Strategic Asset Location

Investors' Silent Business Partner

Many times there is a "missing manual" type of effect in personal finance.  For example, investors reach the point where they understand that asset allocation is the first and most important step in investing, determine that they should put 30%, say, in fixed income, but then are left hanging.  Should they buy individual bonds or exchange traded funds?  And how do they decide on different asset classes within the fixed income arena?

A similar situation exists when it comes to the location of investments among taxable, IRA, and Roth IRA accounts.  Where should stocks be held?  Where should bonds be held?  How does anticipated time of holding come into play?  How do expectations of future tax rates come into play?

These questions are addressed in this short article, "Asset Location, as Well as Allocation, Matters for Retirees" by Mark McLaughlin, to at least get do-it-yourself investors thinking about tax strategy.  This is not an easy area and is definitely not trivial.  The whole investment process is about managing risk and return over a long period of time such that the most ends up in your pockets and not your silent business partner's (Uncle Sam) pockets.  In fact, this is one area where a bit of consultation can yield/produce more dollars than the consultation costs.

Bogle Answers Five Questions

Jack Bogle answers 5 questions in this interview by Ben Steverman of Bloomberg.  Bogle offers the best advice he ever received, his views on the current market, and mentions the biggest problem facing the industry today.

He says "The fund industry has turned into a marketing business, and the important thing is getting a lot of assets under management. It’s run for the benefit of financial conglomerates that own most of the large mutual fund management companies."

Most of you know Bogle's story.  He founded Vanguard and established an S&P 500 Index fund.  The Street referred to it as "Bogle's Folly."  That is until it became one of the largest funds in the world. Today, of course, every major fund provider has a similar fund - which should tell you something.  Still, it is not something pushed by the fund providers - they would rather naive investors go into their money-making (for the fund providers, not the customers) active funds.

Gen-Yers Uncomfortable With Market

Source: Richard Scarry

The September 12 - September 18, 2011 issue of Bloomberg Businessweek reports ("Armageddon" "We're Dealing With a Culture of Hypochondria" by Robert Farzad) that, according to an MFS Investment Mangement survey, 40 % of Gen-Yers (ages 18-30) agree with the statement, "I will never feel comfortable investing in the stock market."

The article goes on to say that this is "understandable"  because funds are underperforming today.  JPMorgan Chase found that 47% of 2,808 funds they track trailed their benchmark by more than 2.5% this year.

This underperformance is not news to the readers of this blog.  I, along with many other bloggers, constantly preach the folly of investing in actively managed funds and constantly report on their underperformance, after all fees and costs, over the long run.  Depending on the time period studied, 75% to 90% of actively managed funds underperform over the long run.  Furthermore, it is impossible to pick the superior performers.

Source: Bloomberg Businessweek 9/12 - 9/18, p, 47

Some specific year-to-date fund returns reported by Farzad are shown in the table.  Over the same period, through September 5 the S&P 500 was down 6%.

The American Funds fund is the largest fund in the country.  The Fairholme Fund is managed by Bruce Berkowitz, who was named "domestic stock fund manager of the decade" in January 2010 by Morningstar.  By contrast to these stalwart funds, the index is the equivalent of "the lowly worm" in the picture books by Richard Scarry my kids enjoyed as infants.

The full picture can be seen in the graphic:

Source: Bloomberg Businessweek 9/12 - 9/18, p, 47

 CLICK IMAGE TO ENLARGE  The negative view of markets by so many young people is disheartening on 2 counts.  First, one of the main tenets of attaining a decent retirement is to start investing early.  In the "haven't we seen this movie before" category, you can bet if the Dow rose 2,000 points over the next 12 months the very same Gen-Yers would be jumping in.

Secondly, in the view of many long time observers of the market, young people shouldn't even be considering high-priced active funds.  Minimize cost and index the market.  Hold on for the long term.  Embrace falling prices.  You are interested in where prices will be 30 years from now!

Long Term Market Outlook

Gen-Yers face the same hurdle as most investors:  they have a hard time seeing ahead.  Like many, they look in the rear view mirror.  Like many, they focus on the problems.  Suffice it to say that, over the past 30 years, there have just about always been very good reasons not to invest, including the S&L crisis, corporate governance problems, the East Asian crisis, the need to bail out the largest hedge fund in the country, the dot.com crash, 9/11, etc., etc.

But go back to 8/6/1991.  This was when Tim Berners-Lee created the first web site.  First cell phone?  In 1994, the first cell phone weighed 2 pounds and cost almost $4,000.  My first calculator was a Bowmar Brain that cost $110 and was equivalent to what you can get today for $12.  And so it goes with flat screen tvs, medical technologies, online courses in education, online banking, and on and on.  These are the things that make the world completely different from 30 years ago and are made by companies who prosper.

These were the changes we couldn't see.  These were the changes that drove stock prices sharply higher.

Is Deflation Always Bad?

OK...I can hear it now...what kind of question is that?  After all, widespread deflation occurred in the 1930s and look at that period.  More recently, Japan has been in a long-term stagnation deflationary period.  In the 1930s, prices fell and businesses couldn't sell their goods as consumers retrenched.  Consumers retrenched because businesses were laying people off.  An impasse resulted and the economy worsened - or so the story goes.  The stage was set for Keynesian prescriptions.

The only way out, according to today's predominant interpretation of history, was massive government spending via the buildup for WWII.  The forces of deflation had to be overcome!

This is taken as the bible by most economists, in particular those pulling the policy levers today.  The Bernanke/Geithner camp and a goodly part of the Federal Open Market Committee continually call for more stimulus and more quantitative easings.  A smugness has set in based on academic authority.

Could this be wrong?  Look again at the 1930s.  What role did the 1930s deflation play in getting  the economy going after WWII?   It, along with massive pent-up demand for truly wonderful products as the nation transformed itself to a peace time economy, surely was a factor.  In the 1920s, as the business sector boomed and the agricultural sector was in a depression, a new price structure was necessary.  This is what the deflation accomplished.

Closer to the present, what if the continual decline in the purchasing power of the dollar, i.e. inflation, had reached the point in 2003 where the economy needed a fall in the overall price level?  After all, housing prices were already rising robustly, along with college costs, medical costs, etc.

