Is This Your Biggest Investment Boo Boo?

As I was cruising the internet recently, I came across a call for readers to submit their biggest investment mistake.  I chuckled and moved on, easily imagining possible submissions.  There will be those who piled into Apple Computer at the top, those who got out of the market in 2008 but never got back in, and those who (like Enron employees) lost their life savings because their 401(k)s was mostly invested in the company where they worked which went belly up. One mistake that pops up frequently is where people got caught in the dot.com bubble of the late '90s and watched their portfolio implode.

This isn't even touching on the business ventures people have gotten into with their bother-in-laws. 

These mistakes all involve what economists call explicit costs.  For example, it is straightforward and easy to calculate the impact of a portfolio dropping from $180,000 to $100,000 because the dot.com market fell off the cliff or $30,000 put into a business that went belly up.

A more subtle mistake that affects more people, in my experience, involves implicit or what economists call opportunity costs.  To economists, these are very real costs; and in the investment world, a big source is poor asset allocation.  I know some readers are thinking this isn't a problem they may have because they think they don't have an asset allocation.  Well, here's the news - everybody with assets has an asset allocation.  This is akin to the oft-made observation that not making a decision is, in fact, making a decision.

When it comes to  asset allocation, people will say "I haven't decided on an asset allocation so I've kept a big chunk of my money in cash."  OK then.  As I look at their accounts, I still see an asset allocation of, say, 60% cash, etc.  What is the cost?  What about the past 12 months?

As it turns out, a portfolio of 60% stocks/40% bonds + cash is up 8.21% year-to-date.  $100,000 parked in cash since the beginning of the year has had an opportunity cost of more than $8,000.  Consider this over a multi-year period, as happens with some people, and you see why I consider mis-allocation of assets the biggest investment mistake of many.

Admittedly, we don't know where the market is headed in the short run; and, in fact, the cost could be reduced sharply from here or it could go higher.  Over the longer term, though, carefully thinking about asset allocation and potential opportunity costs is critical for retirement success for many individuals and is a potential mistake worth seeking to avoid.

The Impact of Interest Rate Changes (Part 2)

Yesterday's post set the groundwork for understanding the mechanics of getting an approximation for the impact of a change of interest rates on portfolio return.  The poll by Edward Jones revealed that many investors are confused by the impact.  This isn't good because investors, and especially retirees, have piled into bonds and bond funds over the past several years in search of yield as the Federal Reserve and global central banks have driven short-term yields close to zero.

So let's take another look at this important influence on portfolio return.  Suppose we agree with what seems to be the consensus - that rates will move higher over the long term -  but still appreciate the fact that the consensus could be wrong and that rates could stay fairly stable or even drop from here. Assume further that our asset allocation calls for 40% of investable assets in fixed income.

One way to play this would be to invest 50% of the fixed income portion in CSJ and 50% in AGG. CSJ lowers the yield of the fixed income portion but also reduces considerably the price volatility.  In other words, it is a bit of a hedge relative to the overall bond market.

Following the approach presented yesterday, we would go to Morningstar and get the yield and the duration of CSJ and AGG.  The yields are 0.86% and 2.40% for CSJ and AGG respectively.  The durations are 1.96 years and 5.08 years for CSJ and AGG respectively.

So what would be the approximate impact if yields rose 1.50% (10-year Treasury yield rises from 2.80% to 4.30%) over, say, the next 6 months?  To figure this out, note that the bond portfolio is equivalent to having an ETF with a yield of (.86 + 2.4)/2 = 1.63% and a duration of  (1.96 + 5.08) = 3.52 years.

The impact of a 1.50% rise over 6 months could then be approximated at -3.52 * 1.5 =  -5.28 (price change) plus 1.63/2 = .815, or a total impact of -4.465%.  This, of course, will be multiplied by .4 because the fixed income portion represents 40% of portfolio assets.

It is important to understand that the short-cut method here is an approximation.  The actual outcome will be influenced by the shape of the yield curve (short-term rates and long-term rates don't all fall by the same amount), the actual accrued interest on the ETFs, and even the premium or discount on the ETFs relative to their respective NAVs.  Still the approximation shown here should help in lessening the surprise investors could get with a sharp rise in rates.

The Impact of Rising Interest Rates on Portfolios

Here are the numbers from an Edward Jones study interviewing 1,008 people as reported by Barron's (8/26/2013, p. 16).

63% said they don't know how rising rates affect their investment portfolios.

