A Simple Rebalancing Example

It is that time of the year where many investors look to rebalance their portfolio to a specific asset allocation. Here is a simple example, using Schwab online resources.

Schwab has 6 different asset allocation models to choose from, to fit an investor's risk tolerance, ranging from 0% stocks to 95% stocks.

This client is close to retirement and, thus, has chosen the model with 60% stocks/40% Fixed Income + Cash Investments.

Source: Charles Schwab

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The table shows the difference for each asset class relative to the target percentage.  Each time you buy or sell a security or a fund, Schwab automatically adjusts the percentages and enables you to see how you are positioned relative to your targeted allocation.

The investor has a choice on when to rebalance.  He or she can choose a percentage difference - for example, rebalance when the difference is 2% or more or once or twice a year on a given date.

It is important to note that, if you are paying a commission, you want to buy or sell enough shares to make it economical.  Here I use Schwab shares which have zero commission and don't have to worry about the number of shares.

Note also the link "View Table in $."  Let's click on this and make our life easy:

Source: Charles Schwab

This shows we need to sell $4,593 in the "Large Cap Equity" sector.

 If you don't invest frequently, you might not recall the ticker symbol for the Schwab ETF that tracks the large cap sector.  Not a problem.  In the quote box at the bottom left on any Schwab page, put in SCH and look what you get:

Here you have a list of Schwab ETFs, and you can see that SCHX is the ticker symbol for large cap.  Note also the ticker symbols for small cap and international (you'll need these to complete the homework assignment).

Here we have the quote for SCHX at 43.92.  To figure out the number of shares to sell, just divide 4593 by 43.92 and get 104.  Thus, selling 100 shares of SCHX will get the large cap position pretty close to the target.

With some sectors over-allocated, there is another sector or sectors under-allocated.  In this case, it happens to be "Fixed Income."  To take care of this, you'll have to google Schwab bond ETFs or use other ETFs.  Again, if you use other ETFs, like AGG or HYS, etc., there will be a small commission.  To find Schwab bond ETFs or other fixed ETFS, just google the relevant phrase or look at the last post on this site.

All in all, the whole process takes less than 30 minutes.  And, THE BEST PART has historically outperformed most market timers and stock pickers over the long term after all expenses.

ENJOY THE NEW YEAR!

Bond ETF Fund Performance (Update)

I last reported on bond ETF performance on 7/7.  Here is an update on the performance of funds I follow based on Morningstar performance data.

Allocating the fixed income portion of invested assets has been a challenge, to put it mildly, for investors over the past few years.  Not long ago, investors could put the bulk of fixed income assets in an index fund tracking the Barclay's Aggregate Index and then go to thinking about the stock portion of assets.  Not true in 2013 and not true as we look ahead to 2014.

As you can see, the returns vary widely and the funds are quite different.  For what it's worth, you'll find that most 401(k)s do not offer a decent selection of bond funds - you are forced to select from a couple.  On the other hand, if you have an IRA, you have the selection available below as well as many others - another reason on the side of rolling over 401(k)s.

In general, you want to limit, to the extent it makes sense,  the bond exposure of your investable assets  in your taxable accounts where they will get hit with your marginal tax rate as ordinary income.

Generally, as you can see in the table, the shorter duration or shorter maturity funds performed best as would be expected in a rising yield environment where the yield curve steepens.  This impact can be seen by comparing IEI (-2.57%) versus IEF (-5.75%).  The table also shows the poor performance of emerging markets and international in general.

The bogey in the bond market is AGG, the Barclay's Aggregate Bond Index - it is to the bond market what the S&P 500 is to stocks. 

Disclosure:  this post is for educational purposes.  Individuals should do their own research or consult a professional before making financial transactions.