Maybe sometimes the price level (especially the way we measure it!) gets too high and needs to come down.  Furthermore, it is important to remember that price doesn't just fall because of inadequate demand.  There is also the supply impact and the spreading impact of competition.  Then and now, the spread of price information via the internet is unprecedented.  In short, the price search process has shortened significantly for many purchases from big ticket items down to the smaller items.

A Bit of History

After WWI, Great Britain tried to maintain an artificially high value of their currency.  A nation's exchange rate, of course, sets the prices of a nation's goods and services relative to the rest of the world. As a result of Britain's actions, resulting fundamentally from an excess of hubris, gold flowed out; and they begged the U.S. in the mid-1920s to lower interest rates.  The U.S. complied, and stocks roared (even while the agricultural sector suffered), setting the stage for the run-up to 10/1929.

There is a parallel with the 2003 Fed with Bernanke covering the country talking up the evils of deflation and pointing to Japan and their economic stagnation because they were not following sufficiently aggressive macro policies.  Chairman Greenspan bolstered this theme ,and the Fed pushed short-term interest rates down to 1% in mid-2003.  Just like in the late 1920s, stocks took off and hit an all time peak in 2007.  This, with an already strong housing and auto market and the 2003 action, poured gasoline on the fire.

As a result, the cost of housing dropped after the 2003 rate cut, even as the printed price rose!  Mortgage brokers got funds practically for free and, thereby, issued mortgages which required no down payment, options with no payment against principal, etc.  Adjustable rate mortgages ballooned (pun intended)  and the gold rush was on.  The 2003 rate cut was then followed by a sharp rate increase.  It was as if you bought a car for $14,000 and then surprise - the real price is $20,000!  Those who fell into this trap are sometimes among those blamed for the crisis!

Today, the problem may be that prices are too high; and the Fed is desperately trying to inflate the economy by pushing them higher.  It stays stuck on the belief that the only way to get consumers to spend is to scare them into thinking that prices will be higher tomorrow.

Here's some news:  a big part of the economy is in good shape.  Those who have a job see that they have exceptional opportunities in front of them.  Many are watching prices drop and are interested in taking advantage of the new price structure.  There is a lot of talk about the values now available in housing. This process needs to proceed which, in turn,  needs the Fed to get out of the way to let it work. Otherwise, the recovery process could take years if not decades.

How to Learn DIY Investing

This post idea came from "Where Can You Learn Extreme DIY Skills?" at the Money Ning blog.  DIY investing is actually a pretty easy skill to learn that can save a boatload of money because of the great books written by the masters, who simplify the whole process.  The basics can be grasped in a single weekend.  A number of these books are listed in the bookstore link on the right hand side.  I would suggest checking out a couple at the library and, when you find one that resonates, buy it.

The Elements of Investing by Malkiel and Ellis is an excellent place to start.  Malkiel and Ellis are to the investing world what Jimmy Page and Eric Clapton are to the world of rock guitar.  In this book, they condense their investment approach into the very basics so that the newbie DIY investor knows exactly what to do and why to do it.

I would then consider The Smartest Investment Book You'll Ever Read by Dan Solin.  Again, a book you can read in a single weekend.  In fact, here's a really good YouTube Google authors talk by Solin that is a bit over an hour long:  Solin talk.

Finally, Millionaire Teacher by Andrew Hallam goes beyond pure investing and talks also about how he, and others, have built sizeable nest eggs.  A really important section shows how little time is required to actually set up and manage an investment approach that, over the long run, has outperformed high priced investment managers!  Not only has the approach outperformed over the long term but it also does not require sacrificing a lot of time as you engage in the work world or even in retirement.

The approach touted in these books is the index approach.  In other words, it is the opposite of trying to pick stocks or funds that will outperform or even trying to time the market.  I understand that this approach isn't for everyone and that many want to try to "beat the market."  If you have the resources, the time, and the expertise and believe you can do it, then I say go for it - just understand that the odds are against you.  There are many books at your book store or library that will lead you down this path.

Managing Retirement Savings - A Couples Study (Con't.)

Yesterday I looked at the first 5 questions suggested by Fidelity for couples thinking about retirement.  Here are the final 5 questions.  The study is the result of a poll showing that less than half of potential retirees discuss this major life change with their partners.  The list is useful for closing this communications gap.  Continuing yesteday's approach, I put my comments in bold.

6. Have we created a retirement plan?  This, of course, is the roadmap to seeing if you can achieve your lifestyle as specified in question 3.  This brings together all of the other questions and lists contingencies - what if you can't work until 65, etc.?

7, Have we factored in future health care costs?  Health care, of course, can upset the whole apple cart.  Having a stroke, suffering from dementia, and just generally requiring long-term care can change the whole financial plan.  In addition, health care costs can be a major issue for those retiring early.


8. Do we know where all your assets and important documents are?  One of the first steps many financial planners take is to seek ways to consolidate finances and get the number of accounts and statements under control.  Having 14 accounts at 5 different brokers makes the whole process unwieldy. 

9. Have we named beneficiaries?  Assets pass first by beneficiary designation, then by wills, trusts, etc.  Typically the spouse is the beneficiary.  Problems sometimes arise with contingency beneficiaries.   For those who have been married before, have had children recently, etc., beneficiary designations may not be as intended.  Easy to check and fix.

10. Do we understand how your Social Security and Medicare benefits will work?  On Medicare, sad to say, many people believe that all their health care expenses will be taken care of by Medicare once they turn 65.  Not true.  Be prepared to learn how Medicare works before age 65.  On Social Security, many take Social Security as soon as they can, at age 62 without considering the need, taxes, and likely life expectancy.  Take some time and learn about the options.  It can make a huge difference in the later years.

Managing Retirement Savings - A Couples Study

 

Quick: What percentage of couples make joint decisions on retirement savings?  According to a study by Fidelity Investments reported on in the September 2011 issue of AAII Journal, it is just 41%.

Furthermore, only 17% of couples feel that either spouse could assume responsibility for managing the assets. 35% of wives and 72% of husbands believe they could manage the assets.  37% of husbands say they are the primary decision maker on retirement assets and 8% of wives.

62% don't agree on when to retire, and 47% disagree on whether to work in retirement.  33% don't agree on where to retire or simply don't know.

