Uncommon Cents

I certainly can’t speak for all 401(k) or 403(b) plans, but the one I have offers a pretty decent selection of funds; over 20 in all, and many in the same category (for instance, it offers three different international stock funds and two different money market funds). For awhile, I owned a little of just about every fund that was offered, but in the last year I decided to simplify my portfolio and cut down to three funds: a domestic stock market fund, a domestic bond fund, and an international stock fund. Picking the domestic stock and domestic bond funds was easy; I simply chose the Vanguard Total Stock Market Fund and Vanguard Total Bond Market Fund. Unfortunately, my plan doesn’t offer the Vanguard Total International Stock Index Fund, because that would certainly have been my first choice for an international fund. Instead, they offer three international alternatives, none of which is an index fund: the T.Rowe Price International Discovery Fund (PRIDX), the Vanguard International Growth Fund (VWIGX), and the AllianceBernstein Global Research Growth Fund (ABZYX).

To decide between these three funds, I looked at a number of factors: load, annual expense ratio, and performance; if this account was taxable, I’d also look at turnover, but since it’s not taxable, turnover is less important (this is one of the reasons why in a taxable account passively managed index funds tend to be so much better than actively managed funds: the more turnover there is, the more tax consequences for the holder). For purposes of this article, I’m also including the fund I’d really want, the Vanguard total International stock Index Fund (VGTSX).

First, these funds have one thing in common: thankfully (and probably due to Vanguard being the plan host), none of these funds have a load. One other thing that sticks out when looking at these funds: ABZYX has a huge minimum to invest of $250,000! That means that it’s about impossible that Mr. or Ms. Average Investor will have a stake in this one outside of a 401(k) or 403(b) or equivalent fund.

Beyond that, let’s look at the expense ratio, turnover, yield, and performance of each fund over one, three, and five years:

Fund   Expense   Yield   Turnover   1 year   3 year   5 year
ABZYX     1.20    0.44      80.00    15.64    16.11    17.07
VWIGX     0.51    1.75      41.00    22.13    21.47    26.70
PRIDX     1.24    0.51      82.00    21.58    26.02    31.47
VGTSX     0.32    1.92       2.00    21.87    23.16    26.70

As you can see, both Vanguard funds lead the pack in terms of expenses; interestingly, they also lead in terms of yield and turnover–the former is often overlooked but is a part of the total return of the fund; the latter, as mentioned above, would be very important in a taxable account, but is not all that important here. The T.Rowe Price fund has been the leader in performance up to this year, where it’s lagging–but by only a small bit–behind the Vanguard funds. However, if you calculate in the effect of the expense ratio and yield into the total return, the Vanguard funds do even better–particularly the index fund (there’s a theme here–it’s very hard to beat the index, especially when expenses, yield, and the tax effects of turnover are taken into account).

In the end, I chose the PRIDX fund when I did this comparison; this was a few months back when it was performing slightly better than the Vanguard funds. I mostly did this based on its five year performance. Still, VWIGX was a solid competitor for it with an expense ratio less than half of PRIDX and a considerably higher yield; had this been a taxable account with the same limited options, I may have opted for it, given its considerably lower turnover. ABZYX was not much of a competitor given how its performance had been, with expenses nearly equal to and a yield even lower than PRIDX.

Still, when I look at this chart, all I can think is, “I wish I could just go with the index.” The considerably lower expense of the index fund, with its comparatively higher yield and performance that is very close to even the best performing of the actively managed funds mentioned here and almost non-existant turnover shows once again that, repeat after me, “It’s really hard to beat the index.”

Asset allocation is one of those things that financial gurus seem to talk about but not everyone understands. Basically it means how someone distributes their total portfolio among numerous classes of investment vehicles. Those investment vehicles can be stocks, bonds, cash, real estate, precious metals, collectables, and other things. For the most part, all I concern myself with is stocks, bonds, and cash, although I do own some real estate investment trust shares, which is kind of like owning real estate in stock form.

The reasons why asset allocation is important is simple: some investments do better than others and it’s pretty much impossible to predict which investment will do better in a given year. Asset classes produce returns in largely unrelated fashion (the domestic stock market going up might coincide with the international stock market going down and the bond market staying flat), so owning some of each is a way of reducing risk.

