while back.  It is as good an explanation/defense of the 4% rule I’ve yet to read. Nothing, of course, is guaranteed. That why we all need to remain flexible, alert and, well, Mustachian.

Last Spring I dealt with a lengthy comment from reader “ddrem” describing the disastrous position the world is in today and calling into question my portfolio recommendations accordingly. (See: https://jlcollinsnh.wordpress.com/2012/05/12/stocks-part-vi-portfolio-ideas-to-build-and-keep-your-wealth)

No worries.

sea by Gusev

Sea

by Sergey Gusev

Not only will we muddle thru, it is my belief we are on the verge of another great bull market. For lots of reasons, not the least of which is simply these things go in cycles and the drumbeat of pessimism (always a bullish sign) seems unusually high.  People seem to believe the world will end on their watch. But it never does. It is the dark that sets the stage for the dawn.

If I’m wrong and the dawn is still a ways off, that’s OK too. There are lots of adjustments I can make and options to explore.

4% is only a guide. Sensible flexibility is what provides security.

Well.  Here we are in Part XII of our series on Stocks.  And the subject is Bonds.  What’s up with that??

When I first began this series the plan was for maybe four or five segments.  Sure enough, those focused on stocks. But then we looked at some portfolio ideas and some other stuff, like bonds, got added to the mix.  Next thing you know we looking at different kinds of investment buckets, the prospect of Vanguard getting nuked and asking if everyone can retire a millionaire.  (Clearly, I should have called this my series on Investing.  Note to self:  make the change for the book.)

So now adding Bonds to the mix seems not such a stretch.  They are, in a sense, the more steady and reliable cousins to stocks.  Or so it seems.  But as we’ll see, bonds are not as risk free as many believe.

In any event, since we have included Vanguard’s Total Bond Market Fund, VBTLX, to the Wealth Preservation and Building Portfolio we should take a little closer look at the things.

The challenge is the subject of bonds is a BIG topic.  Most of the details are unlikely to be of interest to the readers of this blog on simple investing.  Heck, they’re not all that interesting to me.  Yet, unless you are comfortable just taking my word for it, you might want to know just what these things are and why they’ve found their way into our portfolio.

But how much info is enough?  Beats me.  So here’s what we’ll do.  In this post I’ll talk about bonds in Stages.  Once you’ve read enough to be comfortable owning the things (or not) you can just stop reading.  If you get to the end, the point where I’m too bored to write more, still hungry — google is your friend.

Info Stage I

Bonds are in our portfolio to provide a deflation hedge.  Deflation is one of the two big macro risks to your money. Inflation is the other and we hedge against that with REITS (real estate).  Ying and yang.

Bonds also tend to be less volatile than stocks and they serve to make our investment road a bit smoother.

Info Stage II

So what are bonds anyway, and how do they differ from stocks?

In the simplest terms:  When you buy stock you are buying a part ownership in a company.  When you buy bonds you are loaning money to a company, or to the government.

Since deflation is when the price of stuff falls, when you get paid back the money you’ve lent has more purchasing power. Your money buys more stuff than when you lent it.  This increase in value helps to offset the losses deflation will bring to your other assets.

In times of inflation prices rise, so money owed to you loses value.  When you get paid back your cash buys less stuff. Better then to own assets that rise with inflation.  Real estate fits that bill and REIT funds allow us to own a broadly diversified portfolio of properties without the hassles of hands on management.  Our REITs should rise in value even as inflation erodes the value of the money tied up in our bonds.

We’ll only see this sharp rise in the one and fall in the other in times of rapid inflation or deflation.  Both of which are bad times.  In the more normal times of modest inflation our bonds and REITS will still serve us well.  Bonds will pay their interest and REITs their dividends.

Info Stage III

Since we own our bonds in VBTLX, a broad-based bond index fund, most of the risks in owning individual bonds go away.  The fund holds 5248 bonds, all investment grade and none rated lower than Bbb (see Stage IV).  This reduces default risk.  The fund holds bonds of wildly differing maturity dates, mitigating the interest rate risk.  The fund holds bonds across a broad range of terms, reducing inflation risk.

In the next Stages we’ll talk more about these risks, but what’s important to understand at this point is:  If you are going to hold bonds, holding them in a fund is the way to go.  Very, very few individual investors opt to buy individual bonds.  US treasuries and bank CDs being the exceptions.

