LivingCheaply.net » Investing

Investing in Stocks: It’s Not as Bad as You Think

jos — Wed, 21 Jul 2010 10:00:23 +0000

This is a guest post from Robert Brokamp of The Motley Fool . Robert is a Certified Financial Planner and the adviser for The Motley Fool’s Rule Your Retirement service. He contributes one new article to Get Rich Slowly every two weeks. Stocks stink. That’s something you hear a lot these days, and with good reason. The Standard & Poor’s 500 sits at around 1060, a threshold it first crossed in the beginning of 1998. In other words, that index of stocks in 500 industry-leading American companies — companies like ExxonMobil, Johnson & Johnson, Coke, and McDonald’s — has gone up and down a lot over the past 12 or so years, but has ended up in the same place where it started. So you might think that if you invested $10,000 in the S&P 500 through something like the Vanguard 500 index fund back in the spring of 1998, you might still have just $10,000. But actually, you’d have approximately $12,000 — not great, but better than nothing. How is that possible? Permit me to explain with a metaphor. If money grew on trees Let’s imagine that you could buy a plant that grew money. That would be one valuable shrub, so it wouldn’t come cheap. In fact, let’s say a plant that produced $2 a year costs a hundred bucks. Still, you buy a whole bunch of them because: Each one produces $2 today and will provide a little more money each year as the plant grows, perhaps $4 in a decade, and In the future, another gardener might pay you more than $100 each for these plants. What do you do with the cash your plants are providing? Buy more money-growing flora, so you can use the greenbacks they produce to buy, yes, more plants. When the market decides that they’re worth more than $100, you get fewer of them. When the market thinks they’re worth less, you’ll be able to buy more. By the time you retire, you’ll own a whole lot of plants and, as they mature, they’ll each produce more money each year — perhaps $10 or more apiece. You may opt to sell some when the market catches on and offers a price higher than what you paid. But even when you retire, you should still own many of these shrubs because you’ll need to harvest the cash to pay your bills. Stalks for the long run Okay, we all know that money doesn’t grow on trees. But most stocks pay dividends ; plus, historically, over the long term those dividends increase. When you reinvest those dividends — as most people do — you’re automatically dollar-cost averaging (that is, buying more shares when prices are low and fewer when prices are high). You gradually accumulate more shares, which gradually pay bigger dividends, which are used to buy more shares, which pay bigger dividends…and so on. The same goes for mutual funds that invest in stocks. In fact, let’s look at the real-life example of the aforementioned Vanguard 500, which attempts to mimic the performance of the S&P 500 at very low costs. (I own the fund myself.) Not every company in the S&P 500 pays dividends, but this will provide an illustration of how dividend reinvestment can pay off. Had you invested $10,000 in the Vanguard 500 Fund on 31 March 1998, you’d have bought 97.84 shares, according to numbers provided to me by Vanguard. Over the subsequent year, the fund paid out $1.06 per share in dividend distributions. Technical note: Mutual fund shares also pay out capital-gains distributions, but not as consistently. So, for simplicity’s sake, we’ll focus mostly on dividends. Fast-forward to July 2010. You now have 121.15 shares — almost 24% more than you started with. That’s because you were accumulating more shares with all those fund distributions. But the news gets a little bit better. For the past year, the Vanguard 500 paid out $2.08 in dividend distributions. Over the past 12 years, the dividend almost doubled. Plus, you have 24% more shares paying that bigger dividend, which will buy more shares…well, you know the drill. “Big deal!” I know what you’re saying: “Making a 20% total return over 12 years is lame! I know this blog is called Get Rich Slowly, but that’s ridiculous.” I agree. As I said in the title of this post, investing in stocks hasn’t been quite as bad — but it’s still been bad. In fact, the last decade or so has been the worst period for blue-chip U.S. stocks since 1926, including the period encompassing the Great Depression (according to data from Ibbotson Associates). I bring all this up to illustrate a few points: Indexes can be misleading. Stock barometers such as the S&P 500 and the Dow Jones Industrial average are price indexes; they just measure the change in prices of the underlying stocks, and don’t factor in dividends or their reinvestment. That’s unfortunate, because… Over the long term, dividends matter. Historically, dividend reinvestment has accounted for approximately one-third of the total return of stocks. That said, yields on stocks are pretty low these days, which means stocks aren’t a great bargain. But for my long-term money (I don’t plan to retire for another 30 years) I’m betting that the 2% to 3% yield on a broadly diversified portfolio of stocks — along with some capital appreciation — will beat the alternatives, namely, low-yielding cash and bonds (though I own some of each for diversification’s sake). This brings us to our third, final, and perhaps most important point… Don’t invest in just one type of plant stock. Over the past decade or so, large-cap U.S. stocks — the type you find in the S&P 500 — have been the just about the worst type of investment to own. Name another type of stock (small-cap stocks, international stocks, real estate investment trusts) and chances are, as a group, they beat the S&P 500. As I explained in this video (just in case you’re dying to hear my nasally voice or see my hair while it still exists) and touched on in this previous GRS article , a properly diversified portfolio holds stocks of all types, sizes, nationalities, and flavors, with bonds or cash thrown in to suit your risk tolerance or financial needs ( e.g. , a retiree should have five years’ worth of income that is expected to be covered by saving sequestered from stocks and in something super-safe, like cash, CDs, or short-term bonds). I have no crystal ball . I don’t know whether U.S. stocks or international stocks or cash or plants will be the best-performing asset class over the next decade or few. If you think the stock market is a sucker’s bet, I’m not here to argue with you. Just taking a look at the Japanese stock market — which is still down 70% from its 1989 peak, despite being the second-biggest economy in the world — should make anyone appreciate the risks of stock investing. But if you’ve decided to make stocks a part of your long-term portfolio, I think that understanding the role dividend reinvestment plays will give you a little more confidence to hang in there. J.D.’s note: Robert’s “stalks for the long run” pun above made me die laughing. I realize it’s an esoteric personal-finance writer joke , but it’s a funny one all the same. — Related Articles at Get Rich Slowly: The Hardest Thing to do in Investing links for 2007-04-08 Ask the Readers: Where to Start With the Stock Market? Saving and Investing: What is a Stock? Investing 101: An Introduction to Index Funds and Passive Investing