ETF	YTD RET.	DESCRIPTION
HYG	5.33	HIGH YIELD
AGG	-1.43	TOTAL MARKET
SCHZ	-1.26	TOTAL MARKET
MBB	-1.13	MBS
CSJ	1.07	1-3 YR. CORP.
IEI	-0.59	3-7 YR. TREAS.
IEF	-4.08	7-10 YR. TREAS.
EMB	-8.05	EMERGING MKT.
BKLN	3.46	BANK LOANS
IHY	5.83	INT'L. HIGH YLD.
PFF	0.33	PREFERRED STK.
FLOT	0.48	FLOATING RATE
BSJF	5.44	2015 HIGH YLD.
LQD	-2.21	INVEST GRADE CORP.
BAB	-4.53	BUILD AMER.
BOND	-0.56	PIMCO TOTAL RET.
HYS	7.16	0-5 YR. HIGH YLD.
VCIT	-1.47	INTERM. CORP.

Are Stocks Overvalued?

Money Magazine puts out an annual "Professional User's Guide."  This year they have a "best of" section, and one of the items (p. 78)  is "Best New Way to ...Tell If Stocks are Overvalued."  It is based on Robert Shiller's (recent Nobel Prize Economics recipient) work on average inflation adjusted price-earnings ratios (CAPE ratio) and subsequent stock market returns.  Shiller uses the 10-year average of past earnings.

The Leuthold Group has done further research and found better predictions come from using 5 years of past average adjusted P/E data.

They found that, if 5-year adjusted P/Es start at below 10, then 10-year annualized returns average 11.9%.  If P/E is in 10 to 14.9, average return over 10 years is 9.8%, 15 -19.9 gives 6%, 20.0 to 24.9 gives 3.3%, and 25 and higher produces -0.6%.

At the time of the article, the Shiller 5-year P/E stood at 21.3.  Thus, if historical data holds, we can expect 3.3% annualized over the next 10 years.  Not good, right?

Obviously it is not great; but still, in a world where money market rates are practically zero, the 10-year Treasury yield is approximately 2.80%, and most inflation numbers are less than 2%, a 3.3% annualized return is not something to necessarily thumb our noses at.  Throw in the fact that most Central Banks are like deer caught in the headlights when they contemplate the possibility of deflation.

If you accept the Leuthold Group findings of 3.3% annualized returns, you may, however, want to revisit your financial plan and revise some numbers.  Most plans predictive of retirement nest eggs are based on anticipated stock market returns of 8 - 10%.

Disclosure: T his post is for educational purposes only.  Investors should do their own research or consult an investment professional before making investment decisions.

Calculating the Required Minimum Distribution

As IRA and 401(k) holders approach their 70s, they need to start thinking about required minimum distributions.  Inherited IRA holders need to know the RMD as well.  Get it wrong, and there is a hefty tax penalty!  Here is the IRS link with the questions typically asked about the subject:  Retirement Plans FAQs regarding Required Minimum Distributions.

Before doing the calculation, first check your online broker site.  The amount you need to withdraw may be there.  For example, with Schwab, just click "Balances" and scroll to the bottom to find:

Source: Schwab

Done!  At least for this account.

Because this is the first RMD, it doesn't have to be taken until 4/1/2014; but next year's RMD will need to be taken by 12/31/14.

Note the footnote link to a calculator for distributions required from inherited IRAs!

An easy-to-use calculator for the DIYer is provided by FINRA.  Only 2 inputs required: previous year balance and age.

Source: FINRA

The results then are shown as:

Source: FINRA

Think in Real Terms

Back in '73-'74, OPEC, at a time when  the U.S. was a big importer of oil with our gas guzzlers and wasteful energy practices, quadrupled the price of oil overnight.  Economists, in thinking through this type of event, tend to get away from prices and dollars and think in real terms.  Thus, in effect pre-embargo, we would trade x number of autos versus a given number of barrels of oil and after the embargo OPEC wanted 4 times as many autos for the same number of barrels!  Putting the oil price rise in these terms clearly shows the extent of the problem.  Specifically, it showed that something would have to give:  either the U'S. economy would get pounded or OPEC would be paid in funny money as inflation pushed the value of the dollar lower.

In fact, in 1980 OPEC doubled the price of oil again a;nd the U.S. experienced spiraling double-digit inflation that led to Volcker slamming the brakes and throwing the economy into a severe downturn. Anyone remember the WIN buttons?