Fidelity recommends the following questions to remedy this lack of communication.  So, go to your honey, pour a couple of glasses of wine, and say "Babe, I've got some questions to go over with you."  It wouldn't be the worst way to spend a Friday evening.

Questions (my comments in bold)

1. At what age do we want to retire?  Yesterday is not acceptable. If you get past this one then...

2.  Do either of us want to work in retirement?  The questions are obviously inter-related and that's the beauty of them.  Working in retirement is one option to make up for a lack of sufficient funds (see question #5), etc.

3. What type of lifestyle do we envision in retirement?  Retirement specialists say that retirement should be towards something rather than away from something.  It is hard for the stressed-out worker with the long commute and the long hours to appreciate that, after a while, even vegging out gets unbearably boring; but it will happen.  You'll enjoy listening to the early morning radio report on the backup on 95 North because of last night's snow, but it'll get old after a while. Think through what you will do in retirement - you'll be glad you did.  This may change your answer to question 2.



4. Where do we want to live?  This can be a show stopper.  Couples sometimes are very surprised when this question is raised.  You didn't know that all along she was planning to move closer to her sister?  Oops!


5. What does our financial picture currently look like for retirement?  This can be painful (some people view this as akin to doing their taxes), I know, but this is where you start to discuss if you are on the right path - are you taking the right steps?  This is trickier than it looks.  Not long ago people said they would sell their house for a zillion dollars and downsize big time.  The downsizing is still feasible, but it has reached the point where people would rather open their financial statements than go on Zillow.

TO BE CONTINUED.

Musings on Greece and Euro Zone's Problems

As for me, all I know is that I know nothing.  Socrates

On 9/11 last week, I spent much of the day, like many Americans,  watching footage of the terrorist attacks.  One of the things that really struck me more than it had in the past was the giving of advice by those supposedly "in the know" that cost thousands of lives.  People in the towers called 911 after the first plane hit and were told to stay put--that help was on the way.  Others were directed to go to the roof.  The people who supposedly knew how to respond to a crisis had no idea of what was taking place.  Yet they didn't hesitate to tell  people to stay in their offices as smoke and fire filled the room.  They said help was on the way.  Many times we assume that those in charge know what they are doing.  People in the World Trade Center towers did, and it cost them their lives.

Often times in the financial arena, observers believe those in charge know what's going on.  In 2006, we listened as Greenspan and Bernanke claimed the housing crisis wouldn't have a major macro economic impact.  Today, Sarkozy and Merkel and, for that matter, the world's central banks have center stage.

Added into this is the obvious fact that those in charge have to parrot the party line.  A good example comes from the world of sports.  Reporters corner players after a string of losses and ask them how the team is doing.  Their response is predictable.  They talk about taking the season one day at a time, practicing harder, being professional, blah, blah, blah.  They'll never say the truth--that in fact the team is freaking out and the players have lost confidence in the coaches and prima-donnas have destroyed team unity.

Speculative activity enhances volatility and compresses the time frame.  In 1992, Soros made a huge bet against the pound sterling and made over $1 billion when the devaluation occurred.  Today Soros wannabees have put on huge bets against the euro, as reported by the Commodity Futures Trading Commission.  A point to ponder is that today this speculative bet is considerably easier to put in place. Practically anyone can buy the  EUO exchange traded fund - the Proshares UltraShort exchange traded fund.  There has to be some undiscovered law in finance that says the probability of a major financial accident increases as the ability to make leveraged bets becomes more widely available.

Europe is losing dollars as U.S. money funds are moving funds out.  The dollar, of course, is the world's reserve currency; and it can be supplied by running the printing press.  This the Fed has committed to do along with other central banks in 3 liquidity operations.  Still, the major forecasters are predicting a fall in the euro through year end and into 2011.  Credit default swap rates are up sharply, and the yield on 2-year Greek debt climbed to 80% at one point.  The major confusion surrounds the impact of Greece potentially leaving the European Union.

The situation is similar to a family where most members are financially responsible but one consistently runs up the credit card and requires others to bail them out and refuses to become financially responsible. The responsible members have lent money to the problem member and can't decide if "toughlove" is appropriate or if continual bailout and hope is the right course.  Greece's debt is 140% of its economy.

On the truth-telling issue, it is extremely disconcerting when the leaders claim the $440 billion euro European Financial Stability Facility (EFSF) is large enough to buy debt as needed during the crisis when, in fact, every expert has said that this isn't the case. 

Adding insult to injury, economic growth in the Euro Zone is weakening.  Economic growth can solve a lot of problems.  Unfortunately, it isn't happening here.

Bonds (Part 4)

As commenters to my previous posts have pointed out, today a much easier way to participate in the bond market is via exchange traded funds (ETFs).  When you do an asset allocation and determine that a certain percentage of your assets, 30% say, should be allocated to bonds or fixed income, think exchange traded funds.  You immediately get diversification and avoid the pricing problem with odd lots of individual bonds.  You have available at your fingertips mounds of research data detailing portfolio composition, yield, duration, etc.

A natural choice, right off the bat, would be a fund indexed to the Barclay's Aggregate Bond Index.  This index is to the bond market what the S&P 500 is to the stock market.  It is the #1 benchmark active managers try to beat   (most are unsuccessful by the way).

A really good source of bond ETF data is Morningstar.  Put the ETF symbol in the quote box, and then putter around and check out the data under the various tabs.  For example, for AGG, you'll find under the" Portfolio" tab on the right hand side, after scrolling down, the fund duration is 4.50 years.  This is the number of years it takes to receive the presented weighted cash flows of the bonds in the portfolio. Duration is also the approximate change in the price of the fund's bonds for a 100 basis point (1%) move in yields.  If the yield on the 10-year Treasury note, for example, rises from approximately 2% now to 3% 12 months from now, then AGG could be expected to drop in price by roughly 4.5%.  Because the yield on AGG is approximately 3.2%, the total 12-month return would be around 1.3%.

You should be able to do the math and figure out the impact of a sharp rise of 2 -3% in rates.  For comparison purposes, the  ETF with symbol TLT indexes the longer maturity portion (20+ years) of the Treasury market and has a duration of 15.4 years.  For a period where yields change a lot,  this ETF will either hit the ball in the upper deck or strike out big time!

