Uncommon Cents

May seems to have been another positive month in the stock market; my initial belief just looking at (but not actually running) the numbers is that it was not quite as positive of April but it was quite decent in and of itself. Let’s take a closer look:

The Vanguard Total Stock Market Index Fund (VTSMX), which makes up the largest portion of my portfolio, ended May at $34.16 a share after closing April at $33.46, a gain of a bit over 2%. The Vanguard Total Bond Market Index Fund closed May at $10.07 vs. $10.18 at the end of April, down just over a percent but putting out that nice 4.86% yield for the fixed income portion of your portfolio. Finally, the T. Rowe Price International Discovery Fund (PRIDX) finished May at $46.23 versus the $45.28 it finished April at, a nearly identical gain of a bit over 2% to VTSMX.

Hopefully, the market continues to stay on course for a positive end to 2008!

The last time we looked at “Basics”, I discussed the cash flow equation, which is:

income - expenses = cash flow

Now, once cash flow is positive (and the more positive, the better) the wealth equation is also simple:

(cash flow + sensible safeguards + wise investments) x time = wealth

Simple, but not necessarily easy. Once your cash flow is positive, it’s time to do some smart things with your money and let time do its thing.

What are these smart things?

Sensible safeguards: these are your emergency fund, term life insurance, long term care insurance, and disability insurance. You don’t want to toss money away, but you also don’t want to under insure. Keep a reasonable amount (many say a minimum of $1,000, others say six months of salary–personally, I split the difference and say three months of take home pay) in a money market account with check writing and an ATM card (Capital One Direct is the one I use). If you have dependents, get term life insurance; you may also want to consider disability and long term care insurance.

Wise investments: what we’ve been discussing on this blog forever. Passively managed, no load, low cost, tax efficient index funds and exchange traded funds. High quality bonds and bond funds. Traditional and Roth IRAs, 401(k)s, and their equivalents. Reasonable asset allocations. Investments made at regular intervals. Diversification, diversification, diversification.

Time: you know what this is, and the more you have the better.

Wealth: the dollars you end up with at the very end.

The one other thing that you need will be discipline. We’ll cover that later, but in the meantime, remember that formula. It’s a simple, get-rich-slowly, tried and true over time formula that will help you reach your goals–it’s helped me build a six figure portfolio in less than half a decade!

Many investors worry about stock market risk when dealing with their money, and admittedly, very few investments are without risk. The risk in the stock market tends to be around the market declining and the volatility the market often displays. These factors many times scare investors out of the market and into “safer” investments, like money market accounts, government issued bonds, and FDIC insured certificates of deposit.

While there certainly is a place in any investment account for bonds and cash, these investments only isolate you from certain types of risk. They have their own risks, as well, the biggest one being that your investments will not keep up with inflation.

With the current low interest rate environment, many investors (or just people with an emergency fund) are seeing evidence of just this. If headline inflation is 4% right now and your “high yield” account pays 3.5% (which is a pretty decent rate these days), your money not keeping pace.

This does not mean to pump every dollar you have into stocks; quite frankly, there are good reasons to have other types of investments (see our articles on asset allocation). What it does mean, however, is to be aware that what are considered “safer” investments are not totally safe; there are still risks involved, and in some ways, the risks are more dangerous than those in the stock market. Consider other ways (like diversification, asset allocation, and tax advantaged means of investing) to reduce your risk and help your dollars do better than the rate of inflation–hopefully far better!

In response to the Total Portfolio Makeover II series of posts, I received the following email from a reader:

Hi, I like your website. Good post about investing in the Vanguard Total Stock Market Index Fund, however I think it’s important for people who are older to balance their equity holdings with a bond fund to soften the blow when the market goes down.”

The reader makes an excellent point here. Asset allocation, which we’ve discussed many times on this blog, can and probably ought to be influenced by your age and time until retirement. As you may recall, asset allocation is how you divide your portfolio among different types of securities; in this blog we have basically split our assets among domestic bonds, domestic stocks, and international stocks, although it certainly is possible to include other types of assets such as precious metals and real estate in the calculation. We allocate assets to attempt to mitigate risk, and part of the amount of risk someone can afford depends on the amount of time before they need to convert the portfolio into cash. For someone in their 20s with four decades until retirement, having more risk is appropriate; for someone in their late 50s approaching retirement within a decade, reducing risk makes sense.

