A Good Year For Retirees

2016 was a good year for DIY investor retirees in the investment markets. For a basic asset allocation using low cost ETFs the results were approximately as follows:

Large Cap 35% = +11.80% SPY
Small Cap 10% = +19.89% SCHA
International 15% = +4.66% IXUS
Bonds 35% = +2.56% AGG
cash 5% = +0.1%

The total portfolio return approximated +7.77%.

The important point is that it exceeded 4% (the benchmark 4% drawdown rate for retirement) plus the rate of inflation (approximately 2%).

The bottom line is that the DIY investor retiree took his or her drawdown and had more than they started the year with and they are one year closer to the grim reaper. What more could one ask for?

There are some assumptions in here of course. If you invested with an investment advisor who charged 1 percent or more and who invested you in active Funds that follow the
"hokey-poket style" of jumping in and jumping out you likely did considerably less than the above results.

In fact, the above portfolio could have easily been set up on 1/1 and the DIY investor retiree set about enjoying his or her retirement to the fullest. Let the hair pulling over the UK leaving the EU and the Trump election with the barrage of analysis over the stream of tweets to others.

And, oh yes, the grim reaper part is no big deal either. Everyone is one year closer, retiree or not. It is just that many retirees know it and appreciate their time a bit more because of the fact.

Have a great and prosperous New Year and enjoy the ongoing 3 ring circus. As long as they don't get us into a nuclear war it should be pretty entertaining!

Are You Freaking Out About Bonds?

Interest rates are rising and do-it-yourself investors know that pushes bond prices down. The mainstream media loves this kind of story. Scaring investors is a whole genre within the financial reporting sphere. The reporting today anticipates the shock coming when investors check out their quarterly statements.

Well, actually (here's the news for the mainstream news) most investors, if interested, can go online and see their up-to-date results. Waiting for quarterly statements is last century for many investors, especially DIY investors.

So, what about bonds? Let's take the perspective of an investor, i.e. someone who  invests longer term.

The index most widely used to measure bond market performance is the

Barclay's (formerly Lehman) Aggregate Bond Index.

It is an intermediate bond index and is to the bond market what the S&P 500 is to the stock market. It tracks all investment grade bonds in the U.S. with a maturity of greater than one year (once a bond comes to within a year of maturity it is dropped from the index). Thus, the index includes U.S. Treasury Notes and Bonds, Corporate issues, and U.S. Agency issues. It is the most widely used benchmark by professional bond managers to assess and report on their performance. As a point of reference, most surveys are reporting that professional, active bond managers are under performing the Aggregate Index this year.

So how has it done? The yield on the benchmark 10 year Treasury Note has had a nasty back up from 2.22% at the beginning of the year to 2.60% as of Friday's close. So what has been the impact on performance? Shorter term the fear mongers are right. Over the past 3 months the Index has had a total return of -3.55%. But for the year-to-date the return is +1.62%! Pretty good compared to what people are getting on certificates of deposit and especially on money market fund.

In fairness, the return is not great compared to inflation. Still not something to freak out about. The yield on the index is 2.36% and this will be an important return determinant of the the longer term performance.

Most often investors capture this return by using the

AGG

exchange traded fund which has an expense ratio of .06%, i.e. 6 basis points.

Also, it is notable that, just as there are many way to play off the S&P 500 in the stock market, there are many ways to buy bond index funds that will perform differently than the Barclay's Aggregate Index. There are funds, for example that focus on different sectors and funds that have much different durations.

The above information as well as much more can be found by plugging the ticker symbol AGG into

Morningstar.

You'll note at the site that there is a "performance" link which provides up-to-date performance.

A Great Gift

Recently I received a call from a young man seeking my advisory services. As an advisor my satisfaction comes from helping people get on a path to a successful retirement. This means steering them clear of high priced advisors who underperform, avoiding costly Funds that overcharge, and ensuring that the size of their nest egg will be sufficient to produce the income they need in retirement.

But this young man was a different case than I usually handle. He had just gotten out of prison on drug related charges and while in prison had read "Millionaire Teacher", which he found in the prison library, by Andrew Hallam. By reading the book he had come to understand how people build wealth by saving and investing intelligently. The book inspired him to do the same and he enlisted my services to get going. Full disclosure: I, along with a couple of other advisors, are mentioned in the book.