Info Stage IV

The two key elements of bonds are the interest rate and the term.  The interest rate is simply what the bond issuer (the borrower) has agreed to pay the bond buyer (the lender — you).  The term is simply for how long the money is being lent.  So, if you were to buy a $10,000 bond at a 10% interest rate with a 10 year term from XYZ company, each year XYZ would pay you $1000 interest (10% of 10k) and at the end of 10 years they would repay the full $10,000.  If you hold the bond until the end of the 10 years, or to the Maturity Date, the only thing you have to worry about is the possibility of XYZ defaulting.

So, default is the first risk associated with bonds.  To help investors evaluate the risk in any company or government bond, various rating agencies evaluate their credit worthiness.  They use a scale ranging from AAA on down to D, kinda like high school.  The lower the rating the higher the risk.  The higher the risk the harder it is to find people to buy your bonds.  The harder it is to find people to buy your bonds the more interest you have to pay to attract them. Investors expect to be paid more interest when they shoulder more risk.

So, default risk is also the first factor determining how much your bond will pay you.  As a buyer of bonds, the more risk you are willing to accept the higher the interest you’ll receive.

Info Stage V

Interest Rate Risk is the second risk factor associated with bonds and it is tied to the term of the bond.  This risk only comes into play if you decide to sell your bond before the maturity date at the end of the term.  Here’s why:

When you decide to sell your bond you offer it to buyers on what is called the “secondary market.”  Using our example above these buyers might offer more than the 10k you paid, or less.  It depends on how interest rates have changed since your purchase.  If rates have gone up, the value of your bond will have gone down.  If rates have gone down, the value of your bond will have risen.  Confusing, no?  Look at it this way:

You decide to sell your bond from our example above.  You paid $10,000 and are earning 10%/$1000 per year.  Now, let’s say interest rates have risen to 15% and I have $10,000 to invest.  Since I can buy a bond that will pay me $1500 per year, clearly I’m not going to be willing to pay you $10,000 for your bond that only pays $1000.  Nobody would, and you’d be stuck.  Fortunately, however, the secondary bond market will calculate exactly what lower price your bond is worth based on the current 15% interest rate.  You might not like the price, but at least you’ll be able to sell.

But if interest rates drop, the roles reverse. If instead of 10% they fall to 5%, my $10,000 will only buy me a bond paying $500 per year.  Since yours pays $1000, clearly it is worth more than the $10,000 you paid.  Again, should you wish to sell, the bond market will calculate exactly what your higher price will be.

When interest rates rise, bond prices fall.  When interest rates fall, bond prices rise.  In either case, if you hold a bond to the end of its term you will, barring default, get exactly what you paid for it.

Info Stage VI

As you’ve likely guessed, the length of the term of a bond is our third risk factor and it also helps determine the interest rate paid.  The longer the term of a bond the more likely interest rates will change significantly before it matures and that means greater risk.  While each bond is priced individually, there are three bond term groupings: Short, medium and long.  Looking at US Treasury Securities for example we have:

Bills — Short-term bonds of 1-5 year terms.

Notes — Mid-term bonds of 6-12 year terms.

Bonds — Long-term bonds of 12+ year terms.

Generally speaking, short-term bonds pay less interest as they are seen as having less risk since your money is tied up for a shorter period of time.  Accordingly long-term bonds are seen as having higher risk and pay more.  If you are a bond analyst type, you’ll graph this on a chart and create what is called a Yield Curve.  The greater the difference between short, mid and long-term rates, the steeper the curve.  This difference varies and sometimes things get so wacky short-term rates become higher than long-term rates.  The chart for this event produces the wonderfully named Inverted Yield Curve and it sets the hearts of bond analysts all a flutter.

Info Stage VII

Inflation is the biggest risk to your bonds.  Inflation is when the cost of goods is rising.  When you lend your money by buying bonds, during periods of inflation when you get it back it will buy less stuff.  Your money is worth less.  A big factor in determining the interest rate paid on a bond is the anticipated inflation rate.  Since some inflation is almost always present in a healthy economy, long-term bonds are sure to be affected.  That’s a key reason they typically pay more interest.  So, when we get an Inverted Yield Curve and short rates are higher than long rates, investors are anticipating low inflation or even deflation.