So, in Chris’s case, while I suggested an asset allocation of 50% domestic stocks, 25% international stocks, and 25% high quality domestic bonds, someone who was, say, 20 years older (meaning in their mid 50s), I’d probably be a bit more conservative, possibly 40% domestic stocks, 20% international stocks, and 40% high quality domestic bonds. In retirement, I’d likely be even more conservative as the emphasis switches from portfolio growth to preservation of capital–in that case I’d be looking at something more like 40% domestic stocks, 10% international stocks, and 50% high quality domestic bonds.

Are there cases when I would consider a more aggressive asset allocation as someone approaches retirement? Maybe. If the person was a late starter or just didn’t accumulate much in retirement savings and time is rapidly running out, I’d consider adopting a more aggressive stance, but the important word in all of that is consider. A lot would also have to do with the risk tolerance (or, rather, the volatility tolerance) of the person who owned the portfolio. If the portfolio owner had a high risk tolerance, then yes, I would consider a more aggressive stance. However, for the most part, I strongly agree with our reader: as the investor gets older, a more conservative asset allocation is definitely appropriate.

April was a fantastic stock market month. It was such a great month that it almost made up for the awful start to the year in the markets.

Recalling my previous articles in this series, my three portfolio fund consists of the Vanguard Total Stock Market Index Fund (VTSMX), the Vanguard Total Bond Market Index Fund (VBMFX), and the T. Rowe Price International Discovery Fund (PRIDX), with VTSMX making up the majority (approximately 50%) of the portfolio and the remaining being split about equally between VBMFX and PRIDX.

VTSMX started the month at $31.86 a share (as of the close of business March 31, 2008); it ended April at $33.46. That’s a gain of over 5% for the month. VBMFX started the month at $10.22 a share and ended at $10.18, a loss in net asset value of just .3% (yes, three tenths of a percent) but continues to put out monthly dividends, including one of almost four cents that month. Finally, PRIDX began the month at $43.96 and ended it at $45.28, a gain of a hair over 3%.

Hopefully, we’re over the funk that the markets have been in the last few months and we’ll continue to see gains in the months to come–and as much as I’d like to say, “big gains,” I try not to, because booms tend to be followed by busts–which is really what I don’t want. So instead of a boom, in keeping with our April theme, let’s hope for a bloom–like a rose.

When we last left our heroine, we had given Chris some information on the Roth IRA, which appears to be her best choice for the $5,000 she has set aside. We also discussed asset allocation and diversification, and gave her some idea of what percentage of her money she might want in domestic stocks, international stocks, and high quality domestic bonds. We also gave her some ideas about where she might want to open this Roth IRA and discussed issues of risk, which not only include market exposure but also the risk of not keeping up with inflation by being too conservative.

It would be easy to put together this portfolio with three no load index funds, and in many cases that would be the thing to do. However, it’s often difficult for the beginning investor to do that because funds often have minimum investments in the thousands of dollars. Instead, since this Roth IRA will be opened with a discount broker, we’ll use a great alternative: exchange traded funds, also known as ETFs.

ETFs are mutual funds that trade like stocks. ETFs have very low expense ratios and low barriers to entry versus mutual funds that require minimum investments often in the thousands of dollars. We discussed one ETF not long ago when we talked about how to get the performance of the entire S&P 500 in a single share of an ETF; we’ll look at three others to make this portfolio happen. To meet this asset allocation, I would suggest using the Vanguard Total Stock Market ETF (VTI) for domestic stocks, Vanguard Total Bond Market ETF (BND) for domestic bonds, and Vanguard FTSE All-World ETF (VEU) for international stocks.