This technique of putting dollars in real terms is useful in financial planning.  For example, sometimes the decision is to take Social Security today or wait 2 years and get $150/month more.  Many people would think that $150/ month extra, on the face of it, isn't worth waiting for and opt for the payments to start today.  But, in real terms, we might observe that $150/month provides a really nice dinner (wine included) monthly for a couple as long as they live.  Perhaps put in these terms the decision might be worth reconsidering!  Or, more broadly, looking at the payments over a 12-month period shows an amount that could go a long ways towards funding an annual trip.

The technique also works the other way.  Working with annuity payouts typically involve higher payments if there are no survivor benefits.  Allowing, for example, for survivor benefits of, say, 90% may lower the monthly payment by $100/month.  Would you give up a monthly eating dinner out to have the peace of mind that the payments will continue to the spouse as long as she is a survivor?  Again, thinking of the payments in terms of real sacrifices can help in the decision process.

Obviously, I like to eat; but the decision can be framed in terms of rounds of golf, traveling to see friends, time between buying a new car, or whatever.  Framing the decision in terms of what you can gain or have to give up can sometimes be a big help in making the right decision.  This is also useful for young people thinking about saving.  What do they get 30 years down the road, in real terms, by saving a relatively small amount today?

When and How to Save for Retirement Addendum

Here is a good, basic article by Anisha Sekar for newbies that sorts out some of the confusion on when and how to save for retirement: When, and How, to Start Saving for Retirement .

My summary and take: 

#1 basic point:  first pay off high interest debt and set up emergency fund.

#2 basic point:  use company 401(k) up to the point of the company match.  IF YOU DON'T KNOW IF YOUR COMPANY HAS A MATCH, FIND OUT ON MONDAY MORNING BY ASKING YOUR BENEFITS PERSON.

#3 basic point:  if you can save more, then learn how to invest in low-cost, well-diversified funds and open up an IRA.  TO DO THIS, OPEN AN ACCOUNT WITH A DISCOUNT BROKER AND BUY THE ETFS ON LINE.  TARGET A PRE-SET ASSET ALLOCATION.

#4 basic point:  save as well in a taxable account.  The thing is that we don't know what the future brings.  Even though we may have the standard emergency fund established, our wants change over time.  Four years from now, you may want to buy a house, change professions, or start a small business. Too often these events lead people to tap their retirement funds.

The bottom line is that one day you will be 65 years old and, at that point, have choices available to you that depend on your saving habits today.  Putting this off until next month or next year may very well take away these choices.  By all means, don't let the confusion surrounding these different investment vehicles result in inaction and, thereby, steal your retirement!

Create an Income Stream Versus an Annuity

An ongoing conundrum in the financial community is why single premium immediate pay annuities (SPIA) aren't more widely accepted?  After all, they go a long way towards avoiding running out of money in old age (the number one fear of retirees), no matter what the market does.  Furthermore, used intelligently, SPIAs can be used to enable a retiree to take on a bit more risk in the other assets they own.

So what's not to like?  First off, retirees lose control of the money.  For example, suppose the retiree comes home and finds a leak in the attic crawl space?  The roofer guy is going to come out and tell the retiree he or she needs a new roof!  Where do you get the money from?  Hint:  not the annuity. Secondly, though useful, today the timing may not be right with interest rates close to historically low levels.  With the yield on the 10-year Treasury note at 2.50% and the Federal Reserve printing money akin to Anatasios Arnaouti on steroids, many feel that higher yields will be available down the road. Thirdly, most people would rather wallow in their own fear of a market collapse than talk to a silver-tongued insurance agent who has been trained to sell you products that will destroy a retirement portfolio faster than you can get out a high-powered electronic microscope to read the fine print.

So, does it leave the retiree at the mercy of the usual portfolio approach trying to beat the market?  Not necessarily.  Some are constructing a sort of hybrid portfolio whereby the allocation to fixed income is replaced partially with high dividend stocks.  This is not a couch potato approach in that it does require some time on the part of the DIYer but could pay high dividends (sorry, couldn't help it) if done correctly. And, as a matter of fact, a whole industry of bloggers (see below)  has arisen to help the DIYer in this endeavor.