24% say they're completely in the dark about potential effects.

33% of respondents between 18 and 34 admit they don't know the impact of rates.

19% of men said they don't understand the specific impact.

First off, to understand rate movements and bond returns, investors need to understand that bond prices and interest rates move in opposite directions.  When rates rise, bond prices drop and vice versa. Secondly, in addition to the change in price, bond returns are impacted by accrued interest.  Thus, holding a bond with a yield of 3% will contribute that yield to the total return over the course of the year and will add to the impact of the unrealized capital gain or loss.  Over a 6-month period, it will contribute half of that, or 1.5% and so on.

The trick, then, is to get a handle on what will happen to bond prices as yields change.  For this purpose, the investor needs the duration of the bond portfolio or the individual bonds.  Let's back up a moment and think about this.  At first cut, a little thought will reveal that a bond with a longer maturity will have a price volatility greater than that of a bond with a shorter maturity.  But, this isn't enough. Consider two bonds with 5-year maturities, but the first bond pays a coupon of 5% and the second bond pays a coupon of 2%.  These are clearly two different animals with very different cash flows.  In fact, the bond with the 2% coupon has a more volatile price because its cash flows come in slower.

This difference is handled by a metric known as duration.  Duration is the key to estimating the impact on bond prices from a change in yields.  Let's consider a simple example.

Go to Morningstar, an excellent source for finding bond fund durations, and put AGG into the quote box.  AGG is the ETF which tracks the Barclay's Aggregate bond index.  It is used by many investors as the main investment for their bond or fixed income assets.  Hitting the quote button brings you to a page from which you need two pieces of information:  the yield and duration.

Source: Morningstar

As shown, yield on AGG is 2.40%.  On the same page, scroll down and find the duration on the right hand side.

With this information at hand, calculating the approximate impact of a change in yields is straightforward once you understand that duration tells you the change in price per 1% change in yields.  For example, assume that AGG comprises 40% of our portfolio and assume that yields rise 1% over the next 12 months (for example, the yield on the 10-year Treasury note rises from 2.9% to 3.9%).  Then the impact on portfolio return would be approximately .4*(-5.08+2.4%) = -1.07%.  If yields rise 2%, the impact would be approximately .4*(-10.16+2.4) = -3.90%.

If you play around with this, you can see the impact of time (getting 2.4% yield over 12 months as a cushion), portfolio weighting (the .4), etc.

It is a fairly simple step to bring in other bond funds or even individual bonds once you have their durations and yields.  Hopefully, you can see here how the recent sharp rise in yields over a short period of time, as well as the possibility of a longer-term increase, has unnerved investors.  And, hopefully, this short explanation reduces the percentages of people who don't understand the impact of bond yields on their portfolio  ;)

A Rant on Teaching Economics

Caught Up in the Math

I'm an economist.  I know a lot about the allocation of resources, how demand and supply determines prices, and the difference between the Federal Reserve and the U.S. Treasury.  I know how purchasing power parity impacts long-term currency rates and Keynes' exposition of the "liquidity trap."  In fact, I taught these concepts for a number of years.

I taught economics by the book, and by the book is essentially in line with the Samuelson approach.  Paul Samuelson was a Nobel prize-winning economist who produced the text that was used to teach the flood of economists that descended on Washington, D.C. following WWII.  A huge part of the impetus was the discovery that managing fiscal and monetary policy could influence the macro economy.  Classical beliefs, that a free market economy was best left to heal itself after busting at the gut from overindulging, were tossed to the gutter.  Instead, government policies could fight both unemployment as well as inflation.

Samuelson no longer has the leading text.  That honor now goes to Mankiw.  His text has better explanations, examples, and problems for students.  As would be expected, it is up-to-date with recent findings in the field.  But still the approach and general layout are the same.

A distressing fact, that is swept somewhat under the rug, is that students polled several years after taking a course in economics recall very little in terms of basic economic principles.  A second distressing fact (at least I feel it is a fact) is that economists get caught up in demonstrating their prowess in mathematics and clever insights.  Did you know that the effort to reduce traffic fatalities by requiring seat belts produces what is called "an unintended consequence?"

Before getting up a petition to drive economists out of town, it is worth appreciating that economics isn't easy to teach.  I have reflected on this.  It is a challenge.  Most students taking Econ101 are there for the grade.  It isn't like teaching nursing, where you are showing how to take a blood sample and the students are there thinking "I'll be doing this myself one day so I need to pay attention." Again, the typical student in Econ 101 is there for the grade; and a goodly number are hoping to get out alive with a "C" or a "B."