Info Stage VIII

If you’ve read this far, I have a secret to share and a confession to make.  I no longer hold my personal bond allocation in VBTLX.  For now, I’m using VFIDX.  This is Vanguard’s Intermediate-Term Investment Grade Index Bond fund.

This change is buried here because it doesn’t fit with the basic concept of the Simple Path; namely an investment strategy that can be set and left to run with minimal attention.  Meeting that parameter is best served with VBTLX and its coverage of the entire bond market.  That’s still the recommendation I stand by for the Simple Path portfolios, and I’ll personally be returning to it in the future.

But if you have a more active investing inclination, as I do, you might want to consider VFIDX for the time being. Here’s my thinking:

  • A few short years ago we were teetering on the brink of a deflationary depression like that of the 1930s.  Very scary stuff.
  • The antidote is a nice solid bit of inflation.
  • This is exactly what the Fed is trying hard to spark.
  • The Fed has been aggressively pumping money into the system and has taken short term rates to zero.  Historic lows.
  • Surprisingly inflation has remained low, but that is sure to change.
  • Likely fast and hard.

In this environment short-term bonds are paying next to nothing.  Long-term bonds will get hit hard when inflation reignites.  Intermediate bonds pay a decent interest rate and their term makes them less vulnerable than long bonds to inflation.  It’s like Goldilocks and the Three Bears.  Papa’s bed is too big.  Baby’s bed too small.  But Mama’s medium term bond bed is just right.  For now, I’m hangin’ with Mama.

Info Stage IX

Here are a few other risks:

Credit downgrades.  Remember those rating agencies we discussed above?  Maybe you bought a bond from a company rated AAA.  This is the risk that sometime after you buy the company gets in trouble and its rating is downgraded.  The value of your bond goes down with it.

Callable bonds.  Some bonds are “callable,” meaning that the bond issuer can pay them off before the maturity date.  They give you your money back and stop paying interest.  Of course they would only do this when interest rates are falling and they can borrow money more cheaply.  As you now know, when rates fall the value of your bond goes up.  But if it gets called, poof! There goes your nice gain.

Liquidity risk.  Some companies are just not all that popular and that goes for their bonds.  Liquidity risk refers to the possibility that when you want to sell few buyers will be interested.  Few buyers = lower prices.

All of these risks are nicely mitigated simply by owning a broad-based bond index fund.

Info Stage X

There are precisely a gazillion different types of bonds.  Basically they come from national governments, state and local governments, government agencies and companies.  Term length, interest rates and payment terms are limited only by the imagination of the buyers, sellers and regulators. Further….

…and here’s where my interest in writing about these things drifts away.  ~2200 words is enough.  Nothing further matters for us index fund bond investors.  But if you just have to know more, Google is your friend.  Be sure to report your findings in the comments.

Photo by tonynetone

In Part VI of this series we looked at some portfolio ideas to build and keep your wealth.  Last time, in The Smoother Path to Wealth, we did much the same and we discussed the concept of Asset Allocation a bit as well.

In keeping with the overall financial theme of the blog, we strive to keep our investments as simple as possible.  Simple is not only easier, it is more effective.  The most complex portfolio I suggest consists of only three funds invested in stocks, bonds and REITS (Real Estate Investment Trusts), plus cash.

Most advisors recommend far more funds and asset classes.  Indeed, scared witless after the recent market implosion, many would now have us invest in everything in the hopes a couple of those puppies pull thru. To do this properly would require a ton of work understanding the asset classes, deciding on percents for each, choosing how to own them, rebalancing and tracking.  All for what will likely be sub-par performance.

We talked about this in Part I and we’ve looked at better alternatives throughout the series.

Still, for some, even my three fund Wealth Preservation and Building Portfolio seems incomplete. The readers of jlcollinsnh are an astute bunch and the missing asset class they ask about most frequently is International Stocks.  Since almost every other allocation you come across will include International, why not the Simple Path?  Three reasons. Added risk, added expense and we’ve got it covered.

Added Risk:

Currency risk.  When you own international companies they trade in the currency of their home country.  Since those currencies fluctuate against the US dollar with International Funds there is this additional dimension of risk.

Accounting risk.  Few countries, especially in emerging markets, offer the transparent accounting standards required here in the USA.  Even here, companies like Enron occasionally cook their books and blow up on their investors.  The weaker the regulation the greater the risk.