After figuring out how many shares would make up each allocation, one will realize that it’s about impossible to get the allocation perfect in real terms, leaving a little bit of cash in the account to pay for those $6.95 trading fees. Also remember that these pay dividends and you likely want to reinvest (buy more shares of the fund that paid the dividend). You may also want to consider rebalancing the asset allocation once a year or so.

So, there we have it. In three low cost ETFs with low barriers to entry, we have diversification, asset allocation, and market matching performance with low costs and tremendous tax advantages for Chris to start her retirement account. A simple portfolio that’s poised to pay big dividends over the next thirty or so years while Chris works toward retirement. Good luck!

n step two of our total portfolio makeover, we look at a couple of subjects we’ve discussed in the past: asset allocation and diversification.

If you recall, our friend Chris, in her mid-30s, has saved $5,000 and wants to save for retirement. Chris has a minimal risk tolerance and has been counseled about risks outside of net asset value fluctuation and market volatility.

Asset allocation is a sometimes controversial topic; basically it’s how much of your portfolio is dedicated to how much of a particular type of asset. This means at a very basic level that a certain amount of your portfolio is in stock and a certain amount in bonds; it also could mean a further breakdown of a class of asset–for instance, between international stock and domestic stock. Asset allocation is important for reasons we’ve discussed before; it can certainly help you to smooth out the volatility in the stock market, for instance, when it’s volatile by having a high percentage of your portfolio in bonds. It also gives you a certain amount of exposure to various types of markets, which is important because we never know which markets are going to perform well from year to year. Some years, the domestic stock market will return a tremendous amount and bonds next to nothing; other years the bond market will grow by leaps and bounds and the international stock market will be negative. Because of these unpredictable rates of growth in various markets and the incredible difficulty in timing the market, the best answer in my opinion is to be exposed to different markets at all times. For Chris, given her age, I would suggest my standard portfolio of 50% domestic stock, 25% international stock, and 25% high quality domestic bonds. If she finds this too volatile for her taste, she can consider reducing the exposure in both stock categories and increasing it in bonds, perhaps 40% domestic stock, 20% international stock, and 40% high quality domestic bonds.

Diversification is a subject we will cover in depth soon in a Working Backwards piece, but in general diversification means to own a little of a lot of things. Imagine I told you you could have 500 shares of stock and had to choose between 500 shares of a stock in a single company and one share in each of 500 companies. If you choose the former and the company does well, you’ve made out like a bandit; if it doesn’t do very well, you’ve lost a whole lot. If you choose a latter, it doesn’t matter much if one company fails; you have 499 others to bank on. Diversification is another way to manage your risk.

Fortunately, you don’t have to buy 500 individual stocks to be diversified; you can simply buy a single mutual fund or a single share of an exchange traded fund to get a lot of diversification in your portfolio.

In our next look at building Chris a winning retirement portfolio, we will decide exactly which funds to go with for her Roth IRA. Stay tuned!

I had hoped to look at doing a makeover on one of my physician friend’s portfolio, but she still has homework to do. So, in the meantime, another person I know has asked for help doing a portfolio makeover–on to makeover II!

Chris is a 36 year old single administrative assistant with no unsecured debt other than her vehicle. She has set aside $5,000 and wants to start investing. When asked what her goal is, she says, “I guess retirement.” She states she has minimal risk tolerance and was counseled about the risks of not just market trends and net asset valuation but inflation.

For her purposes with this lump sum of money, Chris would seem to be best served by a Roth IRA. She meets the income qualifications and already has a 403(b) plan which she contributes to; she has way more than the five year minimum before she’d withdraw from the Roth, and the amount of money she has saved up is perfect for the Roth IRA. It’s too late to contribute for 2007, but well early in the year for a 2008 contribution.

Where to start a Roth IRA? There are many, many choices; I would recommend a discount broker with online access. Firstrade is what I use and generally recommend, but there are lots of other choices like Scottrade, E*Trade, and TD Ameritrade. Unfortunately, while I highly recommend Vanguard funds, it’s hard for me to recommend them as an IRA choice because they have some fees that seem to be worse for the small individual investor starting out than the discount brokers.

