Uncommon Cents

Welcome to your Link Payday for July 20, 2008. It’s been a busy few weeks as I get ready to head out of town for a week on Monday, so I’ve been hustling to blog as well as to complete some other projects that need to be done for my trip (I imagine I’ll be working on them on the plane!). Here’s some of my favorite blog posts from the personal finance blogosphere over the last couple of weeks:

The always great JD of Get Rich Slowly asks his readers: How to Get Started with Investing? For many it’s a daunting and intimidating task at the onset, even though it really isn’t that hard.

The turbulence in the financial markets (and yes, June was an absolutely horrible stock market month, which we’ll look at soon) may have folks considering getting out of the markets altogether. Fortunately, All Financial Matters warns us wisely: Don’t Run from the Bear.

Much has been made of the disaster known as subprime mortgages; we’ve looked at what subprime means before, and recently Debt Free looked at The ARM: What is an Adjustable Rate Mortgage Loan, and How Did it Get So Many Homeowners Into Trouble.

My buddy Kyle over at Rather-Be-Shopping ponders How Bad Can the Economy Really Be? when people are waiting in line for hours for new iPhones. While as an Apple stockholder I certainly condone the purchase of their products, I worry that people aren’t considering the financial consequences of high end purchases.

And finally, the ever brilliant Mrs. Micah asks What Happens if Your Bank Fails? I had Netbank fail not too long ago and while ING Direct is okay, it’s not exactly the same as Netbank was. Fortunately, I didn’t lose a cent.

And there’s your Link Payday for July 20, 2008!

Welcome to your belated Link Payday for June 23, 2008 (since the fabulous Kyle of Rather-Be-Shopping.com returned and wrote his usual Friday post for us–which fell on the 20th–we delayed this payday a few days). Here’s some of the better posts I’ve read in my RSS reader the last couple of weeks.

The always entertaining JD of Get Rich Slowly discusses Why it Pays to Ignore Financial News. This article puts pretty succinctly one of the key tenets of long term investing: daily stock market fluctuations aren’t meaningful to your holdings over the long term–unless you act on them. Pay more attention to the things in your life that give you joy rather than your retirement account.

Can I Get Rich on a Salary asks how to Teach Yourself to Invest In Stocks? by covering MarketWatch’s daily money tips and offers a few suggestions of their own. I wholeheartedly suggest that people learn about investing in stocks, bonds, and funds; if you have the tolerance and taste for stocks, I suggest checking this piece out.

All Financial Matters asks the question that I wish everyone in this country–particularly those in Washington–would ask: What’s the Solution to Our Energy Needs? Gang, ethanol is not the answer (at least not corn based ethanol), but a combination of other types of alternative energy including (yes, I say this as an environmentalist) nuclear is. Let’s all work seriously to do whatever we need to do to get this resolved and get our country off of its dependence on foreign oil.

I’ve Paid For This Twice Already asks How Do You Decide When “The Time Comes”? In this case they are considering if it’s the time to replace their car. This is definitely worth looking at for making financial decisions with regards to some of the things we use every day, like computers.

Finally, Trent over at The Simple Dollar discusses Addiction and Personal Finance. As a professional in human services, I have to say that addiction can be a huge threat to your finances–if not your family, your relationships, your freedom, and your life.

And that’s your Link Payday for June 23, 2008!

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!

Diversification is a way of reducing risk in your portfolio. In broad investing terms, diversification means to own a small amount of many different stocks rather than a large amount of just a few. Owning a portfolio with 100% of your money in a single stock poses far greater risk than having 1% of your money in each of 100 stocks.

Research has shown that the majority of risk reduction from diversification occurs with a portfolio of approximately 25-30 stocks. Further diversification can reduce risk even more but with diminishing effectiveness. It is difficult for an individual investor, particularly one who is just starting out, to diversify by buying many different individual stocks. Fortunately, today, an investor can easily diversify by buying a mutual fund or exchange traded fund.

Besides diversifying within the domestic stock market, it’s also quite possible for an investor to diversify in international stocks and in bonds, also by purchasing appropriate mutual funds or exchange traded funds. As we complete our Total Stock Makeover II mini series, we will look at three different funds which give diversification within the domestic and international stock markets as well as the high quality bond market.

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!