As always, there’s arguments for doing things in all sorts of ways. When I first studied the subject, I read about a formula somewhere that went like this: 110 minus your age equals the amount in percent of your portfolio to invest in stocks, and put the remainder in bonds, rebalancing every year as your age (and therefore your percentage in bonds) goes up. Therefore, if I’m thirty years old (which I may have been at the time), I’d put 80% in stocks, and the remaining 20% in bonds; the next year, when I turned thirty-one, I’d reduce the amount I have in stocks to 79% and increase my bonds to 21%. I didn’t consider the different categories of stocks (international, large cap, small cap, value, etc.) in those numbers, just going with the total stock market index.

This is not an unreasonable way to do things, but I decided that I really want a bit of an international exposure given the high rates of growth there the last few years, and I was probably managing more than is necessary for really small changes. What I’ve settled on is this:

75% stocks: 50% in the domestic total stock market index and 25% in the international total stock market index

25% bonds in either a GNMA bond fund or a total bond market index

Rebalance every year, possibly by just diverting new money entering the portfolio at a higher rate to whichever allocation is a bit small (if I ended up with a 48% domestic stock/29% international stock/23% bond ratio, I’d put more new money into domestic stock and bonds and a bit less into international stock) or possibly by actually moving existing assets around (watch those expenses, though!).

There are lots of different ways to do asset allocation; many books on the subject exist, and lots of different model portfolios do as well. There’s lots of reasons to do different type of allocations–for example, if I was in retirement, I’d likely want something closer to a 50/50 stock/bond ratio–but for me, right now, I like this allocation, and I’m sticking to it.

The fifth and the twentieth of each month are paydays for many people (my part-time job pays me on those days), so every fifth and twentieth of the month I put together a few links of interest in the personal finance online world:

One of my personal finance blog favorites, Get Rich Slowly, looks at Sweating the Small Stuff

The Simple Dollar looks at a huge social issue with money (as a social worker, I’m always interested in things like this): Finding Potential Friends Who are not Consumer-Oriented.

The author of Being Frugal discusses a way to learn about money from an unexpected source: her hippie brother.

The truth about trying to beat the stock market comes to light at The Digerati Life, pointing out how that beating the stock market tends to be an illusion.

Finally, Million Dollar Journey talks about strategies used to save money, largely considering their wants versus their needs.

The recent subprime panic has resulted in a “flight to quality” in the bond market. What does that mean?

Bonds, which are the debt of corporations or government agencies, are rated, just as our own credit is rated when we apply for a loan. Just like the interest rate on your mortgage depends on your credit rating, the interest rate paid on bonds depends on (among other things) the rating of the bond. If you are willing to take a lot of risk, you’re rewarded with a higher interest rate, but taking more risk of default; if you aren’t willing to take on much risk at all, your interest rate will be lower.

With so much concern about subprime debt, those who have stakes in the bond market have been looking for bonds with better ratings. So there’s more demand for government bonds with better ratings today as the government is a lot less likely to default than other borrowers. Where do we go to get the quality that everyone else appears to be flying to?

Here are two alternatives, both from Vanguard: the Vanguard Total Bond Market Index Fund, and the Vanguard GNMA (Ginnie Mae) Fund.

The Vanguard Total Bond Market Index Fund (VBMFX) is, in the Vanguard style, an index fund, no load, with a low (.20%) expense ratio that tracks the performance of a “broad, market-weighted bond index.” Currently, the fund is up 6.59% year to date and pays a yield of 4.93%.

The Vanguard GNMA Fund (VFIIX) is not an index fund, although it is no load with almost as low (.21%) expenses. This fund invests most of its assets in Government National Mortgage Association certificates; basically, AAA rated government backed debt. This fund has returned 6.96% this year to date with a 5.11% yield.

These funds are both low cost, no load, and from a company that has a long history of quality and performance. I would be comfortable with owning either fund; unfortunately, my 403(b) plan only offers the VBMFX fund of the two. If I had an opportunity to choose, I’d take the VFIIX (there’s no better quality than AAA government backed), but either one has the quality that bond investors fly to in these trying subprime times.