Original post:
Investing in Stocks: It’s Not as Bad as You Think

SEC Proposes New Rules for Target Date Funds

cheapo — Tue, 20 Jul 2010 10:00:43 +0000

This post is from GRS staff writer April Dykman . During the 2008 financial crisis, target date, or life-cycle, funds were hit hard. People who were just a couple years away from retiring held 2010 target date funds that lost 24% of their fund’s assets on average , with a range of 9% loss to a staggering 41%. Same date, different allocation According to the Securities and Exchange Commission (SEC), many investors believed that their asset mix would become more conservative as they neared the target date. But what many didn’t know was that the amount of risk could vary widely, even among funds with the same target date. From the Washington Post : The SEC said that life-cycle funds with the same target date had equity exposures that ranged from 25 percent in stocks to 65 percent. It could be years after the target date is reached before a particular fund’s asset mix switched to a more conservative approach. Proposed rules to educate investors To increase investor understanding of how these funds work, last month the SEC proposed new rules for target date funds in a 100-page report and is seeking comments from the public about the proposal. The highlights include the following: Marketing materials would have to disclose the asset allocation as a tag line with the fund’s name the first time that name is used. The proposed rule would allow an investment company to list a range of allocation for an asset class, such as “30-35%”. Target date firms will have to provide investors with a graphic depiction of asset allocation for the life of the fund (from start date to target date). Firms will have to provide investors with a statement explaining that the asset allocation changes over time, stating the year the asset allocation becomes final, and providing the final asset mix. Marketing materials will have to advise the investor to consider his or her risk tolerance and financial situation; that it’s possible to lose money; and whether the planned percentage allocations can be changed without a shareholder vote. Finally, target date funds have been touted as a “set it and forget it” solution to retirement, but being too hands-off with your money has consequences. To address this, the SEC proposed changes to its antifraud guidance to address the age emphasis and “set it and forget it” representations of target date funds. The SEC noted that marketing materials that lead investors to believe an investment is appropriate for them based solely on age (or target age of retirement) or that the plan is easy and doesn’t require monitoring, are misleading. Are rules tough enough? While most experts agree that more disclosure is good news for investors, others don’t believe the SEC rules are tough enough . Criticisms include the following: The phrase “target date” is misleading and should not be allowed to be used in a fund’s name. The perception is that a 2030 target date fund will provide retirement income for an investor in 2030, and disclaimers are unlikely to change that perception. Some experts don’t mind the name, but feel like complicated graphs and confusing fact sheets won’t be easily understood by the average investor. Instead the investor should be told what sort of income is probable given their investments, rate of savings, asset mix, and years until retirement. The SEC should do more to explain that target date funds are not guaranteed. Critics point to the fact that the Employee Benefits Security Administration has deemed target date funds as a Qualified Default Investment Alternative (QDIA). In plain English, this means that if an employee neglects to direct their 401K investments, the employer can select a target date fund for them without being held liable. So while the SEC can say the funds aren’t guaranteed, the fact that they are a QDIA will continue to send the wrong signal to many investors. Target date funds are still a good option for many people, but it’s wise to invest with your eyes open. To help investors better understand target date funds and what to know before investing, the SEC and the Department of Labor issued an Investor Bulletin that explains how the funds work, how to evaluate them, and what to know before investing. Personally, I’m a fan of target date funds because despite writing about personal finance almost daily, retirement talk makes my eyes glaze over. Nevertheless, I am one of those investors who picked a target date fund without fully understanding much of what the SEC wants to clarify, and now I appreciate how important it is to do some homework when choosing a target date fund .

