Uncommon Cents

As we saw yesterday, the stock market performance in September was horrible; my guess is that October was even worse. Let’s see how the portfolio did in October, reported to be one of the worst stock market months of all time.

The Vanguard Total Stock Market Index (VTSMX) declined a whopping 17.16 percent for the month! But again, that shone compared to the T. Rowe Price International Discovery Fund (PRIDX), which was down a miserable 22.98% for October 2008. Once again (like nearly every time this year), the Vanguard Total Bond Market Index was the star of the portfolio, down 3.23% but still paying a decent dividend. This month the portfolio declined even more than in September, to the tune of a staggering 13.80%! However, the silver lining is that the total performance was, again, better than the total stock market even though most of the portfolio is allocated to the total market and the international market. Bonds again show us their value this month. Now, the question is, these have been bad months…

September was bad, bad, bad in the stock market. How bad was it for my portfolio? Let’s take a look.

The Vanguard Total Stock Market Index (VTSMX) was down a nasty 9.23% for the month. Despite that dismal performance, it was stellar compared to the T. Rowe Price International Discovery Fund (PRIDX), down a horrific 15% for the month! Even the rock steady Vanguard Total Bond Market Index (VBMFX) was down 1.4% but continued to pay its very nice dividend.

The total portfolio returned a negative 8.09% for the month! This would be bad for the year, but is positively horrendous for a month. However, notice that the total performance was better than the total stock market (reflected by the included VTSMX), even though most of the portfolio is split between it and the international fund–again, hooray for bonds and asset allocation! Of course, as you can see, September was bad, but tomorrow we’ll see that it could get worse…

There’s been a considerable amount of discussion here as well as in the personal finance blogosphere on the subject of asset allocation (I particularly like this bit on it by my blogging buddy Mrs. Micah). Asset allocation is, in a nutshell, is how much of your total portfolio (your allocation) you put into, for example, domestic stocks, bonds, or international stocks (various assets). When I discussed the end of year performance of my portfolio, I noted that my goal was to have an asset allocation of 50% domestic stocks, 25% international stocks, and 25% bonds; to explain my model relatively quickly, I took 115 and subtracted my age at the time (40), and came up with the number 75. 75 then became my asset allocation for stocks, 2/3 of which would be in domestic stocks (50% of my total portfolio) and the remaining 1/3 in international stocks (25% of the total). What was left–25%–was to go into domestic bonds.

Looking at the allocation of my portfolio right now, we see this:

Domestic Stocks: 44.54%
International Stocks: 18.94%
Domestic Bonds: 36.52%

What does this tell me? It says that the performance of stocks has not been great this year to date; it also tells me that when it’s time to consider rebalancing my portfolio (which I do once a year), I actually want to put more money into stocks. That’s correct: it’s not telling me to run for the hills from my stock market investments, it’s actually telling me to increase the amount of stocks I’m buying relative to the bonds I’m buying. Why? Because the market is down and I can get more for my money in the stock market (I will look at rebalancing a little later in the year).

This is a large part of the purpose of asset allocation; not only does the bond portion help to prevent the portfolio from having even larger losses when the stock market nosedives, the total allocation gives me an indicator of where to put future investments (and possibly even to move money between the various assets). Asset allocation gives you an idea of where to put your money next. Even when I stick to my 115-age formula, we’re only talking a difference of 1% a year; this year I’d say 74% in stocks and 26% in bonds–not very different than last year.

I’m hoping this example shows the importance of asset allocation to those of you beginning with portfolios!

I’m not surprised to see so many people have a knee jerk reaction to the stock market troubles over the last few months. Just a year after hitting all time highs, the markets have lost close to 40% of their value. Many investors are getting out, or at least stopping new contributions.

Here’s why I don’t, and I wouldn’t suggest anyone else do so–

I’m Following My Plan: I don’t invest haphazardly. I have a plan. My plan includes the common buzz words that people use when talking about their plan: index funds, asset allocation, regular contributions, diversification, low expenses, Roth IRA, 403(b). It doesn’t take a lot of time to come up with the plan, but having one is incredibly important.

More important, of course, is following the plan. Just remember, however, that the whole reason you came up with the plan is for times like these–if your plan was sound, just go ahead and follow it. That’s why you have it!

As an aside, in times like these, asset allocation comes into focus as one of the most important parts of your plan. When you’re in your 20s and early 30s, having the vast majority of your money in stocks is fine, but as you get older, making sure you have a reasonable amount in bonds can provide your portfolio with ballast in difficult times.

My Plan is Based on Time Tested Investing Principles: Regular contributions. Asset allocation depending on age. Diversification. Low cost. Using whatever tax advantages I can. They’ve served me well over time (let me be clear: yes, my portfolio is considerably down for the year, but really, the whole market is down considerably for the year. However, since I’ve started investing seriously, every year before this year has been a positive result.) and I believe they’ll continue to serve me well over time, at least in part because they’ve served many, many other investors well over time, but more importantly, because of my personal history with it.