There are, of course, all kinds of bond ETFs available.  Most of my clients are with Schwab, and I rebalance frequently so I use Schwab's commission-free funds (SCHZ is Schwab's counterpart to AGG) which also have low expense ratios.  Some ETFs are devoted entirely to corporates; some index the international market.  There are low duration and high duration funds.  There are ETFs indexed to the mortgage-backed market.  All of these can be used to tailor the fixed income portion of a portfolio to fit a given interest rate outlook.  Here is a good source of bond ETFs:  Bond ETF List.

There are also many leveraged bond ETFs that can be used to magnify the impact of  increases and decreases in yields.  I would stay away from these unless you view yourself as a highly-seasoned trader and are positioned to take on the risk of these instruments.

Disclosure:  The information here is solely for educational purposes.  Individuals should do their own research or consult a professional advisor before making investment decisions.  I own some of the ETFs mentioned  here.

Bonds (Part 3)

Buying individual bonds is not easy.  Anything under $1 million is an odd lot and will typically not get a good bid or offer price, they trade over-the-counter, are difficult to price, and come with a lot of bells and whistles.  Still, some DIY investors prefer individual bonds because of their specificity and directness. With individual bonds, you know exactly what you own and you have control over holding to maturity or selling.

If you aren't familar with how  over-the-counter markets work, check out the YouTube "Over-the-counter, over-the-top" by Paddy Hirsch, Marketplace senior editor.

Because the bond market is an over-the-counter market, it has been difficult to get transparency on bond pricing.  This, of course, has been beneficial to Wall Street which thrives on opaqueness.  The Financial Industry Regulatory Authority (FINRA) has remedied this to a degree by requiring trades to be reported so that investors can see recent trading activity in specific bonds.  This allows bond transactors in  government, corporate, and municipal bonds to see recent price and volume data at a bond specific level.

Trading Activity in Merck Bond

In Bonds (Part 2) I showed a specific Merck bond held in my Schwab account:

Source: Schwab

CLICK IMAGE TO ENLARGE  Suppose I was interested in selling this bond.  I can see that Schwab prices it at $123.9677.  How realistic is this?  Has this particular bond traded recently?  Or is this bond being priced using a matrix approach whereby the price is determined by similar bonds that have traded - sort of like pricing real estate?

Actually, trade data can be obtained at the FINRA site.  Click "Bonds" under "Market Data" and come to

Source: FINRA

 CLICK IMAGE TO ENLARGE Again, fill in the "corporate" bubble and click "Advanced Bond Search" as indicated.

On the next screen, at the "Search by" option select "CUSIP" from the dropdown list.  The CUSIP is a security identifying tag.  If you look back at the bond listing as shown by Schwab above, you'll see the CUSIP: 589331AE7.  This will take you to :

Source: FINRA

 CLICK IMAGE TO ENLARGE  Note that here you have the price of the last sale, $124.654, and the yield, 3.959%.  This, of course, is valuable info to keep a broker honest if you happen to be buying or selling this issue.  But we can get more trade data by clicking the bond's name and scrolling down to the "Search for Bond Trade Activity." Here we can specify a date range and click "get results." I specified a 10-day period and came up with the following trade activity:

Source:FINRA

CLICK TO ENLARGE IMAGE  Finally you have the trade specific info, including size of trade, date, price, etc.

With this type of data, a bond buyer can more readily ascertain whether bid and offer prices are reasonable.

The FINRA site has an excellent tutorial explaining the site and how to get information.  It also should be noted that they have numerous disclaimers which should be respected because, after all, they are collecting data from outside parties on the behalf of investors but obviously cannot be held accountable for that data.

Bonds (Part 2)

On Monday, we looked at some basic terms used to describe bonds.  At the end of the post, we saw the idea of accrued interest.  Simply, when you buy a bond in the secondary market (after it has been issued), you pay accrued interest to the buyer - the interest earned since the last interest payment.  The Treasury bond example we were considering paid interest on August 15 and February 15 (every 6 months) at a rate of 2.125%.

Assume we buy this bond today, approximately 30 days since the last interest payment.  How much in accrued interest would we have to pay?  It would be 10,000*.02125*(30/365) = $17.50.  If you don't feel like pulling out your calculator, use the online calculator provided by FINRA:

Source: FINRA Financial Industry Regulatory Authority

CLICK ON IMAGE TO ENLARGE

If we buy this bond today and sell this bond next week (wow! we're big time bond traders!), we will get the accrued interest we paid back plus an additional 5 or 6 days, whatever the case may be.







Bond Yields and Prices

The yield on a bond and its price vary in opposite directions.  This is a very simple concept that fools a lot of investors.  The yield that is under consideration is the yield-to-maturity.  This is important to grasp because there are a number of different yields pertaining to bonds:  the coupon yield, the current yield, the yield at cost, etc.

The yield-to-maturity (YTM) is the most important for investors.  People sometimes treat it as the return on the bond because it accounts for interest payments as well as the capital gain or loss at maturity.  In strict terms, it isn't the return for the simple reason that interest payments will be received and return depends on the rate of interest at which those payments are invested.  We, of course, don't know what those rates will be in the future.  For example, the bond considered above pays interest of $112.50 every six months over the next 10 years.  The return on the bond will depend on the rate at which those payments are reinvested.

To understand why bond prices and YTM move in opposite directions, we'll use two approaches.  First, consider you giving me an amount now and me giving you $100 one year from now.  If you give me $90 today, then the yield to you is 100/90 = 11.11%.  If, instead, you give me $80, the yield would be 100/80 = 25%.  If you gave me $95, the yield would be 100/95 = 5.26%.  Putting these in a table, we get:

Price     Yield
$80        25%
$90        11.11%
$95          5.26%

So, this is it.  As the price goes up, the yield goes down - it's this simple.  The more you have to pay for the $100 in the future, the lower the YTM.  The more you pay for any bond, which is just a series of future payments, the lower its YTM.