So maybe it is time to rethink how Econ 101 is taught.  My thought is it can be made more personal and, in fact, should be part of a high school curriculum for all students.  For example, in teaching about economic systems, and in particular the free market capitalistic system, the emphasis can be explicitly put on the positives and the negatives of the system and the student's role in the system.  In particular, teach that the free market system is the best there is at creating material wealth; but the way for most participants to enjoy this wealth is to contribute a good or service that the rest of the economy values.
 
This is a simple idea that many young people just don't get.  They are graduating from high school, and college even, and thinking that the economy owes them a living.  They are flummoxed when their degree doesn't automatically produce a good job.  Then they point their finger at the economy.  They stress out, buried by student debt.

A second simple example is to pound home to students the incentives that get the best and brightest in the economy to seek, 24/7, to separate them from their wallet.  The best and brightest are producing goods and services they will promote with incredible ingenuity backed by a deluge of resources to sink the average consumer into debt.

Teaching how the economy works is the place to introduce students to the fact that going into the real world is akin to going into battle.  It is the place to begin to prepare them.

What is the Cost of Investment Management? (Update)

This post is an update of a post published 4/26/2011.  It looks at market performance from the perspective of investment management cost over 20 years from 1/1/1993 to 2012.  The previous post covered 20 years ended 12/31/2009.

If you are a typical investor using an investment advisor, you probably have wondered at some point exactly what  it is costing.  On the surface, it looks rather small - the typical advisor charges between 1% and 2% of the market value of assets managed. 

Throw into the mix, however, the mountains of evidence which show that, over the long run, 3 out of 4 managers who try to beat the market and charge high fees for their services underperform--and the question becomes really interesting.

Keep in mind that financial planning and investment management are two different endeavors.  You could get a sophisticated financial plan done by a financial planner, and it could be well worth the cost. Understand, however, that FINANCIAL PLANNING AND INVESTMENT MANAGEMENT ARE TWO VERY DIFFERENT SKILL SETS!

There is considerable confusion on this topic in the blogosphere.  Let me be clear:  for many people, a well-done financial plan is worth paying for and, in fact, I've seen costly financial plans pay for themselves as the planner spots profitable attractive tax savings, etc.

What we are  looking at here is solely investment management.  Specifically, we'll think about how much could be saved managing your own assets and just matching market performance.  Bottom line: the savings are huge - this isn't the old "change your own oil" tactic from graduate school days.  This is meaningful savings.  It is the difference between being able to retire comfortably and not.

Regular readers of this blog know I like periodic tables of investment returns because they readily enable analyses of this type.  Here is the link to the Table put out by BlackRock for the 20-year period ended 2012:

Source:BlackRock

CLICK TO ENLARGE  Granted there are many paths we could have gone down over the past 20 years, but this is one path we did travel. The table shows the value of diversifying, why not to chase hot sectors, and the biggest ups and downs of the past 20 years.  It also shows the performance of a diversified portfolio (white box) and, thereby, gives us what we need to calculate the cost of investment management for a basic diversified portfolio. But first, let's back up and review what we are considering.

Google "wealth managers" along with your zip code, and you'll find at least 10 wealth managers within 25 miles, say, of where you live (unless you're in the Amazon jungle or the North Pole).  Call the 10 wealth managers and tell them you have $1.0 million in assets and you need help managing it.

To make a long story short, they will gladly manage it for you at a fee of between 1% and 2% of the market value of assets.  Thus, the first year fee on your $1.0 million will be approximately $10,000.

The question we are interested in is the cost of professional management if we had gone back 20 years ago to 1993.  What would have been the impact on the portfolio of professional management at 1% versus managing it ourselves?  Keep in mind that assets typically need to be managed over much longer periods, so we are actually looking at a short time frame - maybe for someone in their mid-40s with a couple of rollover IRAs and 20 years to retirement.

Again, most professionals (and individuals who try to pick stocks and time the market), after fees, underperform markets over the long term.  If you need evidence of this,  please do not hesitate to contact me.  For our analysis, we assume that the investment manager achieves the returns of the diversified portfolio in the BlackRock table.

We'll also assume that the investment manager gets paid at the end of the year.  In the real world, investment managers are paid at least quarterly.