Originally posted here:
SEC Proposes New Rules for Target Date Funds

Choosing a Target-Date Fund

jos — Wed, 07 Jul 2010 19:00:02 +0000

This is a guest post from Edwin Choi, the founder of Mariposa Capital Management . Edwin is a fee-only investment advisor in Los Angeles and a long-time reader of GRS. Prior to starting Mariposa, Edwin Choi spent several years as a portfolio manager with Merrill Lynch in New York. So, you find the lazy way to invest very appealing: You like the simplicity and the long-term results. But you don’t want to bother with building your own lazy portfolio of index funds and adjusting it as you get older (same as creating your own target-date fund ). At this point in your life, you just want a set-it-and-forget-it solution, at least until you feel more comfortable building your own investment portfolio. Target-date funds seem perfect for the job, but which one is right for you? Choosing the Fund Family The first step is to choose the fund family (Fidelity, Vanguard, etc.). This decision cannot be overlooked since each company manages its funds differently; a 2040 target-date fund from T. Rowe Price will be different from a 2040 target-date fund at Fidelity. Each company has its own philosophy and methodology. Let’s compare the three biggest players in this market: Fidelity Freedom Funds, T Rowe Price Retirement Funds, and Vanguard Target Retirement Funds. The first criteria you can use to compare the fund families is cost, specifically the expense ratio (the total annual cost for things like advertising and managing the fund). As an example, let’s look at the 2040 funds: Fund Family Expense Ratio Fidelity 0.79% T Rowe Price 0.79% Vanguard 0.20% Amazingly, Vanguard’s expenses are roughly a quarter of the other two. This is largely due to the use of actively-managed mutual funds by Fidelity and T Rowe Price; Vanguard only uses low-cost index funds in their target-date funds. If you think 0.59% a year is a pretty small difference, remember that the rough rule-of-thumb for withdrawing money in retirement is only 4% a year. That “small” difference in expense ratios is almost 15% of your potential retirement income! Another important criteria to consider is the asset allocation used by the target-date fund — how much is invested in stocks, and how much is invested in bonds and other instruments. In particular, you want to look at how that allocation is expected to change as you get older. Investing geeks like me call that the “glide path”. Let’s compare the stock portion of the glide paths used by the three fund families: As you can see, although all three glide paths have roughly the same shape, the differences are material. T Rowe Price is consistently the most aggressive; Fidelity is generally the most conservative except for the strange kink around 2005-2010. Ten to fifteen years into retirement, your allocation to stocks can vary from 20 to 40% based on the fund family you choose. Choosing Your Target Date Once you select the fund family, you need to decide on the specific fund to buy. Target-date funds are labeled by retirement year, generally assumed to be when you turn 65. So the 2040 fund is designed for the “typical” person who’s currently 35 and is expected to retire in 2040. Obviously, no one is forcing you to buy the fund that corresponds to the year you turn 65. There are at least two very good reasons to adjust your target date: If you plan on retiring much earlier or later than 65, you should consider adjusting your target date. Let’s say you’re 35 and want to retire at 55. Should you buy the target-date fund for 2030, since that’s when you’d retire? Not necessarily. Although the 2030 fund fits your retirement plans, it also assumes people retire around age 65, so your life expectancy is probably much longer than the target audience for the fund. A good compromise might be the 2035 fund, which respects both your early retirement plans and your longer life expectancy relative to others you retire with. Even if you expect to retire at 65, the amount of risk you want to take is probably not “typical”. An easy way to reduce risk is by selecting a fund with a target date that is five to ten years before when you turn 65. (So, if you plan to retire near 2040, you might choose a 2030 target-date fund.) This lowers the level of risk by holding less in stocks while still considering your investment horizon. And if you want more risk, you can select a target date that is five to ten years past when you turn 65. (If you plan to retire around 2030, you could increase risk by choosing a 2040 target-date fund.) Even though they’ve received some bad press lately due to their poor performance during the recent stock market crash, target-date funds are still useful investments for many people. They’re certainly better than other strategies commonly used by beginning investors: equal-weighting all funds within a 401(k) plan, picking stocks, or just leaving everything in a money market fund. If you already use target-date funds, which funds do you own and how did you choose?