 DIVIDEND PORTFOLIO EXAMPLE

To see one way to approach this, let's look at an account I recently set up.  We began with the usual important first step of doing an asset allocation.  This is for a couple in their 60s.  Income will become important to them shortly.  The allocation was 50/50 stocks/fixed income.  The stocks portion was invested in low-cost diversified index funds.

The twist came with the bond portion.  Instead of bond funds, the fixed income portion was invested in dividend stocks that have a dividend of 3% or greater.  It was decided that the dividend stock positions would be less than 5% of the overall exposure in the dividend sector, making each position less than 2.5% of total assets.  Importantly, it was agreed to carefully look at diversification - the last thing you want is to load up on bank stocks, energy stocks, etc.

With these specifications, here is a partial listing of the  portfolio that was constructed:

Source: Schwab

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You'll notice that NLY is in for a lesser amount.  It is a riskier issue with a yield in excess of 11%.  Its purpose is to juice up the yield of the portfolio a bit with the understanding that its dividend is considerably less secure compared to the other holdings.


The thing to get your head around is that, in one sense, you really don't care about the prices of the stocks.  After all, if you had put the money in an annuity, you would be dealing with an income stream!

Having said this, if prices move higher and this is a taxable account (which, in this case, it is), you have some options.  You can realize long-term gains if you find better replacements and can actually take advantage of tax-harvesting by capturing losses.

Once set up, the next step, which takes all of 30 minutes, is to do an Excel sheet showing dividends received:

The portfolio will be comprised of approximately 20 stocks.  The bottom line is to seek to have income increase over time.  This, of course, won't happen with a bond.  Buy the 10-year Treasury note and you'll get a fixed interest payment every 6 months for the next 10 years.

Here's the bottom of the Excel spread sheet:

The arrows show that already the dividends have increased and, in fact, they will increase this month with the final payment due in.  The goal is to see them double approximately over the next several years.

Obviously, unlike the annuity situation, the investor has control over the assets.  If  the roof leaks or Aunt Maude in Stuttgart Germany kicks the bucket, the investor can sell assets to pay the roofer guy (or gal) or get on an airplane to Stuttgart.  A DOWNSIDE IS THAT THE YIELD WILL BE LESS THAN WITH AN ANNUITY, AT LEAST AT THE BEGINNING!  This is because, with an annuity, you are receiving an actuarial rate based on a group's mortality.

The newbie DIYer should be able to find on his or her brokerage site a history link that shows all cash flows that come into an account.  This is a convenient place to track your dividend receipts to put into your Excel spreadsheet.  In Schwab, it looks like this:

If this intrigues you in the least bit, you should realize you can go at it at whatever size you want.  For example, if your asset allocation calls for 40% fixed income, you could consider putting 20% of your fixed income allocation in dividend stocks and think of the allocation as your personal annuity!

The obvious question is how do you find good dividend-paying stocks without having to spend an inordinate amount of research effort? Actually, today this is easy because there are several really good blogs dedicated to finding good dividend payers.  Here are a few:

DIVIDEND GROWTH INVESTOR , DIVIDEND MANTRA, DIVIDENDS4LIFE .

Disclosure:  This post is for educational purposes only.  Individuals should do their own research or consult a professional before making investment decisions.

Comment on Risk Tolerance Questionnaires

Here is a good, short article from the online Financial Planning site on risk tolerance questionnaires by Alan S. Roth:  Why Risk Tolerance Questionnaires Don't Work.  For those who might not know, risk tolerance questionnaire are a favorite tool of the financial planning crowd, frequently presented with an aura of scientific precision.

But this scientific precision is too simple.  In fact, at the extreme, some people are taking unnecessary risk!

In the article, William Bernstein (author of The Four Pillars of  Investing) poses the question: “if you’ve won the game, why keep playing?”

This question is especially relevant today with the S&P 500 and other indices at all-time highs.  It takes me back to the year 2000 when I attended an event for investment professionals and a young investment professional was bragging about his $3.0 million portfolio of internet stocks.  Someone asked why he didn't sell and take a profit, and his response was "with a portfolio going up $50,000/month, why would anyone take a profit?"