Using the returns provided by BlackRock produces the following results :

Column1	Column2	Column3	Column4	Column5	Column6
	PORTFOLIO (T)	RETURN		FEE	PORT-FEE
1993	1,000,000	1.133	1133000	11,330	46192
1994	1,121,670	0.997	1118305	11,183	45730
1995	1,107,122	1.274	1410473	14,105	40350
1996	1,396,369	1.136	1586275	15,863	44820
1997	1,570,412	1.206	1893917	18,939	44372
1998	1,874,978	1.17	2193724	21,937	43928
1999	2,171,787	1.137	2469321	24,693	43489
2000	2,444,628	0.989	2417737	24,177	43054
2001	2,393,560	0.952	2278669	22,787	42623
2002	2,255,882	0.902	2034806	20,348	42197
2003	2,014,458	1.235	2487855	24,879	41775
2004	2,462,977	1.105	2721589	27,216	41357
2005	2,694,374	1.054	2839870	28,399	40944
2006	2,811,471	1.13	3176962	31,770	40534
2007	3,145,193	1.06	3333904	33,339	40129
2008	3,300,565	0.772	2548036	25,480	39728
2009	2,522,556	1.208	3047248	30,472	39330
2010	3,016,775	1.13	3408956	34,090	38937
2011	3,374,866	1.018	3435614	34,356	38548
2012	3,401,258	1.122	3816211	38,162	38162
	6.02%			386,917	836196

For those who may not be mathematically adept, the 13% return shown for the diversified portfolio in 1993 in the BlackRock table is put in the spread sheet above as 1.13 because $100 will grow to $113 at the end of the year.  The portfolio grew to $1,133,000.  The fee then would be .01* 1,133,000 or 11,300.  As another example, in 1994, the diversified portfolio declined by -0.3%; so the return number is .997 in the table.  Each dollar fell to $.997.  Thus the portfolio dropped, and the fee went down accordingly.

If you can need some practice, work through 1998 which saw the largest drop in the market.

The totals are what we are interested in.  Over the 20-year period, $386,917 went in to the pockets of the investment manager.  If, instead, the yearly amounts had remained in the portfolio and achieved the ensuing market returns, the total amounts to $836,196!  No wonder Fred Schwed stood on the docks at the end of Wall Street looking at the broker yachts and wondered where the customer yachts were!


Disclosure:  This post is intended solely for educational purposes.  Individuals should do their own analysis and/or consult with an advisor before investing.

When Not to Contribute to Your 401(k)

It is almost an automatic reaction to recommend to people that they should contribute to their company 401(k).  As is usually the case, however, it's not that simple.  Cliff Goldstein of Marketwatch has written a nice article entitled "5 Reasons Not to Contribute to Your 401(k)."

Here are his points with my observations in bold:

1. You don't have an emergency fund

The key is that you don't want to be forced into a situation where you have to borrow at high interest rates due to an unexpected expense.  If you do, then you negate earnings on 401(k) assets.  The size of the emergency fund is worth some analysis.  It depends on such things as the dependability of income, how old your house and car are, and even your health.  Bottom line:  first have an appropriate emergency fund before funding your 401(k).

2. Your employer doesn't match contributions

In just about every single case where an employer matches some portion of the employees contribution, it makes sense to contribute up to the match.  For example, if an employer matches 50% up to 6% of salary, then an employee should seek to make a 6% contribution. The employer match is effectively "free money."  If there is not match, then an IRA with a discount broker may be a better choice.  If one spouse has a match and the other doesn't, then it typically makes sense to be sure to take full advantage of the match.

3. You're swimming in debt

If you're paying high rates on debt and contributing to a 401(k), then you are effectively spinning your wheels.  Reducing your debt is a guaranteed return on money compared to an unknown return on investments.  This is especially the case for loans with rates exceeding 6%.

4. You fear future tax increases

In addition to Goldstein's points, consider that it makes sense to diversify retirement assets on a tax basis.  That is, it usually makes sense to have some assets on which you have already paid taxes along with tax deferred assets.  This gives you some flexibility in retirement in terms of which "bucket" you'll draw money from.

5. Lack of flexibility and high fees

All 401(k)s are not created equal.  In fact, some are horrendous.  They charge excessive fees and have poor choices.  Working married couples should look closely at their respective 401(k)s to see if one is superior and, then, use that to a greater extent if it makes sense.  Also, do a bit of analysis before rolling over a 401 (k) into a new employers 401(k).  Many times the better choice is to roll over into an IRA.