It’s the end of the year, which means it’s time for me to consider what to do with my portfolio, as well as to deposit money that I would miss the chance to otherwise (like that Roth IRA deposit that must be done by April 15) or take advantage of changes (like taking a loss) to help my tax situation (I almost never do this). One of the things I do at the end of the year is consider what to do with the stocks in my Roth IRA account. Since the account is tax advantaged, I don’t have to worry what affect changes will have on my tax bill; I just need to consider whether or not the stocks I’ve had in there for the past year are ones that I want to continue to have in there.

When I purchase stocks, I take one of two courses: I’m either looking for something that I think is a “best in the world” type company, or I’m looking for a large cap, dividend paying stock that for some reason has become undervalued, despite the company itself still looking solid. In the case of the first type of stock, some of my picks over time have been Toyota and Apple–these are companies that make products I use, believe in, and have been very financially successful. I consider them to be the best in the world at what they do (which I acknowledge is arguable) and bought their stock as long term holdings. In the case of the second type, some examples of stocks I’ve purchased have been GM, AT&T, and Caterpillar. I consider them to be out of favor (for whatever reason) with the investment community and I’m hoping that they will come into favor while I own them, so their prices soar. These stocks may or may not be long term holdings–GM and Caterpillar were one year wonders, and AT&T has been a few years now but I’m not sure if they’ll be a long termer; I evaluate them at the end of the year.

Why the two different approaches? It was a learning experience. The second method mentioned was my original method; it came from studying the Dogs of the Dow theory, as well as Motley Fool’s now discredited Foolish Four. At that time I believed that a mechanical method of picking stocks was the way to go. The problem is that while there’s some validity to this method, the stock market, as always, is unpredictable.

Along came Google. While I have never owned a share of Google stock, what I learned from it was that if you have a company that is the best in the world at what they do, it’s not likely they’ll hurt your portfolio. So from that point forward, I decided to look for stocks of companies that were the best in the world. I also did some studying of the Beardstown Ladies methods of evaluating stocks (which seemed sound, despite the issues found with their investments long after their initial fame was gained) and the Motley Fool books. I decided that it was important to own stocks of companies with products I understood; companies with solid earnings; companies with products that I actually used myself; and companies that seemed to have room to grow. If I had known now what I knew then, I would have been banging at the virtual door to get onto the GOOG express from day one.

The two paths of how I choose stocks crossed in mid 2006; I was looking at the price of AAPL sitting in the mid to high 50s and thought, “That looks undervalued.” I have used and loved products from Apple since the early 1980s, and I thought this was a great time to buy.

I didn’t. I kick myself for this all the time, but in early 2007 (remember “end of the year”), I went ahead and pulled the trigger with AAPL closing in on 100. Now, when AAPL is near to 200, I think I did okay.

How do I know when to sell? For the most part, I try not to. I tend not to be a guy who will sell my winners; if anything, I sell my losers. But I’m not always convinced a loser in a year will be a loser forever. I think that i’ve probably sold only about 5 individual stocks in my entire life; the rest have become keepers.

Are my systems scientific and perfect? No, no system is (and even when they’re close to perfect, I am not, as the AAPL story above points out). I have faith in them, but they’re much more about judgement calls than numbers; yes, the numbers have meaning, but they’re not infallible. I protect myself by limiting my individual stocks to a small percent of my portfolio. But I have fun with them, and some of my stocks have done much better than the rest of my portfolio (and yes, some have done worse). And once a year, I’ll take a look at them and make some decisions; I like to think I make the right ones.

For some bizarre reason, my sister told my 7 year old niece that her favorite uncle (that would be me) would get her a Nintendo Wii for Christmas. Aside from the fact that the thing has been incredibly scarce, one of the questions that it raises is what cost do the holidays have for people?

The obvious cost is the financial cost; even for someone like me who tries to keep costs down, things add up. Today I spent $36 for the Aeropress coffee maker for SF (which was in addition to a few DVDs I already got for her) and $125 on four gift cards; I still have a few gift cards left to get. All of that is added to the $140 I already spent on gift cards (and SF’s DVDs, which I paid for in part with an Amazon gift certificate), and the still unpurchased non-Wii gift for my niece.