Let's make this slightly more realistic by looking at how price is determined on a 3-year bond.  For this purpose, let's assume interest payments are made once a year.  Assume the coupon interest is 4% and the principal amount is $100.  Then the following payments will be made:  $4 each year, including at maturity, along with the $100 principal at maturity.  A key factor is that money to be received in the future has to be discounted back to the present to determine worth today:

$100 = 4/(1+YTM) + 4/(1+YTM)^2 + 4/(YTM)^3 + 100/(YTM)^3

Here I have assumed that the bond is at par - i.e., it probably was just issued.  Notice that the discount rate is the YTM!  In other words, the YTM is just a by product of the bond pricing formula.  If the bond price was higher - $110.50, say - the YTM would automatically be lower and vice versa.  Once you get this, the whole mystery about bonds goes out the window.

Just for kicks, let's think a moment about holding the bond to maturity.  Assume we've bought the bond and that we are going to hold it for 3 years until it matures.  Do we want (from a total return perspective) yields to rise or fall?  The answer is rise because we want to be able to reinvest the interest payments at higher rates.  While this is going on, the bond will fall in price as it is "marked-to-market" on our portfolio.  Keep in mind, however, that the price of the bond will be par at maturity - this is what makes bonds different from stocks.  Buy any stock, and 3 years from now we don't know what its price will be!

Corporate Bonds

I'm not a fan of retail investors buying individual bonds, as I will discuss later.  Still I understand that some do-it-yourselfers like to buy individual bonds.  In the "do as I say not as I do" category, let me introduce a bond I bought some time ago before I started using funds:

 CLICK ON IMAGE TO ENLARGE
At this point, you should be able to understand a lot about the Merck bond shown.  You should be able to figure when interest payments are made (12/1 and 6/1 each year), how much they will be ($892.50), the maturity date (12/01/2028), the principal amount ($30,000), etc.  You should even be able to tell what has happened to yields since the bond was issued.

Next time we go further into the world of bonds.

Bonds

Few subjects confuse new investors as much as bonds.  Many struggle to understand that prices and yields move in different directions.  They aren't sure whether to buy individual bonds or a bond fund. They aren't sure where, in fact, to go to buy individual bonds or what bond fund to buy.  This series will examine the basics of bonds.

Terminology

Bonds have some basic terms that all investors should master:

• principal - bonds are typically sold in $1,000 units. The principal amount is the amount the investor will receive when the bond matures.  For example, if the investor purchases a $5,000  Microsoft bond that will mature in 5 years, he will receive interest for 5 years and then get back the principal of the bond.
• coupon - the coupon rate is fixed and determines the interest payment the investor will receive. For example, if the Microsoft bond has a coupon interest rate of 4.5%, the investor will receive $225/year ( 5,000* .045).  In actuality, most bonds pay interest twice/year, so that in this example the bond holder would get $112.50 every 6 months.
• yield-to-maturity - this is the yield that equates the discounted cash flows of the bonds to the price.  See below.
• maturity date - the date on which the principal is paid back.
• principal - the amount paid back at maturity.
• duration - a measure that takes into account the timing of the cash flows and is used to determine the volatility of bond prices.

The best way to get a handle on these terms is to go to an actual bond.  A list of Treasury bonds can be found at Bloomberg :

CLICK TO ENLARGE IMAGE Note that in the black bar we have clicked U.S. and that there are other countries listed for which you could get bond yields.  The yields of other countries are interesting to those following current events and, especially, the debt problems in Europe.

The list of U.S. Treasury bonds is special.  It is the list of what are called "on-the-run" bonds.  These are the most recently issued for each maturity and are the most liquid in the market.

To explain the terms listed above, let's concentrate on the 10-year maturity.  It matures on 8/15/2021.  On that date, holders of the bond will receive back their principal.  Notice that the coupon is 2.125%.  This rate stays constant throughout the life of the bond.  Assume we hold $10,000 in principal of the bond. Then we will receive $10,000 * .02125 = $212.50/year (actually $106.25/every 6 months).  The payments will be on 8/15 and on 2/15 each year.  At maturity, the bond holder will receive the final interest payment as well as the principal of $10,000.

Notice the price is listed as 101-31.  Bonds are priced in $100 units.  This price, since it is above $100, is said to be "above par."  When the bond was issued on 8/15/2011, it was issued at a price very close to par.  The reason it is above par is that yields have declined since the bond was issued.  Like stocks, bonds trade in a secondary market.  In a future post, we will examine the relationship between bond prices and yields.  Here we want to concentrate on what it would cost if we bought $10,000 in principal of this bond.

First ,we need to convert the price to decimal form because bonds trade in 32s/  The price is 101.96875. The cost for $10,000 in principal, therefore, would be 10,000*1.0196875 = $10,196.88.  When you buy a bond in the secondary market, you also have to pay accrued interest (i.e., the interest earned on the bond by the current bond holder up to the time of the sale).

Tomorrow we'll delve further into the world of bonds.

Bogle versus Cuban

This is a really good interview, by Jason Zweig, of Jack Bogle found at Biz of Life's blog.  Jason Zweig is an excellent interviewer and asks the questions that occur to listeners.  The interview is about Mark Cuban's approach to investing where he says "buy-and-hold" and "diversification" are not the keys to good investing - I've paraphrased here big time; Cuban is a bit blunter.  All of this is exactly counter to the principles Jack Bogle has touted and on which his flagship index fund was built.

There are some interesting tidbits in the interview.  Bogle talks a bit about how exchange traded funds (ETFs) have increased volatility.  He mentions leveraged ETFS.  He is against them.  I agree and believe they should be banned.  Instruments that push capital markets more towards becoming a gambling casino just increase the odds of a bad macro outcome in the capital markets.  We know the script:  some "too big to fail" entity overdoes it, etc., etc.  I know there is a huge lobby out there ready to produce data for Congressmen and their staffs on the hedging characteristics of these instruments - especially over a fine dinner of steak and wine at one of DC's outstanding restaurants.  Leveraged ETFs remind me of other derivatives and former Fed Chairman Greenspan extolling their value as a hedging instrument.