This young man was hardly the exception.  Back then, many had a portfolio they could have retired on comfortably at a young age but let ride. 

Later, someone told me he eventually finally sold out after the portfolio had dropped to $150,000.

The same behavior frequently occurs with state pension funds where they become fully funded, or close to fully funded, as markets rise but then become more aggressive with their asset allocation.  All of this points out the astute observation, made in the article, that risk tolerance isn't some stable magnitude that can be measured by a risk tolerance questionnaire.  Instead risk tolerance changes as markets change.

I would add that there is a difference between a highly volatile market that is trending upwards versus a highly volatile market trending downward!

Year-to-Date Performance - 9/30/2013

My favorite investment chart is the BlackRock 20-year sector performance.  It details the relative ranking of asset classes on an annual basis as well as the performance of an easily replicated low-cost diversified portfolio comprised of 65% stocks, 35% bonds.  The diversified portfolio returned 12.2% over the 12 months ended 12/31/2012 and 7.9% on an average annualized basis over the past 20 years.

The diversified portfolio allocation is an appropriate benchmark for individuals in their 40s and even early 50s, depending on risk tolerance.  The table contains sufficient data, however, to construct a benchmark for any specific allocation; and, in fact, the allocation can be changed over time--as it should be as the individual ages.

Voluminous data from unbiased academic studies have been presented over the years showing that a diversified portfolio of low-cost funds outperforms upwards of 70% of active managers over the longer term after all costs are taken into account.  These studies cover various time periods, countries, asset classes, and investment methodologies.  In line with this data, the low-cost diversified approach warrants consideration as a benchmark for investors.  It shouldn't go unnoticed that the approach economizes on the investor's time.

Here is an update showing the approximate performance of the diversified portfolio for the 1st nine months of 2013:

Weight	Fund	Return (%) 9 months ended 9/30/2013	Expense Ratio
35	AGG  (Barclay’s Aggregate Bond Index)	-2.00	.08
10	EFA (EAFE Index)	14.46	.34
10	IWM (Russell 2000)	27.69	.24
22.5	IWF (Russell 1000 Growth)	20.68	.20
22.5	IWD (Russell 3000)	20.19	.21

 
The overall return of the diversified portfolio was approximately +13.06% over the first 9 months of the year.

Disclosure:  This post is intended for educational purposes only.  Past performance is not indicative of future performance.  Individuals should consult a professional or do their own research before making investment decisions.

Bernanke in a Box

 One prerogative of blogging is an occasional rant.

Here's one lesson from recent Fed history:  transparency is great WHEN YOU HAVE A PLAN, not so much WHEN YOU DON'T.  In trying to reduce uncertainty and volatility, our Fed Chairman, the esteemed student of the Great Depression, has ramped it up.  Ah yes...unintended consequences!  Now markets are totally confused, and every piece of economic minutiae going forward will be analyzed to death as capital markets try to divine Bernanke's take on it.

What we see unfolding is starting to look more and more like the Greenspan exit.  Recall Greenspan went out riding on accolades from fellow governors and others praising him as the greatest (apologies to Ali who is the greatest) and a maestro only to find out in short order that he had set the stage for the worst economic downfall since the the 1930s by pandering to Wall Street.

But let's review the downfall to gain some perspective. In 2003 Greenspan and, yes, Bernanke pushed short-term interest rates to the historically low level of 1% and kept them there for a year.  This in the face of a robust housing market.  By pouring gasoline on a fire, this was the single action that caused the housing boom and consequent bust.  It wasn't greed by various groups, etc., although they played an important role in carrying it out.  To be absolutely clear, let's restate it as follows:  if short term rates had hovered around 3%  as was normal prior to the Greenspan/Bernanke manipulation, there would have been no housing crisis as we saw it.

There is a lot of pussyfooting around on this subject, so it deserves some emphasis.  Many point to Wall Street's greed as the culprit for the 2008 debacle.  Well here's some news, folks.  Wall Street has been greedy since the first gatherings under the buttonwood tree.  Wall Street's ongoing thrust has always been to make a killing anyway they can.  They will use inside information, front trade, and rip away the retirement years of the nation's workers by charging unconscionable fees.  They'll structure products filled with toxic product that even Einstein couldn't understand and sell the product to your local school district.  Whatever it takes!  The point is that Wall Street and the investment banking community, including the ratings services, didn't just get greedy in 2008.