Read the original post:
Choosing a Target-Date Fund

Choosing a Target-Date Fund

LivingCheaply — Wed, 07 Jul 2010 19:00:02 +0000

View post:
Choosing a Target-Date Fund

Review: The Investor’s Manifesto

cheapo — Sun, 04 Jul 2010 19:00:26 +0000

Every Sunday, The Simple Dollar reviews a personal finance book or other book of interest. The Four Pillars of Investing , an earlier book by William Bernstein, was one of my favorite books I’ve ever read on investment topics. It was intellectually challenging, offered great investment advice, and stuck to reasonably conservative investment plans – in other words, it did not tell you to put all of your money in stocks and/or real estate. I wasn’t even aware that Bernstein had a new investment book out, but when I was scanning the personal finance shelves at my local bookstore, the vague tongue-in-cheekness of one book’s full title caught my attention: The Investor’s Mainfesto: Preparing for Prosperity, Armageddon, and Everything in Between . My immediate reaction was that someone else was tired of the constant onslaught of books predicting a financial apocalypse and that actual good financial planning involved preparing for a full range of potential long term outcomes. When I saw that the author was William Bernstein, I was immediately intrigued. Is it anywhere close to as worthwhile a read as the excellent The Four Pillars of Investing ? Or does it just photocopy information available elsewhere? Let’s dig in and find out. 1 – A Brief History of Financial Time Whenever you invest money, you’re investing it in one of two forms: loans (including bonds and savings accounts) and equity (partnership or ownership or stocks). In the eyes of the law, the former has more legal standing and importance than the latter, thus bonds and savings accounts will always have less risk than stocks or business partnerships. When a nation goes through a period of great political upheaval, both loans and equity can significantly drop in value and the possibility exists that neither will recover (though, as said before, loans have more legal protection). This is essentially the reason why conservative investments are encouraged during periods of economic turmoil. When economic turmoil happens, the less protected positions (stocks) are often abandoned for the more protected positions (bonds, cash savings, etc.). During prosperity, the reverse happens – people move their money back into the less protected positions because the potential returns are much greater, especially in times of economic growth when companies and partnerships are making lots of money. 2 – The Nature of the Beast You don’t know the day you’re going to need to cash in your portfolio. You also don’t know what’s going to happen next in the stock market or in the broader economy either. If it’s good news in the future, stocks and business partnerships will outgain bonds and other conservative investments. If it’s bad news in the future, bonds and other conservative investments will beat stocks and bonds handily. The only way to prepare for the future, then, is to balance the two. “Expected returns” are mostly just best guesses, so your best bet is to simply design your portfolio to minimize the chances of you dying poor. Balance. Don’t time the market or focus on individual stock picks unless you have psychic abilities. 3 – The Nature of the Portfolio Many people go way over the top when it comes to portfolios. It really doesn’t help to be overly complicated with your portfolio, because the fees and effort involved in making a complicated portfolio rarely add up to any sort of significant premium over a simple portfolio. Bernstein suggests simply having a domestic total stock market fund, a foreign total stock market fund, and a bond fund as your entire portfolio. You can adjust the percentages as you like, but an equal split is fine, as is a 40 (bond)/30/30 split. 4 – The Enemy in the Mirror Many people fall into the trap of oversimplifying the stock market, which is usually a mistake. There are many, many factors constantly at work in the stock market, from big institutional investors and human error to the general economy and the specific businesses within it. As humans, we tend to oversimplify stuff all the time in order to make the complicated comprehensible. Your best move is, almost always, to just stick with large index funds. That way, you’re not trying to make bets on various companies or on various specific aspects of the stock market. You’re instead betting on capitalism as a whole and human ingenuity. 5 – Muggers and Worse The more “complex” an investment product, the more laden with fees and expenses it likely is and the harder a salesman will try to sell it to you. Of course, such “complex” products often end in disaster, too (see 2008). If you don’t understand an investment, don’t invest in it. For example, if you can’t explain how a derivative works, don’t buy it and don’t let any of your investment advisors do so, either. Stick with what you know, even if you’re missing out on some salesman-created glowing promise of outsized returns. 6 – Building Your Portfolio It’s okay to lose money in stocks as long as everything is declining. What’s worrisome is when you’re losing money while the rest of the market is holding steady or growing. That’s the danger of not buying broadly – you’re trusting someone else’s judgment of a situation so complex that no one fully understands it. Bernstein walks through various portfolios – some complex and some very simple – and talks about the ins and outs of each. To put it bluntly, the simple ones almost always win. Why? They’re not laden with extra fees and they just hold everything very broadly. The complex ones win on occasion, but the broad ones usually win over the long haul. 7 – The Name of the Game The book closes with a very short chapter that essentially says that the real challenge for an individual investor is to decide the percentages. What percentage stocks? What percentage bonds? That’s really the question, because it sums up the true risk we’re willing to take on. Is The Investor’s Mainfesto Worth Reading? This book is basically a simpler, easier-to-read version of his excellent The Four Pillars of Investing . I would be much more likely to drop a copy of The Investor’s Mainfesto on someone than the other, simply because this one is much more readable and approachable. The Four Pillars of Investing is a deeper book, don’t get me wrong, but The Investor’s Mainfesto covers most of the same principles with a lot more straightforwardness and clarity without losing Bernstein’s written eloquence. It’s well worth reading, particularly if you’re just starting to think about investing on your own. In fact, it’s one of the best all-around beginning books on investing I’ve ever read.

Read the original:
Review: The Investor’s Manifesto

Rebalancing & asset allocation: critical for investing. So why don’t you do it?