Bogle also mentions "apocalyptic risk" - a subject on the minds of many today, especially with the ongoing failure of government finances.  He says that it is impossible to hedge against.  Actually that isn't exactly correct.  Investors can buy long-term puts on the S&P 500, for example.  Granted, they will cost and eat into positive returns.  For example, take 5% of the portfolio and buy long-term puts and, if the market is up 12%, you'll only get 7%.  But still, it is a hedge.

http://online.wsj.com/video/jack-bogle-why-mark-cuban-is-wrong-on-investing/A12A870B-7B21-42F5-BCA6-69329DDF5CA0.html


To be politically correct, here's the Mark Cuban interview.  I think he makes a good case for how a billionaire might approach investing.  He says to avoid diversification and stay fully invested.  Instead, invest in what you know, hang out in the weeds until volatile markets come along, and then make big bets in what you know better than the experts. Going unsaid is what happens to the smaller investor who makes a wrong bet and/or who doesn't have access to the sources that a billionaire attracts.


He does offer interesting comments on patent trolling and some basic rules that should be followed--like paying off credit cards and thinking about the transactional value of cash.  He is wrong in mentioning a deficit of $10 - $11 trillion.  The deficit is actually around $1.4 trillion.  He had in mind the national debt.

9/11

9/11 is the saddest day in our history.  It is very well presented in numerous documentaries.  One of the best is "On Native Soil" which clearly shows the failure of our government.  It answers the question of how this could have happened - at least for me.

Unfortunately many citizens who lost loved ones in New York, Washington D.C., or Pennsylvania  had to struggle with spineless government officials who didn't do their jobs ( all the way up to presidents of both parties) to get meaningful reforms. Sadly the same government officials never apologized for their ineptness - except, of course, for one--Richard A. Clarke.

At the end of "On Native Soil," a plea is made to overcome complacency in America.  After all, the families of 9/11 victims gave up much of their lives to  push the 9/11 Commission to make meaningful reforms and they, in fact, are asking it of us.

I know it is a completely different area, but politicians and many others haven't done their job in the economic arena; and it is wrecking lives.  Posturing and vote-getting continue to be put ahead of doing the right thing for the American people.  And it is reaching dangerous levels.

Unfortunately, those responsible for the housing crisis have never accepted responsibility; and many are still in power.

From 9/11, we have learned what happens when people are complacent.  If you are bothered by the bickering going on in D.C., email your Congressman and let him or her know.  If you are bothered by bankers receiving million dollar bonuses after a taxpayer funded bailout, let your Congressman know.  If you are bothered by zero responsibility taken by those manipulating our economy, let your Congressman know.

One thing 9/11 clearly proves is that those in charge are completely inept at carrying out their responsibilities.

Bad Economics

Hire someone who has been out of work for more than 6 months, and Uncle Sam will pay you $4,000 under Obama's Job Act described last night.  You hired 4 chronically unemployed last week?  Too bad - you're screwed.  You left $16,000 on the table.

You applying for a jo,b but you've been out of work for only a week.  There's a good chance someone less qualified will get it.  Sorry, you're screwed.  Employers need to reshuffle applicants into the chronically unemployed and others.  Forge  ranking job applicants by "most qualified"..

Getting ready to hire somebody?  My advice is to wait until Congress passes this act.  Out of work for 5 months?  Hey...you should wait a month because you can probably get a better job.

The good news is there will be job creation.  Bureaucrats will be needed to track the program and to write the rules.  Pundits will get more attention as they try to explain the program and why we're turning into Europe.  After al,l Europe has done a great job.  How long before companies can't fire their worst workers?

People of a certain vintage remember the days when considerable resources were directed towards getting around the ravages of inflation.  Today resources are directed towards gaming the government's macroeconomic policies.  It's too bad.  The free market system is all powerful, but it needs room to work. Setting up perverse incentives spirals the country downward.

One wonders where they are getting the economists who think these things up!

Create a Dividend Table (Part 3)

On Monday we saw how to find dividend information for exchange traded funds. By going to Yahoo! Finance and putting the ticker symbol into the quote box, we saw how to find the actual payment dates and payment amounts on a per share basis.  On Tuesday we created a table to calculate the weighted yield of a simple portfolio.

The final step is to take this information and put it into a table that shows payments expected throughout the year.

As shown, the table here is from Excel and just shows the first 4 months of the year.  In Excel, or whatever your favorite spreadsheet is, you can put in various formulas to update to calculate dividends based on number of shares and changes in dividends.  As usually happens, much of the work is in the setting up of the table,

Bonds are no problem.  They typically pay interest every 6 months, so they would have 2 payments at the appropriate times during the year.

To track payments as they come in, you want to use the "History" tab of your broker.  For example, in Schwab:

Source: Schwab

CLICK IMAGE TO ENLARGE Click and then, in the "Show" drop down box, select "Dividends and Interest" to get:

Source: Schwab

CLICK IMAGE TO ENLARGE For do-it-yourselfers who prefer individual stocks, there are several dividend bloggers who, in my opinion, do outstanding analysis and present many good ideas.  They look for companies that have the ability to increase dividends over time.

Two idea sources are:

http://www.dividendninja.com/ 

http://www.thedividendguyblog.com/ 

These sources will give you ideas and lead you to other bloggers in the dividend blogger community.

Disclosure:  This post is for educational purposes only.  I hold some of the securities mentioned. Individuals should do their own research and/or consult professional advice before making investment decisions.

Create a Dividend Table (Part 2)

Yesterday we took step 1 in creating a dividend table for a simple portfolio of 5 exchange traded funds.  The goal is to understand when payments will be received, approximately how much they will be, and the overall yield on the individual securities as well as the portfolio.

We went to Yahoo! Finance and found the payout record of SCHX.  It pays quarterly in September, December (actually right before Christmas!), March, and June.  On the basis of the most recent payment, the amount is approximately $560.  This information will eventually go into a table with the issues listed down the left hand side and the months across the top.

Using the approach described yesterday, we can go to Yahoo! Finance, put in the ticker symbol for each security, click "Historical Prices" and then "Dividends Only" and find the following:

SCHA (Schwab small cap ETF) pays quarterly--Sept., Dec., March, and June.  It is paying approximately $.10/share/quarter and will pay approximately $97.50 each quarter on the 975 shares held. Its yield is 1.11% as reported by Yahoo! Finance.

BSV (Vanguard short term bond ETF) pays monthly.  It is paying $.128/share/month and will pay approximately $82 each month on the 646 shares held.  Its yield is 2.05% as reported by Yahoo! Finance.