Selling Into a Huge Loss is a Loser’s Game: If I sold my stocks right now and moved into cash or bonds, that’s it; my chances of being part of a stock market recovery–and it has always recovered–are zero. I’ll have locked in my losses forever.

Even Recent History Backs My Position: Does anyone remember the bear market that happened earlier this decade when the dot com bubble burst? Yes, it was tough, and it was painful–this was in 2000. And yet, a few years later, the stock market was higher than when it burst. Let’s not forget: 2007 marked an all time high for the major indices; the market doesn’t just go up and up and up. Even though in the short term the market decline was painful, I’m way better off even now than I was then, and I was even better off a year ago. I fully believe I’ll be even better far before I’m ready to retire.

Yes, there’s been a lot of stock market chaos the last few weeks, but I’m not planning on doing anything that wasn’t in my plan in the first place. I’m here for the long term!

Some people discover their risk tolerance is rather low, or lower than they thought, in stock market times such as these. If that is indeed the case, what options do these people have?

The principle of risk/return does not disappear just because someone can’t deal with somewhat higher risk; rather, it becomes very clearly in effect. If someone wants to take absolutely no chances with their money (or just shy of no chance), they can certainly do that, but the returns their money will gain will be quite low–but they will exist. This is unless it’s someone who would rather bury money in coffee cans in their back yard or stuff it in their mattress, of course–but that’s not investing.

Realistically, everyone needs a safe place to put at least some of the dollars they have. An emergency fund needs to be kept away from stock market risk, because emergencies don’t come on a schedule (some would say the market currently is in a state of emergency!). So “chicken money” is something everyone has at least some of–money we’re too chicken to put at any risk at all.

Savings or Share Accounts: These are your typical accounts at a bank or credit union. Right now the rates of interest on them are anemic–in the case of my mother’s bank account, one fourth of one percent of interest! That’s definitely not keeping up with inflation. However, since the account is FDIC insured and she’s well within the limits of the insurance, it’s as safe as the federal government’s word. If you’re going to use one of these, make sure you have insurance by the FDIC or the NCUA (in the case of a credit union). You won’t make much, but your money will be safe, and it’s really high in liquidity, meaning you can get at your money pretty much anytime (provided the bank’s business hours work for you).

High Yield or Money Market Accounts: These tend to be a lot like savings or share accounts but with a somewhat higher rate of interest and possibly more limits on accessing your money. For instance, I have a Capital One Direct high yield savings account that pays me 3.55% interest and allows check writing and ATM access–but limits how many checks I can write per month. Fortunately, it also allows electronic access, which is a bit more liberal. This is a nice place to stash an emergency fund, since it’s almost as liquid as a savings or share account.

Certificates of Deposit: CDs tend to have rates about the same if not a little higher than high yield or money market accounts. In return for offering a little more interest, you lose liquidity. Still, CDs you may be appropriate for an emergency fund with a little planning (having a CD mature every month with 5/6 of an emergency fund means at most you’d be one month away from access, and having that remaining 1/6 in something like a high yield account could do it) but for simplicity’s sake, you may not want to use these for that purpose. Make sure you are wary of the FDIC limits (which apparently will be increasing, at least for awhile) on how much they’ll insure if you really are concerned about safety!

Treasury Bonds or Notes: In many ways considered the safest of investments, there are lots of different bonds and notes you can get; some may offer tax advantages. I have a bit of my portfolio in I series bonds, for instance. There are also government issued bonds or notes from local or state governments that may be worth looking into as well. Again, the rates are not fantastic, but combined with possible tax advantages as well as safety, this could be a viable option.

Money Market Funds: Not quite the same as the money market accounts, these are mutual funds that invest in short term instruments. They are not backed by FDIC or NCUA insurance as they are mutual funds, although they recently had some temporary insurance offered to them with unusual circumstances that led to a “run” on them as a consequence of the Lehman Brothers bankruptcy. Money Market funds nearly always have a stable net asset value of $1 per share and pay a return based on how their investments do. Of course, since it’s a mutual fund, your initial investment will likely need to be more than you can put into a savings account, money market account, or CD, and you may have commissions to deal with.

Bond Funds: In bond funds, you have a ton of choice just as you do with stock funds. If you’re looking for safety, consider the quality of the bonds in the fund; “junk bonds” may offer higher yields, but more risk. Funds that are based on Government National Mortgage Association bonds–Ginnie Mae funds–tend to be both very safe and pay very nice returns. A fund like the Vanguard Total Bond Market Index has offered similar performance and safety to the Ginnie Mae funds over time. Again, these are funds, but unlike the money market funds which almost never move off the $1 per share net asset value mark, these do fluctuate a bit, but historically, nothing like stock funds.