jos — Fri, 25 Jun 2010 02:20:51 +0000

As you know, I love mocking people who believe that we are “rational” and “logical.” These tend to be economists, engineers, and other people who are clueless about human behavior. One of the best ways to reveal the difference between what rational people “should” do and what real people actually do is to talk about rebalancing and asset allocation. Today, I want to demystify what most people think determines investor success…versus what actually matters. * * * The reasons for investment success are not obvious. Most people mistakenly believe that your stock choices determine your success. In reality, you shouldn’t even be picking individual stocks (though this is what men in their 40s talk about at parties…that and traffic routes). Others believe that timing the market works, which is false . In reality, one of the most important parts of investing — perhaps THE most important part, besides starting early — is your asset allocation . This is basically the way you’ve laid out the pie chart of your portfolio: How much do you have in equities (stocks)? How much in bonds? And how does it change over time? Are you in your mid-20s? Here’s a sample asset allocation for you Look at that chart. Again, most people mistakenly believe that “investing=picking stocks” and therefore they need to worry about which stocks to buy, when in reality the actual equities (stocks) you choose are far less important than your overall asset allocation . In other word, your pie chart matters more than the actual ingredients. Ok, so the person in the above example is 25. Under which conditions would the pie chart change? It turns out this is one of the most important questions investors can ask themselves. What is rebalancing? Over time, your asset allocation will change, and so will your needs. For example, let’s say the stock market climbs for a 10-year period. You may have far more stocks than your pie chart calls for, so you’ll want to adjust back down. Alternatively, your needs will also change: When you’re 25, you have a long time before you need your long-term investment money. Therefore, you’re risk-seeking : You have a large appetite for risk because you want higher potential rewards. At 45, you’ll want to become more conservative and protect what you’ve acquired. You can’t afford the same risk as a 25-year old. At 65, you are simply waiting for your inevitable death, so you become correspondingly more conservative. I wrote about this more eloquently in my book, so here’s an excerpt. And yes, I find it remarkably fulfilling to quote myself: How do you do that? Who wants to monitor that? Asset allocation and rebalancing are hard Asset allocation is complicated. The best institutional investors in the world — like investment managers at university endowments — are hyper-focused on deciding whether they should have 13.1% or 13.3% in their portfolios. But asset allocation is complicated for individual investors, too — though not for the reasons you think. Since individual investors don’t have access to sophisticated alternative investments, we essentially have to decide among 3 areas of investment: Equities (stocks), fixed-income (bonds), and cash. 3 choices. On the surface, it doesn’t seem too difficult. But over time, it becomes profoundly difficult to maintain the “right” asset allocation. Why? The reason may surprise you. The Looming Enemy: Why you don’t rebalance We now know that asset allocation is one of the most important factors in investing success. So why do we find it so difficult to maintain a reasonable asset allocation? Why do you find grandmas with 90% in stocks, while you also find 25-year-olds with 30% in bonds? Since we’re wading into fairly advanced investing strategy, you might think that the primary reason is that people don’t know about complex mathematical models or fail to understand some deep nuances of investing. Not so. The primary reason we fail to maintain a reasonable asset allocation is human psychology. We are subject to many powerful psychological biases when it comes to investing (more about the psychology of money ). Even if we have a helpful chart like this… …we still fail to maintain a reasonable asset allocation over time. “This analysis assumes that for all of these portfolios, investors kept their money in the funds through the hair-raising markets of 2001 and 2002 and rebalanced the portfolios annually, returning them to their original allocation. But such disciplined rebalancing can be a tough sell, said Hersh M. Shefrin, a professor of behavioral finance at Santa Clara University in California. “We are pleasure-seeking beings who want to avoid pain,” Professor Shefrin said. Rebalancing, he said, would have forced investors to do exactly the opposite — by making them either prune assets that had done extremely well, or to load up on assets that had disappointed them.” (via NYT ) To put a finer point on it, from a nice article in the Canadian Business Online blog : “When stocks were crashing in late 2008 and early 2009, did you rebalance your investments? Did you actually move money out of cash and bonds into stocks? Many did not. They either froze or dumped stocks in a panic. At least that is the conclusion of a recent study released by two finance professors, Louis H. Ederington and Evgenia V. Golubeva, at the University of Oklahoma.” Let’s get to the nitty-gritty of what you need to know. What you need to know about asset allocation and rebalancing Asset allocation is the #1 or #2 most important thing you can control when it comes to investing Contrary to what most people think (especially technical people), the difficulty in maintaining asset allocation is not technical skill. It is investor psychology . You will inevitably think you can out-think the market. You will fall prey to several investor biases. You will not be disciplined enough to rebalance on a regular basis. You are human. “Trying harder” in this area doesn’t work for 99% of people. Forget picking stocks, since investing is not about picking stocks. Again, investing is not about picking stocks. Most individual investors shouldn’t even pick one stock . Instead, they should use target-date funds (aka lifecycle funds), which choose an asset allocation based on your age and automatically rebalance for you over time. The media does not like to write about asset allocation because it’s complicated, scary, and you can’t easily put a picture of a guy standing in a suit with his arms crossed talking about how asset allocation helped him pay off his debt and send his kids to college. Jesus christ I am getting angry writing this Most people don’t even know what asset allocation is. But even those who do fail to rebalance their portfolios in a disciplined way. This is true even of professional portfolio managers! The best solution is to automate this process by investing in a target-date fund (aka lifecycle fund). Those funds automatically rebalance for you. And for each person who debates minutiae about the minor percentages they disagree with (“it should be 16% large-cap, not 14%!!!”), 1000x more people are helped by the automation of regular rebalancing. Investing without an asset-allocation plan is like riding a tricycle in South Central LA, naked, blindfolded, wearing a large fanny pack full of $20 bills. It doesn’t matter how disciplined you “think” you are going to be in steering straight and true. You are still going to get your ass beat. Most investors don’t even have a plan for their asset allocation. They simply invest randomly here or there, picking a fund or stock that catches their fancy. 40 years later, they complain about the government, taxes, and the media for their poor investing returns. (They’re not the only ones to blame , of course.) But perhaps even more pernicious are the people who are well-read about investing — but then decide they want more “control” so they’ll manually adjust their asset allocation. This may work when they initially start investing and are highly motivated, but over time, they — like everyone else — fall prey to natural human biases and weaknesses, leaving them with an exposed asset allocation. Perhaps 1% of investors can maintain the discipline to maintain an appropriate allocation over time. Chances are, you can’t. I know I can’t. And that is why I use target-date funds. Bottom line: You are human. No matter how motivated you are about investing right now, you will find other things more urgent and important later. We are all cognitive misers with limited cognition and willpower. Investing in a target-date fund lets you compensate for your natural weaknesses and biases by automating complex asset-allocation decisions. Setting up an automatic investment system How do you set up a target-date fund? Which one should you use? What are the things to look out for? Get a 6-week step-by-step system in my book, including specific recommendations, negotiation scripts, the best (and worst) companies, and advanced investing material. Get my book here .

Original post:
Rebalancing & asset allocation: critical for investing. So why don’t you do it?