BND (Vanguard total bond market ETF) pays monthly.  It is paying $.213/share/month and will pay approximately $ 109 each month on the 513 shares held.  Its yield is 3.25% as reported by Yahoo! Finance.

VCSH (Vanguard short term corporate bond ETF) pays monthly.  It is paying $.147/share/month and will pay approximately $ 105 each month on the 716 shares held. I ts yield is 2.31% as reported by Yahoo! Finance.

CLICK TABLE TO ENLARGE  Here is a simple table created in Excel showing the weighted yield of the portfolio as well as the yield of each issue.  Notice the overall yield is 2.05%.

As stated in yesterday's post, an investor in the so-called decumulation stage would want a portfolio having a yield of at least 2.4% (60% of the annual 4% payout of the portfolio) in order to feed the cash account during a market downturn.  With the table set out here, it is easy to see how this would be accomplished by reducing SCHA, for example, and increasing VCSH.

It is important to note also that there are ETFs that index the dividend paying part of the market.  DVY is one example that yields 3.51%.  DVY, or a similar issue, would go a long way towards bolstering the yield of the portfolio.  Finally it is worth noting that dividend yields and interest payouts change and should be updated as necessary.  I would expect, given recent market developments, that dividend yields will increase over time and yields on bond ETFs will decrease.  Again, they need to be monitored to avoid unpleasant surprises.  Investors who buy individual stocks will see the value of issues like VZ, INTC, et al. in raising portfolio yield.

Disclosure:  The information here is for educational purposes only.  No recommendations are intended.  I hold some of the securities mentioned.  Individuals should do their own research and/or consult professional advice before making investment decisions.

Create a Dividend Table

A really good way to better understand your portfolio, whether you manage it or an advisor manages it, is to create a dividend table showing when dividends will come in on a security level basis and then derive a weighted average yield for the portfolio.  This become crucial when an investor reaches the decumulation stage when investors need to draw down their nest egg.  Using the rule-of-thumb, that 4% of the nest egg can be drawn down, and a recommended approach to have at least 60% of your income satisfied by dividends and interest requires a yield of at least 2.4% (.04*.6).  Creating a dividend table enables an investor to see the overall yield and to even get ideas on how to bolster yield.

Finding the Dividend Payout For a Security

There are many sites you can go to find dividend payable dates.  Let's start with Yahoo! Finance and with the first security in the portfolio:

Source:Schwab

SCHX is the commission-free Schwab large cap exchange traded fund.  The portfolio shown on the left  holds 4,030 shares.

Step 1 is to go to the Yahoo! Finance link above and put in the symbol SCHX as shown:

Source: Schwab

Click "GET QUOTES."  This takes you to a page with a lot of basic information.  FYI:  It provides real time prices during the trading day. Many sites provide prices on a 15-minute delayed basis.  Also, note that it lists other stocks that viewers have looked at as well as the one you are getting a quote on.  This is a good page for the beginning investor to putter around on.

In getting a quick idea of the dividend payout record, we want to click "Historical Prices" on the left side of the page as shown:

Source Schwab

This takes us to :

Source: Schwab

Click "Dividends Only" and then "Get Prices" and we get the dividend payout record we are after:

Soutce: Schwab

You can quickly see that SCHX pays quarterly and that we can expect approximately .14 * 4,030 (number of shares) = $564 sometime around 9/20.  The actual date can be pinned down, but that is the subject of another post.  In fact, every investor should be aware of ex dates, payable dates, dates of record, etc.  But, as I say, that is a subject of a future post.

So step 1 in creating the table is to do the above for each security and, for each one, create a line item showing the security, # of shares, dividend expected, and date expected.  Eventually we want to get at the weighted yield of the portfolio.

As with many of these procedures, it takes longer to explain than it does to go through it.  It is a great exercise for the DIY investor.  I suggest that "newbies" try their hand at finding the amount of the dividend, etc. for the second issue in the portfolio above.

MLPs

Investors interested in yield (who isn't these days) should consider master limited partnerships (MLPs).  These are a bit tricky, however, and you just can't load up on them in an IRA.

Here is the best article I have read in some time on MLPs by Steven Bavaria entitled "One Thing Jim Cramer Didn't Mention About IRAs."  It explains the "UBIT" - unrelated business taxable income well and tells how to get around it.

Operation Twist

Bernanke

Just when we thought (and hoped) the Federal Reserve might have shot all its bullets (without hitting the target by the way), it turns out  there are plenty left.  The latest to garner attention, after Chairman Bernanke's mention in his much anticipated Jackson Hole speech, is "operation twist," an action last carried out in 1961 during the Kennedy administration.  It lowered longer term rates back then by .15% and raised shorter-term rates marginally.

Doesn't sound like much, but when employment is stalled at zero net job creation and GDP is anemically bouncing along at 1%, the Fed will try anything.

What is "Operation Twist"?

The Fed's usual modus operandi is to manipulate short-term interest rates by controlling the federal funds rate.  Federal funds are borrowed and lent by banks to meet their reserve requirements.  Banks can also buy or sell Treasury securities to meet reserve requirements, and so the Fed's manipulating of the fed funds rates affects other rates as well.

In fact, typically rates all along the maturity spectrum - the so-called yield curve are affected.


"Operation Twist" seeks to carry out this impact directly by changing the composition, instead of  the size, of the Fed's balance sheet.  The plan is to sell shorter maturity Treasury bills and buy longer-term Treasury notes.

The idea is that longer term yields will drop - specifically the rate on 30-year fixed rate mortgages.

Likely Impacts

Markets anticipate.  On Friday, the yield on the 10-year Treasury dropped to below 2% and the yield on the 2-year Treasury note rose 2 basis points.  Dealers and others want to position themselves ahead of the Fed's move.  This is similar to the carry trade that heats up when the Fed announces it will keep short-term rates low.

Secondly, the Fed will likely find itself loaded up with longer term securities at the lowest point in yields. When the inevitable rise comes, it will have on the books significant underwater positions.

Thirdly, this action, like much the Fed does, ramps up uncertainty.  What can I say to a client who asks if now is a good time to take a mortgage?  Very likely, by the Fed's manipulating longer term yields, 30-year mortgage yields could be lower in the near future.  Market observers believe the policy could be formally announced at the 9/21-22 Federal Open Market Committee meeting.  With the uncertainty, it is better to just sit on the sideline and wait.