Added expense:

VTSAX has a .06 expense ratio for rock bottom costs.  While cheaper than comparable funds, even low cost Vanguard International Funds have expense ratios at least three times that level.

We’ve got it covered:

With VTSAX you own 3277 companies, virtually every publicly traded company in the USA.  More to the point, the largest of these are all international businesses, many of which generate 50% or more of their sales and profits overseas.

The top ten holdings of VTSAX, for example, are all international in scope.  Apple, GE, IBM, Exxon/Mobil and the like.

Since these companies provide solid access to the growth of world markets, while filtering out most of the additional risk, I don’t feel the need to invest further in international specific funds.

Your world view however may lead you to a different conclusion.  If it does, and you feel the need for even more international exposure than that imbedded in VTSAX, our friends at Vanguard have some excellent options.  Here are two I suggest:

VFWAX  FTSE all-World ex-US Index Fund (expense ratio .18).  This fund invests everywhere in the world except the USA, which you’ll have covered with VTSAX.

If you prefer to keep things as simple as possible, look at VTWSX  Total World Stock Index Fund (expense ratio .40).  This fund invests all over the world, including 50% in the USA.  With it you no longer even need to hold VTSAX.

It all depends on how much of the world you want and how comfortable you are with the cost in money and risk it takes to get it.

You don’t have to read very far into this blog to know I am a strong proponent of investing in Vanguard index funds.  Indeed, you’ll find this in the Manifesto:

Vanguard.  End of story.

Understandably, this raises some questions.  Today let’s look at the four most common:

1.  What makes Vanguard so special?

When Jack Bogle founded Vanguard in 1975 he did so with a structure that remains unique in the investment world:  Vanguard is client-owned and it is operated at-cost.

Sounds good, but what does it actually mean?

As an investor in Vanguard Funds, your interest and that of Vanguard are precisely the same.  The reason is simple.  The Vanguard Funds, and by extension the investors in those funds, are the owners of Vanguard.

By way of contrast, every other investment company has two masters to serve:  The company owners and the investors in their funds.  The needs of each are not always, or even commonly, aligned.

To understand the difference, let’s look at how other investment companies (most companies in fact) are structured.  Basically, there are two options:

1.  They can be owned privately, as in a family business.  Fidelity Investments is an example.

2.  They can be publicly traded and owned by shareholders.  T. Rowe Price is an example.

In both cases the owners understandably expect a return on their investment.  This return comes from the profits each company generates in operating its individual mutual funds.   The profits are what’s left over after the costs of operating the funds are accounted for — things like salaries, rent, supplies and the like.

Serving the shareholders in their funds is simply a means to generate this revenue to pay the bills and create the profit that pays the owners.  This revenue comes from the operating fees charged to shareholders in each of their individual funds.

When you own a mutual fund thru Fidelity or Price or any investment company other than Vanguard, you are paying for both the operational costs of your fund and for a profit that goes to the owners of your fund company.

If I am an owner of Fidelity or Price I want the fees, and resulting profits, to be as large as possible.  If I am a shareholder in one of their funds, I want those fees to be as modest as possible.  Guess what?  The fees are set as high as possible.

Now to be clear, there is nothing inherently wrong with this model.  In fact it is the way most companies operate.

When you buy an iPhone built into the price are all the costs of designing, manufacturing, shipping and retailing that phone to you.  Along with a profit for the shareholders of Apple.  Apple sets the iPhone price as high as possible, consistent with costs, profit expectations and the goal of selling as many as they can make.  So, too, with an investment company.

In this example I chose Fidelity and Price not to pick on them.  Both are excellent operations with some fine mutual funds on offer.  But because they must generate profit for their owners, both are at a distinct cost disadvantage to Vanguard.  As are all other investment companies.

Bogle’s brilliance, for us investors, was to shift ownership of his new company to the mutual funds it operates.  Since we investors own those funds, thru our ownership of shares in them, we in effect own Vanguard.

Any profits generated by the fees we pay would find their way back into our pockets.  Since this would be a somewhat silly and roundabout process and, more importantly, since it would potentially be a taxable event, Vanguard was structured to operate “at cost.”  That is, with the goal charging only the minimum fees needed to cover the costs of operating the funds.

What does this translate into in the real world?

Such fees are reported as “expense ratios.”  The average expense ratio at Vanguard is .20%.  The industry average is 1.12%.  Now this might not sound like much, but over time the difference is immense and it is one of the key reasons Vanguard enjoys a performance as well as a cost advantage.