The Marginal Utility of Money

cheapo — Wed, 16 Jun 2010 17:00:53 +0000

This is a guest post from Mike Piper , who writes at Oblivious Investor, where he explains such thrilling topics as 401k rollovers and Roth IRA rules . I know I’m taking a risk by starting an article by defining a term from economics. But please, stick with me. It’s not a hard concept to understand, and it directly relates to your financial success. Utility is a term used in economics to describe how much value or happiness one derives from a good or service. Marginal utility refers to how much additional value/happiness is derived from one additional unit of the good or service. Most goods and services are said to have “decreasing marginal utility.” “Decreasing marginal utility” sounds like gibberish, but it’s actually pretty easy to understand: First slice of apple pie: “Yes, please!” Second slice of apple pie: “Well…OK…one more piece.” Third slice: “Oh, I couldn’t. I’m stuffed.” Each slice of pie provides less happiness (”utility”) than the previous slice. The same thing holds true with nearly every good or service. In fact (or perhaps, as a result), this idea holds true for money as well. For many of us, an extra $500,000 in cash could accurately be described as life changing. But what if you already had a liquid net worth of several million dollars? An extra $500k would still be nice, but I doubt it would change your life meaningfully. Get Rich Slowly has practically been a real-time case study in this concept. J.D. used to be deeply in debt, at which point he had a high marginal utility of wealth. That is, every extra dollar he earned and saved made a big difference to his well-being. However, as he climbed out of debt, built his income, and built his wealth, his marginal utility of wealth has slowly declined. J.D. recently put it this way : “Debt used to be my biggest source of money stress. Then it became an obsession with frugality, which led me to cross the line to cheap bastard. Now my biggest problem seems to be an obsession with income: I want more money all the time. I’m beginning to see, however, that if I relax on my drive for a higher income, I can have more of other stuff, like time with friends — and travel.” Marginal Utility and Risk Aversion Because most us have a decreasing marginal utility of wealth, a loss of a given amount has a greater impact than a gain of the same amount. For example, would you be willing to accept a wager of $10,000 on a coin flip? If you win, you get $10,000 — but if you lose, you owe me $10,000? I sure as heck wouldn’t take that bet. The idea of winning $10,000 is exciting, but the idea of losing $10,000 in an instant is downright sickening. Fifty-fifty odds just aren’t good enough to get most people to put a meaningful amount of money at risk. In economic jargon, we say that we’re “risk averse”. That is, we’re unwilling to take a risk unless the probability is good that we’ll come out ahead as a result of taking that risk. Eliminating Risk Where Possible If you’re like most people, you’re more afraid of running out of money than you are excited about being filthy rich. And if that’s the case, why not eliminate as much risk in your investment portfolio as you possibly can? For example, have you checked to see if you’re saving enough each year to meet your goals by investing entirely in TIPS ? (TIPS — Treasury Inflation-Protected Securities — are bonds that provide protection against inflation.) If so, why take on stock market risk? With TIPS, you know exactly what inflation-adjusted return you’ll be getting. It’s hard to have less risk than that! Or, if the modest return from TIPS isn’t going to be enough to meet your goals — and you therefore need the higher expected return that comes with stocks — why not try to make the stock portion of your portfolio as safe as possible? For example, if you’re saving enough each year to get the job done with index funds , why take on the additional risk that comes with picking individual stocks ? Alternatively, if you’re in (or near) retirement and you’re worried that you’re going to outlast your portfolio, why not minimize that risk by purchasing an annuity that can provide predictable income for the rest of your life? When it comes to investing, rather than asking how much risk you can stomach, try asking how little risk you can get away with. After all, is it worth jeopardizing your goals for a shot at that third slice of pie? — Related Articles at Get Rich Slowly: How Marginal Tax Rates Work links for 2007-01-04 Money Hacks Now at Get Rich Slowly Quick and Easy Self-Watering Garden Planters Missing Money