He related to me how his parents and entire family are poor but he had attained a job and was primed to start investing on a regular basis. To say the least this was one of my most satisfying consultations.

But the bottom line here is receiving the methodology. Admittedly, there are a number of books that describe how to invest in low cost Funds, allocate assets, and rebalance as needed. "Millionaire Teacher" is one and it is a good one. It is well written and can be read in a couple of weekends.

In my opinion it is a great life changing gift, especially for the young couple ( many of whom are financially illiterate) starting out in the professional work world. But many in mid-career find it useful as well.

So, I suggest instead of showing up with the soon to be consumed bottle of wine at the holiday party or putting a DVD of "Deadpool" under the tree consider "Millionaire Teacher".  It is an excellent choice for the budding DIY investor. As this blog and many others have harped on for a long time DIY investing done intelligently can save huge amounts and  increase the size of the nest egg over longer periods of time.

For additional background check out Andrew Hallam's website.

Can You Retire Early?

Here's a neat little chart from businessinsider "How close am I to early retirement"? Just find your income level and then the difference between your spending and saving. The answer as shown in the chart is how long it takes to build a next egg you can retire on by taking the magical 4%/year. Do this and you won't run out of money.

Simple? Yes, but useful as a general guide.

The problem is tricky as I've written several times on this blog. You've got inflation, market performance, how long you will live, medical costs and all sorts of unknowns. Some people take more comfort in getting complex analyses which produce Monte Carlo scenarios etc. To me simple is better. But it is very important to revisit the issue every couple of years at a minimum to see where you stand.

Some people target a number. For example they might have $1 million as the value of their nest egg at which they can retire. A problem here is that the number will be hit when the market is at a high point. I had a distraught individual who came to me after he had retired in 2000 and then went through the dot.com bust and had to go back to work. He then retired after the market hit a  record high in 2007 and then experienced the 2008 down 37% market. Needless to say he was at wit's end!

One way to approach this is to consider 4% of 80% of your portfolio. Can you have a nice retirement off of this? It may not be ideal but would it be ok? For example, if your nest egg is $1 million then 4% of 80% (.04 * $800,000) would be $32,000. If this would be ok (combined, of course, with Social Security etc.) then you could withstand a downturn in the market.

But back at the chart, what I really like is the out front emphasis on income and sending. The gap is what is key and it is important to not get lost in the weeds with all the other moving parts!

What's Next?

Ok, so you've listened to Bogle and Buffett, you've read Bernstein and Malkiel. Now you want to get started investing in low cost index Funds. You've got numerous accounts: 401(k)s, IRAs, taxable accounts etc. You've got capital gains to think about and a host of questions on how to get going.

My suggestion is to find a Registered Investment Advisor (RIA) you can work with. This is code for "who is an adherent of the low cost index Fund approach".  If you (1) have made trades and know what ticker symbols are etc., (2) can withstand volatility in your portfolio and (3) are willing to spend some time continuing to be educated on the investment process as it relates to creating a retirement
"nest egg", then you are likely a good candidate for hourly consultation or having the RIA invest for a short-term period to set the account up and then doing your own investing. From the start you save advisory fees of 1% to 2% as well as avoid high cost Funds that tend to underperform the market.

In my practice I do a session for $160. During the session we typically Skype and look at the investments, talk about goals, talk about how big the nest egg should be saved at various ages, how much should be saved, risk tolerance and Funds to be invested in. Sometimes we go over the process of rolling over 401(k)s, withdrawal strategies etc.

Many times this is enough to get the do-it-yourself investor headed in the right direction. Other times I manage assets for a short term period at a low rate of 0.4% per year. If for instance the account is $600,000, I charge $600 for the first 3 months. If at that point the client is ready to take over then that's it - no further charge. Typically, the client will schedule a session for $160 approximately 12 months later.

Some clients of course have me manage their assets on an ongoing basis. They have other things in their daily work life or even in retirement they would rather do than to be managing their assets.

Why an RIA? Good question. Because RIAs are fiduciaries and as such are required to tell you if they have conflicts of interest in regards to compensation. That is, do they get commissions from referring you to people or selling products? Many are like me and the only compensation they receive is what their clients pay them. This is the primary factor in determining that RIAs do what is in the clients' best interests!