What to buy with the Roth IRA? That’ll be in our next segment! Remember, though, that we’ve discussed asset allocation, costs, taxes, and diversification to the hilt over the last few months; with a Roth IRA, we’ve already addressed taxes and with Firstrade’s low fees we’ve already addressed costs. Next time we’ll look at asset allocation and diversification. We’ll get Chris on the road to retirement in a very simple way!

It’s likely that your 401(k) will be your largest investment account. Knowing that, it’s prudent to determine what asset allocation you want in that account, as well as what mutual funds you’d like to be included.

We’ve discussed asset allocation before; basically it’s how much money you would like in certain kinds of investments. I’ve pretty much standardized on a mix of 50% domestic stocks, 25% high quality bonds, and 25% international stocks. This makes the math easy and builds you a fantastic portfolio with just three funds. If I was very close to retirement (or in it) I’d likely be closer to 35% domestic stocks, 15% international stocks, and 50% high quality bonds, but your mileage may vary. This is, in fact, the way my portfolio is currently constructed.

In an ideal world, I’d construct this portfolio with these three funds:

Vanguard Total Stock Market Index (VTSMX)
Vanguard GNMA Fund
Vanguard Bond Index

That said, there are many, many fine mutual funds out there, and your 401(k) plan may not offer the ones you want most. In my case, they only offer one of the three funds, so I have substituted a couple of other funds [given that my plan, which is actually a 403(b) because I work for a non-profit, has a brokerage option which I am still investigating, I may in fact someday get exactly the funds I want]. In any case, my first choice for the portfolio in principal would be low cost, passively managed, no load index funds–while Vanguard is the king of these, there are many alternatives such as T. Rowe Price, Fidelity, and TIAA-CREF.

While I am not a fan of actively managed funds, if you for some reason do want to include them in your investments, the best place to keep them is in a tax sheltered account of some kind like a 401(k). The reason for this is that these funds tend to generate taxable capital gains every year which are much larger than the negligible capital gains generated by passively managed funds, so if you for some reason want to have a few actively managed funds in some segment of your total holdings, this may be the place to do it (this concept is known as asset location, which is similar to but definitely not the same as asset allocation). I would, however, totally recommend staying away from load funds–there’s no reason to pay a load, ever.

One other issue to consider is your employer match. If your employer matches you using the stock of the company you work for, it is quite likely you will quickly become overweighted in your company stock. This becomes one of the basic issues of diversification; all is well while the company is doing well, yet if the company falls on hard times (Bear Sterns, anyone?) so will your portfolio. Strive to keep your own company stock under 5% of your total if at all possible.

Thinking about what you will have in your 401(k) is almost as important as starting it in the first place. Consider asset allocation, asset location, and diversification while working on this aspect of your portfolio and you will do just fine–with only three funds, too!

When I was in intermediate school, back before the turn of the millennium, we had an assignment in math class to choose a few stocks and track them daily. While this was probably a horrible introduction to personal finance, it did illustrate a few things:

It was incredibly difficult to read those stock listings in the newspaper; not only was the font tiny but the lines seemed to blend together–and that’s with the eyes of a thirteen year old!

It was very tedious to track the stock prices on paper, by hand, without even a calculator to use.

I had great difficulty seeing why anyone would spend that much time to track small movements of a stock on a daily or even weekly basis.

Today, things have changed dramatically. I have any number of tools available to make things tremendously easier. The introduction of the spreadsheet back in the late 1970s (Visicalc, anyone?) already took away a lot of the headache of looking at stock prices. The advent of the Internet made the headaches fade even more–this one link gives me almost all the information I need to know about every single stock in the Dow Jones Industrial Average–and this doesn’t even touch on software like Quicken or The Mint. I can easily get historical quotes, graph results, compare one stock to any number of others or the index, and even buy and sell quickly and at low cost. A trade today costs less than the long distance phone call did back in the early 80s!

As much as information overload is an issue (in online life in general, not just with financial information), I can’t argue that the old way is better. I can get all the information I need about a stock, fund, or bond free, quickly, and execute a low cost trade without needing to even pick up a phone. The information age has made investing incredibly better than it was less than a quarter century ago!