Finally, this is another slap in the face to those who live off of fixed income.  The already anemic rates on such things as 3- and 5-year CDs will decline further.  But, hey, it's for the good of the bankers and we all have to sacrifice ( I'm getting ready for Obama's speech on Thursday!).


 

Obama's Speech

Adam Smith

I, along with many others across the nation last week, introduced students to the marvels of the free market system.  We discussed how, by allowing individuals to act in their own self-interest, unprecedented wealth has been created over the past 250 years in the Western world and how many nations that had chosen a different economic system have seen the folly of their choice and are moving to the capitalistic, free market system.  Along the way, we mentioned Adam Smith and the Wealth of Nations - written prior to the industrial revolution but fully cognizant of the role of self interest and its influence on our founding fathers. We pointed out that the Wealth of Nations with its emphasis on economic freedom, was published in the same year, 1776, as Jefferson's  Declaration of Independence - the foundation of political freedom.

I like to go a step further with my class and think back, to say 1750, and suppose that we were able to get the 25 smartest people in the world in one room.  And suppose we pointed out that the world is on the verge of an industrial revolution - that it will be moving from an industrial society to one of factories, specialization, and unprecedented division of labor.  People will leave farms and move to the cities.  The smartest people would then be asked how best should economic activity be managed.

I think we can imagine that there would be considerable interest and excitement over this clearly very important problem.  I imagine that all sorts of plans would be forthcoming about setting up planning boards, how far plans have to go in the future, how to find the appropriate people for the jobs that need to be filled.  After all, how would the economy be assured that there are enough teachers, doctors, farmers, etc.?  What a great problem!

But wait...in the back of the room a hand is up.  "What if we just let the economy organize itself?  What if we just set the ground rules and then let individuals act in their own self interest?"

The response would likely have been incredulous.  How in the world could this possibly work?  For one thing, the brains of the world's smartest people wouldn't be needed.  Throw all the elaborate plans into the trash cans.  This would have been, undoubtedly, taken as an insult by many.

This, of course, is the debate raging today.  Many very smart people cannot fathom that the economy would be better off without their elaborate plans.  As a result, planning has increased to an unprecedented level.  Last night I saw a pundit ask how we (think "the government") can create demand, that is, the willing consumer?  Huh?  They discussed the president potentially proposing an infrastructure bank.  Other stimulus will be proposed in the president's speech on Thursday.

Interestingly, a comment was forcefully made, by the pundit planners, to the effect that our employment problems are the result of uncertainty holding back consumers and businesses.  I held my breath - would they get that their incessant schemes are what creates this uncertainty?  Didn't happen.

I, for one, would like to see the president say that the government is backing away from managing the economy--that it recognizes that prices are out of whack because of ill-advised programs, that the free market system needs room to breathe, and that the process, though painful, will lead to an adjustment that will legitimately create jobs and enable the economy to move forward in the  information age.  He should state unambiguously that artificially manipulating the economy hasn't worked and has run up an enormous bill that will be a drag for decades even under the best of outcomes.

There are a lot of problems in Washington - not just the nuts at the ideological extremes.

Maybe its time to listen to that voice in the back of the room.

Quote on Indexed Investing

One of the 3 or 4 books I recommend to those serious about learning investing is Your Money and Your Brain by Jason Zweig.  This is a book that will change the way you look at investing.  It is the single best intro to leading-edge research on the field of "neroeconomics" which carries out experimental research to understand how financial decisions are made.  It came to mind after reading the quote by Jason Zweig presented below.  I sheepishly discovered that I had not listed the book in my bookstore (link to the right) but have since added it.

I came across the quote when reading a piece entitled "How to Manage Your Investment Anxiety" by MarketRiders, an online portfolio management service.  The service is well worth considering for DIY investors and offers excellent free educational materials.

This is what Jason Zweig said about indexed investing:

Indexing enables you to say seven magic words: “I don’t know, and I don’t care.”
Will value stocks do better than growth stocks? I don’t know, and I don’t care – my index fund owns both. Will health care stocks be the best bet for the next 20 years? I don’t know, and I don’t care – my index fund owns them. What’s the next Microsoft? I don’t know, and I don’t care – as soon as it’s big enough to own, my index fund will have it, and I’ll go along for the ride.
Indexing enables me to say, “I don’t know, and I don’t care,” liberating me from the feeling that I need to forecast what the market is about to do. That gives me more time and mental energy for the important things in life, like playing with my kids and working in my garden.

MarketRiders goes on to point out that you can control the allocation of assets but not how the overall market will perform or how individual sectors will perform.  Focusing on what can be controlled frees up the investor from anxiety over what can't be controlled.

Well worth thinking about as we navigate today's volatile markets.

The First Economist

This cartoon made me think of the Fed Chairman and the Treasury Secretary.

CLICK TO ENLARGE From Greg Mankiw's blog (former head of Council of Economic Advisors to the President) and author of the best-selling undergraduate micro and macro economics texts.

Ponzi Scheme Gets Teachers

Charles Ponzi

Have you heard of James D. Risher and Daniel Sebastian?  They apparently defrauded teachers and retirees in a $22 million Ponzi scheme.  Teachers!  Teachers are at the forefront in many parts of the country teaching financial literacy! 

The men are said to have promised returns of 124% annually, according to the Securities Exchange Commission.  The M.O. appears to be boringly the usual, including false statements, getting suckers (sorry - I have to call it as I see it) to cash in annuities and participate in their "...sophisticated trading strategies."  One of the perps used his list of insurance clients.

All of this after Madoff?  You can warn people about smoking, driving without a seatbelt, investing with individuals who take custody of assets, and running in the opposite direction when performance is promised - especially when it is ridiculous.  Hopefully it gets through to some.

Obviously that's the best one can hope for.  These cases always get questions circulating through my brain for days.  Did the perps (love that word) think their scheme wouldn't come to an end?  Why 124%? Didn't the friends of the scammed laugh them out of the room when they told them what they had put their money into?  Imagine telling your next door neighbor you invested in a private equity fund that's going to get you 124%!

You try to feel sorry for people whose lives have been ruined, but sometimes it isn't easy.