See original here:
The Marginal Utility of Money

The Best Way to Pay for Advice: The Advantages of a Fee-Only Financial Advisor

LivingCheaply — Wed, 09 Jun 2010 10:00:24 +0000

This is a guest post from Robert Brokamp of The Motley Fool . Robert is a Certified Financial Planner and the adviser for The Motley Fool’s Rule Your Retirement service. He contributes one new article to Get Rich Slowly every two weeks. A few weeks back, I wrote about having a financial health day at work. With the help of some of my Foolish colleagues, we’ve created a PDF that outlines how to host your own financial health day at work, including a checklist of what to consider accomplishing during the day. Note: You can download this free special report here. [220kb PDF] As you’ll read, a key component of the financial health day was classes taught by experts we invited to Fool HQ, include several fee-only financial advisors from the Garrett Planning Network . Which brings us to the topic of today’s post: how to pay for help from a financial professional. It all begins with my experience as one myself. My short life as a stockbroker Way back when (in those crazy, hazy, dot-com-zy days of the 1990s), I put on a suit every workday and headed to the offices of Prudential Securities, where I was a (very junior) member of team that managed $200 million. I started off as essentially an office gopher, and ended up being a licensed broker in a span of about two years (at which point I left to join The Motley Fool). The term “broker” is important; it means I earned commissions for sales of stocks and mutual funds. I also was a licensed insurance agent, and earned commissions for selling insurance products such as annuities. Now, the fellows I worked work were smart and ethical, and I’d trust them with my own money. And they’re not the only good brokers in the industry; I know plenty of them. But I saw enough to know that this is an industry driven, first and foremost, by people who want to make a lot of money for themselves. That money doesn’t materialize out of thin air; it comes straight from their clients’ accounts and into their own. As part of my training, I spent three weeks in New York City. During the day, we heard from various representatives of the firm’s departments — the bond desk, the equity analysts, etc. We weren’t being taught how to choose better investments for our clients; it was more of an introduction to how the firm worked. Then, we’d learn sales techniques. At night, we practiced them by making cold calls while instructors listened in, giving us advice after the call on how to provide more “sizzle.” When I joined the firm, I thought I’d be getting “the keys to the kingdom” in terms identifying the best investments. After all, this is a big-name Wall Street firm; they surely knew how to beat the market. Alas, it was not true. I learned more about investing from reading a collection of good books than I did from Prudential’s training. What I did learn was that recommending certain investment products resulted in a bigger payday for the broker than recommending others — regardless of what was best for the client — and that many brokers weren’t able to overcome (and loath to disclose) this conflict of interest. The fee-only way Is there a way to get financial help without this conflict interest? Yes, there is — by hiring a fee-only financial advisor. Such an advisor gets paid by the hour, by the project, or — if they will be managing your money — as a percentage of the assets under management. These folks have just one incentive: provide good advice. You know they will recommend what they really think is the best course of action, because they get paid the same no matter what they recommend. Here are a few other reasons why I like fee-only planners: If you walk into your local Merrill Lynch, Morgan Stanley, or some other brokerage, the advisor you speak with will care mainly about your investments, and maybe your insurance, because that’s how they get paid. (Don’t expect much guidance on the money in your 401(k), because they can’t get paid for providing advice about that.) Fee-only advisors, on the other hand, take a look at the whole picture, from debt to cash flow to employee benefits to estate planning. Many fee-only planners will work on an as-need basis. Perhaps you just need help answering one or two questions, such as whether you’re saving enough for retirement. Or you’d like to continue handling your own finances, but you want an objective second opinion to make sure you’re on track. An hourly fee-only advisor can help you. It’s not exactly cheap — approximately $150 to $200 an hour. But not spending that money can be hundreds-wise but thousands-foolish. Fee-only planners tend to have professional designations, such as Certified Financial Planner or Chartered Financial Analyst. Plenty of brokers have those designations, too, but not as many, percentage-wise. Such a designation doesn’t guarantee good behavior or perfect advice, but it does mean the advisor knows enough to pass very rigorous exams and fulfill continuing education credits, including classes in ethics. Most fee-only planners are fiduciaries, which means they are legally obligated to put their clients’ interests first. Surprisingly, and appallingly, the typical broker is not a fiduciary, and is held to a lower standard. I won’t bore you with all the legalese, but it has been in the news lately since it’s a part of the debate about financial reform . Just know that it’s a topic you should research and bring up with any financial advisor you consider hiring. Where do you find such a fee-only planner? The Garrett Planning Network is a start. Visit their locate an advisor page and click on your state to see if there’s an advisor in your area. (In the interest of full disclosure, and revealing my own conflicts of interest, The Motley Fool has a partnership with Garrett, but no money has changed hands. It’s more of a “we like each other, so let’s spread the good word about each other” type of arrangement.) Another option is the National Association of Personal Financial Advisors , or NAPFA. Finally, you can use the PlannerSearch tool of the Financial Planning Association, and specify “Fee Only” under the “How Planners Charge” link. Fee-only advisors are independent, and have their own ways of doing business. So not every fee-only advisor will manage money, and not every one will work on an hourly basis. Determine what you need, and find an advisor who will work on your terms — and put your interests first. — Related Articles at Get Rich Slowly: links for 2007-05-15 MyFinancialAdvice.com Helps the Average Person Find a Financial Advisor Ask the Readers: Finding a Financial Advisor? Fix It or Junk It? Win a Free Consultation with a Financial Planner

View original post here:
The Best Way to Pay for Advice: The Advantages of a Fee-Only Financial Advisor

Ramit’s 12-minute guide to automating your accounts (video)

cheapo — Wed, 09 Jun 2010 01:41:55 +0000

This is an oldie but goodie, and one of the most important videos I’ve posted in my 100+ YouTube videos . In this 12-minute video, I show you how to set up your bulletproof personal-finance system to automate your accounts. I cover the entire system in extreme detail in my personal finance book . To find out about the psychology of automation — including how it affects your money — check out my section on automating your personal finances . This post is part of a series on Automating Your Personal Finances . For more personal finance hacks and articles on money management, follow the links below.