With Vanguard, I own my mutual funds and thru them Vanguard itself.  My interests and those of Vanguard are precisely the same.  This is a rare and beautiful thing, unique in the world of investing.

Click on the quote below for more:

“No one, other than the funds and their shareholders, owns a piece of Vanguard. Nobody. Our CEO, Bill McNabb, and even our founder, Jack Bogle, are client-owners in exactly the way you are.”

2.  Why are you comfortable having all your assets with one company?  Isn’t this what tanked investors with Bernie Madoff?

Because my assets are not invested in Vanguard.  They are invested in the Vanguard Mutual Funds and, thru those, invested in the individual stocks, bonds and REITS those funds hold.  Even if Vanguard were to implode (a vanishingly small possibility), the underling investments would remain unaffected.  They are separate from the Vanguard company.  As with all investments, these carry risk, but none of that risk is directly tied to Vanguard.

Now this can start to get very complex and for the very few of you who care, there’s lots of further info you can easily Google.  For our purposes here, what’s important to know is:

1.  You are not investing in Vanguard, you are investing in one or more of the mutual funds it manages.

2.  The Vanguard mutual funds are held as separate entities.  Their assets are separate from Vanguard, they each carry their own fraud insurance bonds, each has its own board of directors charged with keeping an eye on things.  In a very real sense, each is a separate company operated independently but under the umbrella of Vanguard.

3.  No one at Vanguard has access to your money and therefore no one at Vanguard can make off with it.

4.  Vanguard is regulated by the SEC.

All of this, by the way, is also true of other mutual fund investment companies, like Fidelity and Price.  Those offered in your 401k are, in all likelihood, just fine too.  (If you have an employer sponsored retirement plan, like a 401k, that doesn’t offer Vanguard funds by all means invest in it anyway.  Especially if any company match contributions are offered.  Those are free money and an instant return on your investment.)

It is NOT true however for what are called Private Investment Funds.  Those are where you turn your money over directly to an individual or group of individuals to manage and invest.  That’s what Madoff was running.

3.  What if Vanguard gets nuked?

Ok, let’s be clear.  If the world ends on December 21, 2012 as evidently the Mayan Calendar suggests it might, everything you have invested in Vanguard (or elsewhere) will go up in smoke.  But that’s not gonna happen. (Come December 22nd, I’m putting “told you so” right here.)

If a giant meteor slams into Earth setting the world on fire followed by a nuclear winter, your investments are toast.

If space aliens arrive and enslave us all, unless you bought human feedlot futures, it’s gonna mess up your portfolio.

If super volcanos or global warming or viruses or an ice age or the reversal of the magnetic poles or AI robots or nanobots or maybe Zombies take us out, investing with Vanguard will be of no help at all.

Relax.  It ain’t none of it gonna happen.  At least not on our watch.

But lesser disasters can and do happen.  Vanguard is based in Malvern, Pennsylvania.  What if, God forbid, Malvern is nuked in a terrorist attack?  What about a cyber attack?  Hurricane?  Pandemic? Power outage?

Every major company and institution is aware of these dangers and each has created a Disaster Recovery Plan.  Vanguard has one of the most comprehensive going.  The company is spread across multiple locations.  Its data is held in multiple and redundant systems.  You can check out their plan here:  Business Recovery Plan

But, if you are expecting a planet or even just a civilization ending event, Vanguard’s not for you.  But then, no investments really are.  You’re already stocking your underground shelter with canned goods.  Short of that, you can sleep just fine with your assets at Vanguard.  I do.

4.  Am I on the take?

This blog is such strong a proponent of Vanguard it is reasonable to ask….

“Am I on the take?”

Nope.  Vanguard doesn’t know I’m writing this and they are not an advertiser.  Nor do they pay me in any fashion whatsoever.

In fact, at the moment, I have no paid advertising on this blog.  Maybe someday.

(However,  I understand that you might occasionally see an ad here.  Those are placed by WordPress.  I never see them on my pages.  I don’t know if, when or for who they run.  I do know that’s how WordPress is able to offer me this blog hosting at no charge.  And, for now, I’m OK with that.)

For my International readers — an Addendum:  With its client centered focus, Vanguard is growing rapidly and now is available in many countries outside the USA.  You can check the list out here:  Vanguard Global