On Bernanke's watch, he has tried unsuccessfully over the short term to reignite inflation and, in the process, pushed investors (including retirees and Pension Plans and the whole investment community) into a much riskier posture than they should be in or desire to be in.  This was undertaken by the Federal Open market Committee with eyes wide open.  Another way to view this is to understand that assets aren't being allocated by free market forces but by the a Fed micro-managing interest rates.

Again, to be clear, it is important to understand that, in controlling interest rates, the Fed is controlling prices and, in this instance, the most important price in the economy - THE PRICE OF MONEY! Think about it - you can have a mortgage payment of $2,600/month or $2,200.  You can borrow $15,000 at your bank to put on an addition or buy a car, and your monthly payment depends on the Fed setting interest rates.

I would be remiss if I outlined the problem and didn't indicate a solution.  Here it is.  Instead of a Federal Reserve that micro-manages the price of money, how about the Fed going back to Volcker's approach that broke the back of inflation by controlling the growth rate of money in the economy.  Let the millions of economic entities that daily make asset allocation decisions set the price of money.  This is called a free market economy.   Granted this requires a dramatic drop in arrogance.  It means admitting that the market knows better than the Central Bankers what interest rates should be.  For what it's worth, you can be sure it's not coming from Yellen.  She's steeped, as are present governors, in the Soviet-style price control mindset.

As you think about this, here are a couple of other points to throw into the mix.  Whenever there is a debate in DC, it seems that the higher ground is taken by debaters asserting what the founding fathers intended.  Along the same lines, what if we revisit the intentions of the creators of the Federal Reserve 100 years ago.  It is beyond dispute that then (as today) people didn't trust big banks.  Thus, they came up with a somewhat convoluted system IN ORDER TO PREVENT CONCENTRATED POWER OVER THE NATION'S MONETARY POLICY.  They specifically intended for the regional banks to  pull the levers.  Instead, today, power resides in DC to the extent that the Fed Chairmanship is said to be the second most powerful position in the world!

A second point concerns whether the FOMC has any clue on what they are doing.  Point one is their forecasts which, literally, are a joke.  Forecasting GDP out 2 to 3 years is ludicrous.  You can examine the record yourself.  Suffice it to say that it's not just the emperor; but, in fact, the whole monetary policy committee is naked.  Thirdly, and this to me is most telling, ask Bernanke if 10 years ago he could imagine (in his wildest "expert on the Great Depression" dreams) how an economy could have reported inflation under 2% with the Federal Funds target rate at essentially zero percent and the Federal Reserve monetizing the debt to an extent greater that the annual Federal deficit.

Any economist confronted with these policy facts would have made a good model for Edward Munch.

But where are we headed from here?  It is accepted with absolutely no question that interest rates jumped 1% because of the talk of reducing the tapering by $10 billion (a scary thought in its own self). But maybe the cause and effect is over emphasized.  After all, this rise in rates has been predicted for a long time.  If it continues, it will be an upheaval because there will be a massive re-shifting of portfolio assets and could take the economy South.

Part of the problem is that past policy has pushed investors into assets they don't understand.  I'm "boots on the ground," so let me give a simple example.  I see people who I ask about their holdings in bonds. They tell me that they read up on bonds and they read that, by holding individual bonds, they can't lose money!  They don't understand even that the 10-year bonds they bought 3 years ago, priced at $105.5, will drop to $100 at maturity and could go below $100 over the next 12 months with a big enough push upwards in interest rates.  Many have zero understanding of corporate bond spreads and the impact on prices if spreads widen.

Sometimes I think the FOMC understands these underlying market dynamics about as well as they understood credit default swaps in 2007.

Going forward, if this all leads to a nasty collapse, Bernanke and his committee will thankfully have those they can point the finger at and blame.  Front runners here are Congress, emerging markets, and the Far East.  Part of the job requirement of central banking today is being able to cast blame elsewhere.