There are some alternatives–from about as safe as you can get to pretty safe with some amount of risk–to consider for your chicken money, whether that’s just your emergency fund or your whole portfolio. Good luck in selecting one that might meet your needs!

Risk tolerance is a subject that’s discussed a lot in investing. It means how much you can live with in terms of taking a chance with your money, typically meaning that in order to have more potential gain, you have to live with more potential loss, and if you only want to avoid losses, you can, but sacrifice the potential for larger gains. Some people have virtually no risk tolerance in investing–those are folks who need to be in investments like Certificates of Deposit and government issued notes, bills, and bonds or to bury their money in coffee cans welded shut in the back yard. On the other hand some will take huge risks by investing in a single stock with everything they have. If that stock is the next Google, they’ll be incredibly rich! If it becomes the next Pets.com, they’ll lose everything.

The vast majority of people would say their risk tolerance is somewhere in the middle. Where on that continuum you are is easy to overstate when the market is doing well; lots of folks say they’re very comfortable with stock market risk when the market is having the kind of run it did in 2003-2007, with positive returns every year. However, when a year like 2008 happens–with virtually the entire market in a tailspin–those who really have the risk tolerance they state to stay in the market actually do that: stay in the market. Those who don’t start heading for the exits.

You can tell the low tolerance group easily: they’re the ones who are saying that if you stay in, you’re a fool, and proudly declare how they moved everything into cash. They said they have risk tolerance, but they really didn’t. Of course, history shows that cashing out and moving to cash after a market dump tends to be exactly the opposite of the best decisions, but that doesn’t stop them.

Times like this say a lot about how much risk you’re willing to stomach.

As for me? I haven’t sold anything since my usual bit of changes in April of this year. How about you?

Actually, yes, there is, although there’s not a lot of it.

The positive parts are:

stocks you were planning to buy are now more of a bargain they were last month–maybe too much of one (see Fannie Mae and Freddie Mac as examples);

high quality bond funds are still doing well;

and oil is still plummeting in price! Right now oil is at a seven month low, about 1/3 off of its all time high price set on July 11, 2008. For an economic recovery to happen, we absolutely need lower energy prices.

So even when things don’t look great, there’s still some things worth cheering about out there!

Up until recently, Ginnie Mae (GNMA), the Government National Mortgage Association, seemed to be just another nickname for a mortgage backer like Fannie Mae and Freddie Mac. Yet with all the disaster around Fannie and Freddie, there’s little talk about trouble at Ginnie Mae. Why is that?

One simple, but world making difference between Ginnie and its siblings: GNMA is a government owned corporation which has the explicit guarantee of the federal government. Fannie and Freddie simply had implied guarantees of the federal government. Where investors have fled from stocks and bonds in Fannie and Freddie (and their prices have reflected this), Ginnie Mae funds, on the other hand, have benefited from a flight to quality and are doing as well as ever.

For what it’s worth, I do own shares in the T. Rowe Price GNMA fund, PRGMX, which has returned 3.54% year to date with a yield of 4.79%. And I’m glad, too!

Did the market’s leveling off in July after several months of freefall translate into a positive August? Let’s take a look at my sample portfolio in August.

The Vanguard Total Stock Market Index (VTSMX), which makes up the majority of my portfolio, was up 1.58% for the month. The Vanguard Total Bond Market Index (VBMFX) was up a meager .3%, but continued to pay its very nice dividend without issues. Finally, the T. Rowe Price International Discovery Fund (PRIDX) was down 3.60%.

All said, this portfolio was up about a percent for the month, which is much better than it’s done in previous months. Bonds are continuing to be the mainstay, now comprising over 29% of the portfolio (it started at about 25%)–years like this are the reason you keep a healthy part of your portfolio in a high quality bond fund!

We’ll keep reviewing my portfolio to see how it does the rest of the year.

It’s been a rough time in the markets recently without question, but also not quite an awful time. One of the things that I like about my Vanguard account is that it quickly calculates one, three, and five year returns for my accounts. While the results right now are far from stellar–market appreciation is negative for both one and three years, and my one year rate of return for my total portfolio is a negative 7.4%–things are also not all that awful.

Despite the fact that the market has been in reverse for awhile (but may have stabilized in July and so far is positive in August) my total returns for both three years and five years are a positive 4.7% and 7.2%, buoyed by positive earnings in the bond market (yes, there is a reason to keep somewhere between 20 and 30 percent of your portfolio in bonds!) during this time. And because I’ve continued to contribute money (and so has my employer) as the market difficulties have gone on, my account is worth more even though the returns have not been great.

One final thing: keep perspective on these things–a loss of 7.4% doesn’t make me happy over a year, but it’s not the kind of losses we’ve seen in the past during bear markets–just remember 2000!