2015 Performance - BlackRock Diversified Portfolio

Regular readers know my favorite investment chart is the BlackRock 20-year sector performance.  It details the relative performance ranking of asset classes on an annual basis as well as the performance of an easily replicated low-cost diversified portfolio comprised basically of 65% stocks, 35% bonds.  The diversified portfolio returned 8.3% on an average annualized basis over the 20-years ended 12/31/2013.

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

Below is an update showing the approximate performance of the diversified portfolio's sectors for the 12 months ended 12/31/2014.  Overall, the portfolio returned approximately 7.96%.

For the year, sector performance was mixed.  Large Cap Growth  (IWF) and Large Cap Value (IWD) achieved the highest performance with double digit returns.  International (EFA) had a negative return. The surprise for the year was the solid 6.04% return of the bond market (AGG).  Most forecasters believed rates would rise in 2014!

As a point of reference, a 7.96% average annualized will double your money in 9 years.


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.

Weight	Fund	Return (%) 12 months ended 12/31/2014	Expense Ratio
35	AGG  (Barclay’s Aggregate Bond Index)	6.04	.08
10	EFA (EAFE Index)	- 5.04	.34
10	IWM (Russell 2000)	4.94	.24
22.5	IWF (Russell 1000 Growth)	12.84	.20
22.5	IWD (Russell 3000)	13.21

A New Year's Resolution That Pays

It was probably Warren Buffett, but who knows, maybe it was Yogi Berra, who said (I paraphrase), "Don't wait until it rains before fixing your roof."  In this spirit, I suggest the resolution for 2015 to read some personal finance/investment books.  This isn't as painful, for most people, as most resolutions.  It isn't like pushing away the second piece of blueberry cheesecake or trying to quit smoking.  In fact, many people would surprise themselves because it is, in effect, the same as finding money.  The important point to understand is that these books lay out the steps you need to take before "...it rains."

For example, the wrong time to worry about your disability insurance is right after the doctor has told you that you'll need hip replacement surgery.  The wrong time to question your home insurance is as you watch fire trucks pulling up to your house.  And, yes, the wrong time to seriously think about funding life in your 60s is in your 50s.

Here is a post where I listed 4 of the books I recommend most often:

recommended books.

Let me add, as well The Charles Schwab Guide to Finances After Fifty by Carrie Schwab-Pomerantz.

As an example of what you'll find in this book, consider the following table (p. 251):

LIFETIME SOCIAL SECURITY BENEFIT

Source: The Charles Schwab Guide to Finances (p. 251)

The table shows the break-even for a $1,000 monthly benefit.  The payout equalizes, as shown, at age 78 for the earliest take-out opportunity and the full retirement age of 66.  Comparing full retirement age and age 70, the break-even occurs at age 83.

Notable, of course, is the additional almost $100,000 from holding off versus earliest choice for the 95-year-old.

Admittedly, the information in the books recommended here can be garnered by paying an advisor a couple of thousand dollars, and this is a route those with more complicated situations should go if they can afford it.  Still, it can be beneficial even for those of you in this boat to have at least a cursory knowledge of the areas you will cover.

Happy 2015 to you and your family!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!


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Investment Costs

Those paying any attention to giants in the investment management field in 2012 are aware of the constant admonition to pay attention to investment costs.  Bogle, Ellis, Bernstein, Buffett - the list goes on and on.  These giants in the field have studied the impact of excessive costs over long periods of time on the bottom line returns of investors.  The impact can amount to several years of retirement spending.

This has also been hammered home on numerous occassions here.  In fact, it is one of the key reasons for going the low-cost, indexed fund approach.  Whether you do your own investing, choose funds from a list of 401(k) offerings, or hire an investment manager, paying explicit attention to investment management costs is important.

It is fitting, therefore, to end 2012 with an interview video from WealthTrack "Controlling Investment Costs" found at Biz of Life.  The video features Charles Ellis and Mark Cortazzo.



My position is that many investors can minimize costs by doing the investing themselves.  Alternatively, today they can find low-cost advisors.

This is not to say that the area of personal finance should be completely low cost.  Depending on your situation, you may want to pay up for a really good financial plan and/or an estate attorney.  Paying up in these areas can definitely be worth it.  In fact, a good financial plan sometimes pays for itself.  But these are areas to be expounded on in 2013.