You can add to this the cost of time, the cost of paying too much, and the cost of stress. It took me 30 minutes to get to the store where SF’s coffee maker was; this was after a rough day at work where I left late. I could have easily been home by the time I got to the mall, but instead, I was looking for parking. Had I planned far enough ahead, I could have spent $10 less by ordering ahead from Amazon.com, but instead, I fought through a crowd that was building up to a Christmastime crescendo a week ahead of time. And if I had gone there early on a weekend, I would likely have avoided a lot of the drama involved with trying to get the perfect gift for someone with time running out.

There are other costs too. Like others, I notice I’m exercising less; I’m eating more, and what I do eat tends to be less healthy for me. I wonder about what other people think and worry about who might give me a present that I haven’t prepared for, concerned about the social awkwardness of the situation. And like many of my fellow bloggers, I’m also concerned that the true meaning of the holidays has been lost in a sea of retail raunchiness and commercialism.

What does Christmas cost you? Both in dollars, and in everything else? Is it still all worth it?

I will not deny that I like my latte–in fact, right now I sit at Coffee Talk in Kaimuki putting this article together, with my second latte of the weekend. At this small, locally owned Starbucks alternative, an iced latte skim costs $3.75, and a regular customer card makes my expense into a “buy ten, get the eleventh free” proposition. That makes my final cost for the latte $3.41, rounded up.

Despite my fondness for the latte, I’m not a heavy duty coffee guy, so I really only have a couple of these a week; if I really do have two a week over the course of a year (which is likely a fair estimate), that’s a bit over $350 a year–under a buck a day. The amount doesn’t surprise me; the question is if it’s worth it.

Like many other expenses around food, it’s certainly possible for me to cut this cost if not eliminate it altogether. The Aerobie Aeropress is about $30, which would leave me with the cost of the coffee beans, milk, and water, and maybe replacement filters, which would likely be far less than the $350 listed above. And while $350 isn’t a ton of money, it would pay for, say, most of a half year’s car insurance or a couple year’s worth of Web site hosting.

The advantage to getting my latte is that it helps my creative process and my work week recovery. It helps me get more done when I go out and hit the coffee place; at home, while there’s a million comforts that I have created over the years, there’s at least as many distractions and responsibilities that will keep me away from getting things done. So while I’m paying $350 a year, there’s a value to it that might not be easily measurable in money–and at least the coffee place has no charge WiFi, so I’m not spending anything on top of the money I dish out for my cable modem and EVDO.

Is $350 worth it? I think so; if I was home I doubt I’d be as productive as I am at Coffee Talk, as at home I’m just a bit of distraction away from starting up a programming project or rebuilding a computer. If I decide this is an area in which I want to reduce spending, maybe it’s time for me to find a cheaper drink. Some things are worth paying for, and some relatively quiet distraction-free time away from home where I can be productive is high on my list.

What’s some expense that you might not consider reducing or eliminating, even if you sometimes believe it’s extravagant?

This past week on one of my favorite blogs, Get Rich Slowly, came discussion of the stock market, its fluctuations, and some question of whether it was time to buy in.

One of the great mysteries of modern times has been how to time the stock market, meaning knowing when it’s time to buy in and when it’s time to get out. The difficulty with this is the idea that it’s all that possible. Almost no one has shown that they can do it on a consistent basis, and one of the folks who was well-known for it with a long streak of outperforming the S&P 500, fund manager Bill Miller, now has another streak all but sealed up: two straight years of underperforming the index.

There are many others who try, sometimes successfully, sometimes not, to time the stock market. There are newsletters, books, and Web sites dedicated to doing it. One of the radio shows I listen to regularly is hosted by someone who talks about doing just that, although at least he tries to do it in macro rather than micro terms.

The difficulty in market timing is quite simple: the markets are unpredictable. When and how much they go up (or decline) is never known. It’s simple to say “buy low and sell high” but it’s very difficult to know when low is low and when high is high. About a year and a half ago I was looking at AAPL at being a bit below $60 and thinking it was a great time to buy in; yes, that was correct, but I could easily have looked at the stock early this year and thought it was time to sell. Certainly, it would have locked in a nice gain, but not nearly as nice as what’s happened since.