The Snowball: How Compounding Affects Money, Knowledge, and Life

jos — Wed, 12 May 2010 10:00:33 +0000

This is a guest post from Robert Brokamp of The Motley Fool . Robert is a Certified Financial Planner and the adviser for The Motley Fool’s Rule Your Retirement service. He contributes one new article to Get Rich Slowly every two weeks. Happy anniversary to…well, all of us, I guess. This post marks my one-year (and five days) anniversary of being a contributor to Get Rich Slowly . It’s been a hoot. My very first post was a report from my journey to last year’s Berkshire Hathaway annual meeting. While I didn’t attend this year’s meeting, which occurred two weekends ago, my interest in Warren Buffett’s commentary and biography hasn’t flagged. After all, I’m a Berkshire Hathaway shareholder. The wealth snowball This post’s Buffett lesson comes from The Snowball , the recent Buffett biography by Alice Schroeder in which she writes: “Since Warren looked at every dollar as $10 someday , he wasn’t going to hand over a dollar more than he needed to spend.” Buffett apparently was so cheap, he only washed his car when it rained so he wouldn’t have to pay for the water. Former Washington Post heir and publisher Katherine Graham once asked Buffett for a dime to make a phone call. (Before the advent of cell phones, people had to use these things called phone booths if they wanted to make a call in public — and they didn’t even have Twitter !) Buffett only had a quarter, so the billionaire first went to get change. Now, we all know that spending a dollar today means we won’t be able to spend it later. We may also allow that a dollar invested today will be worth more years hence, so that we not only delay gratification — we can pay for more of it. But a dollar saved today leading to $10 someday? That’s an awful lot of compound growth. Yet for Warren Buffett, it turns out that he was underestimating himself. From 1965 through 2009, Berkshire Hathaway stock returned an average 20.3% annually, turning $1 into $4,341. That, ladies and gentlemen, is how you become the richest person in America. Compounding for mere mortals But what about the rest of us? Is it reasonable to think an investment today could decuple ? (Yes, that’s the word for something that has increased tenfold, and, yes, I had to look it up.) That depends on the return you earn, and how long you earn it. Below are three charts, assuming different rates of return, initial investments of $100, $500, and $1,000 (which are more representative than $1 of the spending decisions we make nowadays), and the numbers of years the money is invested. Initial Investment Earns 4% Annually Years $100 $500 $1,000 5 $122 $608 $1,217 10 $148 $740 $1,480 15 $180 $900 $1,801 20 $219 $1,096 $2,191 25 $267 $1,333 $2,666 30 $324 $1,622 $3,243 Initial Investment Earns 6% Annually Years $100 $500 $1,000 5 $134 $669 $1,338 10 $179 $895 $1,791 15 $240 $1,198 $2,397 20 $321 $1,604 $3,207 25 $429 $2,146 $4,292 30 $574 $2,872 $5,743 Initial Investment Earns 8% Annually Years $100 $500 $1,000 5 $147 $735 $1,469 10 $216 $1,079 $2,159 15 $317 $1,586 $3,172 20 $466 $2,330 $4,661 25 $685 $3,424 $6,848 30 $1,006 $5,031 $10,063 In these examples, the only amounts that have increased tenfold are the ones invested for 30 years and earning 8% annually, a return not quite as easy to earn these days as they were in the second half of the last century. Still, the numbers might be compelling, especially for younger folks. A few additional thoughts about these tables: These numbers don’t take inflation into account. So forgoing $100 today doesn’t mean you’ll buy $1,000 worth of goods at today’s prices; it’ll likely be quite less. But as long as you earn a return that exceeds inflation, you’ll still be able to buy more in the future than you could buy today. While most of us don’t drop $100, $500, or $1,000 on purchases every day, I do find it informative (and occasionally painful) to annualize expenses. Spend $6 every workday on lunch? That’s approximately $1,400 a year. Your cable costing you $100 a month? That’s another $1,200. And that’s after-tax money. In other words, to spend that $1,200, you had to earn $1,600 and then pay $400 in federal and state taxes (assuming a 25% combined rate) to have that $1,200 to spend. If you put that money in a traditional retirement account, you can at least defer the federal and state income taxes (though not the FICA taxes — you still have to pay those). The numbers in the charts reflect a one-time investment, and not continual, regular investments. For example, if you invest $500 every month and earn an average annual 6%, you’d have approximately $500,000 after 30 years. If you’re closer to the day you hope to retire than the last time you pulled an all-nighter, you might be saying, “But I don’t have 30 years for my money to grow!” That may be true for the money you need in the first several years of your retirement, but if you live to the average life expectancy (or longer), you won’t touch some of your money until you’re a decade or two into your retirement. Unless you’re an 85-year-old one-armed chainsaw juggler who smokes, you should plan on some of your money being invested for decades. If you, like Buffett, find thinking about future values helps being frugal, print out those charts. Put them in your wallet. Wrap them around your credit cards. Post them on your computer monitor about where the “Place your order” button shows up on your favorite e-shoppe. After all, as Alice Schroeder explained in an interview with The Motley Fool , the power of compounding is where the title of her book comes from: The Snowball is from a saying of Warren’s about life being like a snowball. It is really a metaphor for compounding, for the way that things tend to grow at an exponential rate when they are rolling forward over time. So his money has obviously been like a huge snowball, but it also refers to relationships and to knowledge and all the different things that tend to grow and layer upon each other. Balancing tomorrow and today Despite Buffett’s famed frugality, he doesn’t recommend forgoing all of life’s pleasures. As Schroeder explained in another next segment of her Foolish interview , even Buffett recommended that you have to strike a balance between enjoying today and investing (your bucks or your brains) for tomorrow: He said to me one time, if there is something you really want to do, don’t put it off until you are 70 years old. … Do it now. Don’t worry about how much it costs or things like that, because you are going to enjoy it now. You don’t even know what your health will be like then. On the other hand, if you are investing in your education and you are learning, you should do that as early as you possibly can, because then it will have time to compound over the longest period. And that the things you do learn and invest in should be knowledge that is cumulative, so that the knowledge builds on itself. So instead of learning something that might become obsolete tomorrow, like some particular type of software [that no one even uses two years later], choose things that will make you smarter in 10 or 20 years. That lesson is something I use all the time now. J.D.’s note: While I realize that much of the discussion about compounding involves theoretical, it’s still fascinating. If you start early enough and are disciplined (and things go according to plan), you really can use the power of compounding to build great wealth. But, as Buffett points out, it’s not just money that compounds. Knowledge does, too, as do relationships and experience. The more you do to improve your life today, the better it will be tomorrow. — Related Articles at Get Rich Slowly: Free Debt Snowball Spreadsheet Ask the Readers: How to Prioritize Savings Goals? Daily Links: Compound Interest, Web Income, and Happiness In Praise of the Debt Snowball Daily Links: Question and Answer Edition

Here is the original post:
The Snowball: How Compounding Affects Money, Knowledge, and Life