I hope 2012 has been prosperous for you and your family and 2013 is as well.

HAPPY NEW YEAR!!!!!!!!

Stock Rover

Source: Capital Pixel

Looking for a state-of-the-art investment management, analysis system?  Stock Rover may be exactly what you are looking for.

In just the couple of days I have played around with it, I have used it to screen for stocks, analyze portfolios, set up watch lists, etc. The software has an easily accessible abundance of info that can only be truly appreciated by giving it a test drive.  Download and create  portfolios, and then find market news or firm-specific news by rolling over portfolio holdings' stock symbols.  Compare performance to various benchmarks over 11 different time frames and arrange information how you want to see it.

There are a number of reviews on line and really good supporting videos showing capabilities of the system, so I'll just point out one feature that impressed me.

I have recently been analyzing and making presentations on how investors can use ETFs to improve the yield on the bond portion of their asset allocation and at the same time manage risk.  This can be tricky given the number of bond ETFs available in the market place; and structuring them into a portfolio for analysis and comparative analysis is challenging, to say the least.  Thus, I was pleasantly surprised to see that Stock Rover carries bond ETFs and makes it easy to create portfolios.  Here is a small partial listing of the bond ETFs they list:

Source: Stock Rover

CLICK IMAGE TO ENLARGE   Note that this is just some of the ETFs that begin with the letter "c"!  This is the middle panel of three on the page that you'll see.  It holds stocks for screening, portfolios and, as shown here, available ETFs.

The image shows performance view.  In fact, there are numerous other views.  Because CSJ  (an ETF of short maturity corporate bonds) is highlighted, a graph of its price is shown on the bottom portion of the graphic.

Clearly, it is easy to see the price history of numerous bond ETFs efficiently by selecting them.  As you play around with this, you'll find it easy to move columns in the table and get the information you want in the format you want.

To the right of this middle panel graphic is security level information on the highlighted security:

Source: Stock Rover

 CLICK IMAGE TO ENLARGE   Again, just by a click and scrolling down, you have an incredible amount of information at your finger tips.  Note the "news" tab.  Click on it, and you get general market news as well as security-specific news.

With ticker symbols, security characteristics, etc. at your finger tips, it is a piece of cake to begin putting together a portfolio to examine.  With Stock Rover, you do this on the same page using the panel on the left hand side of the page you are already on!

As you can see in this panel, you have a couple of portfolios already set up.  I set up a Benchmark portfolio comprised of 65% stocks and 35% bonds benchmarked to the BlackRock diversified portfolio they use in their asset return table.

Source: Stock Rover

CLICK IMAGE TO ENLARGE  Again, you get an idea of the available information.  Just click the green "New" button, and you're set to construct a new portfolio.  Note that I've been on the "Portfolio Performance" view and that there are numerous other views available. Also, note the arrow pointing to ETFs. Clicking there produced the ETF listing in the center panel looked at earlier.

To really get a feel for the information available, you should play with it a bit.  I'm not sure how this will eventually be priced, but Stock Rover does make life easier for those who do a lot of security and portfolio analysis.

Check it out.

Disclosure:  I am not affiliated in any way with this product.  This post is purely for educational purposes.

Monte Carlo Analyses - Useful or Not?

Financial planning is challenging because of the number of unknowns.  We reach a point where we aren't generating a career-type paycheck, from which date we need to generate an income.  We don't know how long we need to generate an income, the rate of inflation, or what market performance will be.

We can start by making point assumptions on the unknowns.  We can assume we'll live to be 100, inflation will average 3%, and our investments will earn 7%.  Then, given the desired income and our income sources, we can see whether our plan will succeed.  As we think about this, we realize that it is way too simplistic.  One important observation is that sequence of market returns and inflation are important.

An "elegant" way around this problem is to carry out a Monte Carlo analysis where many paths are generated for inflation and market returns.  Then, of the paths generated, we can get a percent of success determination (I hesitate to use the term "probability" because we are using a sampling technique - it is not exactly like flipping a coin which is, in fact, a probability).

I put elegant in quotations because, like many things mathematical, a Monte Carlo analysis can project a greater degree of determination than is actually obtained.  As such, it has the potential to be abused by  practitioners to present an aura of expertise.
 