Wisely, J.D. over at Get Rich Slowly displayed caution on the market timing subject and pointed out, with help of a reader, that dollar cost averaging was likely the best thing to do. I agree with that; while mathematically dollar cost averaging doesn’t show an advantage over putting money into the market all at once, both in terms of performance and, according to some studies, risk reduction, it doesn’t necessarily matter. Even if the gain is mostly psychological, it can help the investor get out of the market timing game. In fact, in my opinion one of the most understated advantages of the 401(k) plan is its dollar cost averaging approach. It’s more important over the long run that an investor regularly put money away than it is for them to time the market. Even if it makes more mathematical sense to put $15,000 into the stock market on January 2 rather than $1,250 a month for 12 months, I know I don’t have $15,000 to do that very often. Doing it $1,250 a month (or $625 twice a month!) makes it a lot easier to deal with.

To answer the question, “Is it a good time to get into the market?”, as someone who believes in dollar cost averaging and a long term view, I simply answer, “it’s always a good time to get into the market,” and I do practice what I preach.

I work, I save, I pay taxes. I am not opposed to paying taxes because I like things like trash pickup and paved roads; I am, however, opposed to poor use of tax dollars. Of course, “poor use” is, like beauty, in the eye of the beholder.

One of the things in the state in which I live that I believe is the exact opposite of poor use of tax dollars is our public library. I can’t speak for library systems elsewhere, but the public library in Hawai’i is well stocked with books, magazines, videotapes, DVDs, CDs, cassette tapes, and yes, still, vinyl records. As someone who loves reading and music, I have been able to use the public library as a way to not spend thousands upon thousands of dollars throughout the years.

A week’s DVD rental for a dollar, or three weeks with a book or CD for free. Online electronic card catalog systems that allow books to be reserved and brought in from other libraries statewide, sending you a postcard to remind you, at no charge. That’s the kind of service I would like from a library–and that’s actually what I get from my library.

Note that I avoid using the word “free” when I refer to the library. It does take money to run the library system, and most of that money comes out of the pockets of taxpayers. Since I pay taxes, I don’t consider the library “free”; I do, however, consider it something I’ve already paid for. If I’ve paid for a service like this, it’s unlikely I’d pay for the same again–if there’s a book I want to read or a CD I’d like to listen to, I’ll always check the library first to see if they have it rather than buying it. If I decide I really want to have it for my own, I’ll buy it. This way I can spend less and accumulate less clutter, which is better for my environment–and my pocketbook.

An index fund (which is typically a mutual fund or its sister exchange traded fund) mirrors the market performance of an index of a specific financial market, such as the Dow Jones Industrial Average, the Standard & Poors 500, or any of a number of other such indices. As the index goes up, the fund goes up, and as the index goes down, the fund goes down. Given that historically the indices have gone up a lot more than down, an index fund is a convenient way to capture those gains. Index funds are passively managed, meaning they do not take the aggressive tactics of trying to time the market or buy and sell stocks to make gains, their fees are extremely low, and the taxes they generate are minimal–their returns ought to equal the performance of the index minus their fees. Many of the index funds out there–I am partial to those from Vanguard, although there are many, many more–also are available no load and can be purchased direct from the fund family at no cost.

The alternative, as far as funds go–and funds remain the best way for investors to get the safety net of diversification that is so desirable–are actively managed funds. There are several issues with these that make them much less favorable than index funds. Actively managed funds almost never beat the indices on a consistent basis and their costs and taxes are considerably higher than on passively managed index funds. In fact, their costs and taxes are so much higher that in order for them to be a better overall performer than an index fund, it must outperform the index by about 2%–and managed funds almost never match indices on a consistent basis anyway.

The real reason I love index funds, however, is this: it puts the power of the whole stock market into the hands of the small investor. It would be impractical if not impossible to buy one of every stock in the S&P 500, let alone the Wilshire 5000, yet in one fund, you can get all of those, and in one ETF, you can get one for likely under $100. That in and of itself is amazing; it’s the same reason I love things like personal computers, podcasts, and digital video–it brings power previously restricted to those with large amounts of money to the average consumer.

Do index funds have a place in your portfolio? I’d venture to say they ought to be in everyone’s portfolio, and in fact be the biggest portion of them!