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!

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!

Yes, March is long over, but the analysis is not. As we take yet another look at my retirement portfolio, which continued to struggle as the market as a whole has this year, we see that the ship might be righting itself.

The Vanguard Total Stock Market Index Fund which, as a reminder, is about 50% of my total portfolio, was down a small bit in March, just a hair over 1%. The Vanguard Total Bond Market Index Fund was up a hair, under .3% (yes, three tenths of a percent). Finally, the T. Rowe Price International Discovery Fund was down, close to 2%, for the month of March.

All of these are very small numbers, matching the rather small period of time we’re looking at. If anything, it looks like it’s possible that the bleeding may have stopped and that the downward tumble the market’s been in for a few months may be reversing itself; given the (so far!) strong results we’ve seen in April, I’m hoping that the bad times are behind us–for awhile–and there’s good times in the here and now. And that’s no April Fool’s joke!

One of my physician friends (when you work in a hospital, you tend to have a lot of physician friends) asked me about dividends last year and whether or not she had to pay taxes on them.

“Is this an IRA or 401(k) or other tax sheltered account?” The answer was no.

“Then, of course. It’s income, but if they’re qualified dividends, typically the federal tax is pretty low.”

She said that she didn’t understand how this was income as she never saw any money.

“Well, if you’re not actually seeing checks, either cash is being deposited in your investment account or better yet, it’s being reinvested and buying more shares of whatever stocks or funds are generating the dividends.”

I mostly forgot about this discussion until this year, when the same friend asked about capital gains as well as dividends and why she had to pay taxes on money that she didn’t earn, and in fact that her portfolio was really no bigger than it was last year.

“What’s in your portfolio?” I asked.

“I don’t really know.”

She and her husband (who is also a physician) have turned over control of this portfolio to a financial planner. They have absolutely no idea what is in the portfolio aside from generically (”mutual funds and stocks”), but she does know that she is being taxed for dividend income and capital gains and not seeing much of an increase in the value of her portfolio.

It looks like it’s time for a change, I think.

“Tell you what, I don’t want to know the details of your actual numbers, but at least get the names of the funds and stocks in your portfolio and I’ll take a look at them.”

If she follows through, I’ll share what I find and look at what we can do to give this portfolio a total makeover. Let’s see how we can combine her goals with our investing principles of low cost, indexing, passive management, high quality, and diversification to make her portfolio a winner!

A tax is a fee imposed by the government on products, forms of income, or activities. In the United States we are very familiar with various taxes on products (such as a gasoline tax or tobacco tax), income (such as the federal income tax or state income tax–which is not in all states, Medicare tax, and Social Security tax), or activities (such as retail sales tax). Taxes fund public goods and services (think sewer services, trash pickup, and street lighting). In some cases taxes may also be used to try to discourage certain types of activity (such as cigarette smoking) and/or attempt to recoup public dollars spent dealing with that activity (such as Medicaid funds spent to deal with lung cancer).

One of the best ways to help your investments is to take advantage of tax advantages. IRAs and 401(k)s offer ways to build your portfolio tax free and/or reduce or eliminate taxes in the end. There are certain government bonds and money market accounts that are tax free as well. Taxes are also one of the reasons why passively managed portfolios and mutual funds tend to outperform actively managed ones–when stocks or bonds within the portfolio or fund are sold, they typically trigger a capital gain, which is subject to tax. I suspect we will see some of this when I assist my friend with her portfolio makeover in coming posts!

I am personally not opposed to the idea of paying taxes because I like having paved roads and trash pickup; I do, however, want my tax dollars to be used wisely–which is an entirely different issue that we won’t get into on this blog. What do you think about your taxes?