Suppose 80% of the paths succeed?  What does this tell us?  Is it good practice to report to a client that his plan will "fail" 20% of the time?  Does it require more elaboration?  To put it bluntly - does a Monte Carlo analysis with an 80% success ratio mean that 20% of the time the client will end up eating dog food?  Is the client hearing what we are trying to convey?

This issue has been examined by Michael Kitces in Do Our Brains Really Even Know How To Evaluate A Monte Carlo Analysis? on his blog Nerd's Eye View.  Michael is perhaps the brightest young financial planner in the country, and his blog is a must-read for those interested in the cutting edge of financial planning research.

My own take is that Monte Carlo analysis is valuable at higher rates of failure.  For example, if the failure rate is 60%, you probably need to work longer, save at a greater rate, or draw down a smaller income stream.  On the other hand, if the failure rate is 20%, then examining flexibility issues comes into play.  Can the client cut down on spending for a few years to get back on a successful path?

The good part of all this, I think, is that it gets the planner and the client to focus on the dynamic nature of the process.  Financial plans need to be revisited.

I think we may even have to take a step back and reconsider what we mean by "success."  "Success" is defined as "not eating dog food" in the Monte Carlo results.  Many clients, however, define
success as dying broke.  The client who ends up with $4 million in the analysis is a "success" but not so according to his or her goals.  The real success metric may be the percentage of paths leaving a client with $100,000 or less.

For those interested in an easy-to-use program based on  Monte Carlo simulations, I recommend the T. Rowe Price Retirement Calculator.  It is free and straightforward.  Use it at least annually.

Best-Selling Author Commends RW Investment Strategies' Approach

Andrew Hallam, author of Millionaire Teacher: The Nine Rules of Wealth You Should Have Learned in School, says "If the average American Fund salesperson saw what Wasilewski charges, they would hide their pink heads under the covers of shame."  Nobody can ever say that Hallam doesn't have a way with words!

My conviction has long been that the financial services industry overcharges by charging sales fees, marketing fees, outrageous management fees, and  numerous additional hidden costs to individuals who are led to believe that market timing and stock picking are superior approaches.

I, of course, am not the only one practicing along the low-cost index approach.  Hallam mentions Assetbuilder as well, and there are others.  In fact, my sense is that the movement is growing - helped along by the works of Hallam et al. .

Although I work with all age groups, I am especially interested in getting the message across to young people.  Too many procrastinate with their investment program because they won't take a bit of time to learn how it works.  They convince themselves they are right whenever they see markets drop, when, in fact, they should see declining markets as a great opportunity.

Bonds versus Stocks: Buffett versus Gross

The media is playing up the differing views of Buffett and Gross on stocks and bonds.  Buffett recently previewed his much-anticipated shareholder letter and called bonds "dangerous investments."  At the other end of the spectrum, Bill Gross, manager of the world's largest bond fund, at PIMCO, has recently increased exposure to Treasury issues.

Five years from now, we will look back and see that one of these icons of the investment world will be right and the other probably very wrong.  With the yield on the 10-year Treasury below 2%, the Fed and other world central banks on an inflation mission, and the yield on the S&P 500, for the first time in decades, yielding more than the 10-year Treasury, I have to side with Buffett - up to a point.

Some, in fact, like Laurence Fink, CEO of BlackRock Inc. (the world's largest investor), are pounding the table and arguing that investors should be 100% in equities.



I have to say that I believe Buffett is right but wouldn't go 100% into stocks.  I could sketch out a scenario where 10 years from now the S&P 500 is 10% lower than today (think Medicare, U.S. dysfunctional  government, Southern Europe, nutcase in Iran, etc., etc.) and the 10-year Treasury note is at 1.50%, say, where, in fact, Buffett followers would not have done well.  It is why my clients are diversified.

One comment that Fink made got a chuckle out of me.  He said he was sitting with Buffett one time and the market was falling off a cliff.  He said Buffett got up 3 times and bought stock.  This impressed him. It doesn't me.  Buffett is a multi-billionaire.  He has, for all practical purposes, unlimited capacity to take risk.  If the market fell 50% tomorrow, it would not make one bit of difference to Buffett's economic well-being.

I would suggest that  Fink sit with a couple who are 3 years into retirement, have a "nest egg" of $600,000, and are trying to generate an income from the nest egg and social security that will last.  See how often they are jumping up and down to buy stocks in a market that's falling sharply!

To me, the disagreement on the most important investment decision of all--asset allocation--by these extremely bright, successful long-term investors is the strongest argument for diversification.  Although I agree that long-term Treasuries should be avoided today, bonds in general should not.

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

Stock Picks Guaranteed to Beat the Market

Zacks, the well known stock research company, is offering 10 stock picks that "...promises market-beating gains no matter the direction the market heads."

Not only that, but with a $299 subscription, you get a number of free reports!

Some of you might question what happens if (alas!) the picks don't outperform.  No problem:  "...if the service doesn't BEAT the market, we'll credit the cost of your annual subscription to another Zacks product."

Maybe I'm being a bit nit picky here, but isn't this a bit like a used car dealer offering another lemon at a discount after the first one broke down?

Market Predictions

This is the season of predictions and forecasts.  Pundits are getting a lot of air time and magazine space trotting out all kinds of charts and esoteric facts to support highly specific predictions on where markets are headed.

If you are like a lot of investors, you will be impressed.  In fact, crystal ball seers in the market are usually introduced by citing a time in the past when they made accurate predictions. 

What should you make of them?  Sometimes potential clients reel off well-known pundits' names and their forecasts.  They say so-and-so says the market is headed higher/lower or gold is going to $ _____/oz. etc.  They want to know what I think.

I patiently explain that I can get super smart, very articulate people to give well-reasoned, highly-believable arguments on both sides.  Jeremy Siegal (author of Stocks For the Long Run), for example, will argue forcefully that stocks are headed higher while Bob Shiller (author of Irrational Exuberance) will take the opposite side and say that now is not a good time to buy. 

What you don't see are all those in the gutter because their predictions turned out horribly wrong.  You won't see Miller, Paulson, Berkowitz, et al.  Sometimes this gets through; often times it doesn't.  After all, some people have their whole view of investing grounded in predicting which stocks and which sectors will do best.



If I thought forecasting was useful, I'd probably go with the most recent presenter given that they are so persuasive.  But I don't think it is useful.  In fact, it is harmful, IMHO, because many times investors use these forecasts as a  substitute for thinking; and when forecasts start to go awry, emotions come into play and the investor is set up for a stressful period that typically ends badly.


Larry Swedroe is the director of research of Buckingham Asset Management, LLC and a well-known proponent of index investing.  Here is his response when asked to make a forecast of macroeconomic events:
 
 From interview of  Larry Swedroe by "Seeking Alpha":


SA: Global Macro considerations dominated the headlines in 2011. Do you see 2012 unfolding differently? If so, how?
LS: Yes, it is always different, but my crystal ball is always cloudy. So I don’t make forecasts. Investors should learn what Warren Buffett knows: A market forecast tells you nothing about where the market is going but a lot about the person doing the forecast.
       There are good studies on the ability to forecast and the only thing that correlates with accuracy is fame, and the correlation is negative:  The more famous the forecaster, the less accurate the forecast.

Why Are Interest Rates So Low? (Part 8)

In this final, 4-minute Khan Academy video on currencies, "China Keeps Peg But Diversifies Holdings," Sal notes that China's holdings of U.S. Treasuries are decreasing as they diversify their holdings but other countries holdings of Treasuries are increasing.  In fact, globally the rest of the world has to do something with the excess of the amount we buy from them versus what they buy from us, i.e. our trade deficit.  They buy Treasury issues because they are liquid and safe and can be bought in very large amounts.

So, the end result is that China buys Treasuries to peg their currency below the market rate which results in a humongous demand for Treasuries, driving Treasury prices higher and rates lower.  This is a major factor holding U.S. rates low and expanding the U.S. trade deficit.  It holds Treasury rates lower than they would be otherwise as well as the rates on other issues. B y doing this, China is able to build their manufacturing base.  Eventually they should reach the point where they create a middle class to buy the goods they produce.

To me, the Khan Academy videos are a treasure.  For those interested in understanding how the economy works and financial markets, I suggest visiting the site on a regular basis and viewing the videos systematically.  To keep up-to-date on events, check out the new videos he is constantly producing.  Eventually your understanding of markets will become much more sophisticated.  I actually believe that many big-time money managers didn't fully appreciate the impact on rates described by Sal in the videos we have viewed this week.

Why Are Interest Rates So Low? (Part 7)

In today's Khan Academy video, "Debt Loops Rationale and Effects," Sal looks at the positives and negatives--for both China and the U.S.--of the on-going pegging of the Yuan on global markets.  He discusses the likely outcome once the process is halted and the result when it is reversed.  Very simply, it has held interest rates low and enabled the U.S. to finance its massive debt at historically low interest rates.  Understanding this whole dynamic is crucial, IMHO, for the DIY investor going forward because it will be a driving force.  In fact, it could be the driving force of the next big crisis - banks hold Treasuries!  Central banks around the world hold the dollar as a reserve currency in the form of Treasuries.

Why Are Interest Rates So Low? (Part 6)

In this Khan Academy video, "American - Chinese Debt Loop," Sal explains the effect of China pegging the Yuan, lending the U.S. funds via the buying of Treasury securities, and thereby contributing in a major way to low U.S. interest rates.  U.S. Treasury rates affect other U.S. rates as well, along with global interest rates.  Furthermore, low interest rates push global investors out on the risk spectrum - after all, individual investors, pension funds, insurance companies, et al. aren't satisfied with miniscule rates on the least risky assets being affected by this process.

Understanding the process leads naturally to the questions of how it gets unwound and what happens if and when the Chinese get tired of holding U.S. assets.  Not long ago, Fed Chairman Greenspan wondered why long-term Treasury note yields didn't rise as the Federal Reserve raised rates from the 1% level in the latter part of 2004.  His so-called "conundrum" is partially explained by the process explained here by Sal.

Enjoy the video:

Trading Bonds

Source: Capital Pixel

This post is for the active DIY investor who would like an approach  for  the fixed income portion of the portfolio.  It is presented solely as an idea to get the creative juices flowing.  In fact, in the end, the best approach for most DIY investors is to just buy the market, via AGG or BND which tracks the Barclay's Aggregate Index, i.e. the overall bond market, and forget it.

There are others who take investing as a challenge.  They like to try to "beat the  market" - at least for a portion of their assets.  They have a lot of time to study the market.  They spend considerable time researching stocks but are stymied when it comes to the bond portion of their assets.

Should I Try to Predict Interest Rates?
 
Serious investors understand that bond yields and bond prices move in opposite directions.  This, then, suggests that predicting interest rates is the natural way to outperform the bond market.

Sadly, as most professional bond managers will tell you, predicting interest rates is like predicting stock prices - it is a losers game.  2011 has been an excellent example of this.  When yields had been considerably higher than where they are today, most pros predicted yet higher rates.  Instead they dropped sharply; and, as a result, some of the most high-profile bond managers underperformed the bond market significantly.  So much for predicting rates.

Trade the Spread
 
Instead, many pros will tell you it is considerably easier dealing with spreads.  This is what I want to look at here.

A simple under-appreciated fact, IMHO, is that bonds are fundamentally different from stocks in that we know the future price of a bond.  For example, if we buy a 5-year Verizon bond, we know that at the maturity date the price of the bond will be $100 (for $100 in principal).  Obviously, if we buy Verizon stock, we have no idea where the price will be 5 years from now.

This gives special meaning to the much discussed "reversion to the mean" concept.  Think about it like this:  the price of a Verizon bond, for example, can wander all over the place depending on how investors feel about risk; but, in the end, it has to track closer to Treasury yields as it gets closer to maturity.  This is true in spades when a portfolio of bonds is considered.

I find it interesting that professionals spend a lot of time studying and trading on the basis of yield spreads and yet, despite all of the investment information on line, yield graphs are not easy to find!  In fact, I had to create my own data for this simple exercise to illustrate this idea of investing on the basis of yield spreads.

In thinking about what we are trying to do, first consider two bonds:  a corporate bond and a government bond.  Assume the Treasury bond yields 5% and the corporate bond yields 7%, i.e. the spread is 2%. Then, if the spread goes to 1.5%, it means that the price of the corporate bond has risen (or decreased less) relative to the price of the government bond - remember:  bond prices rise when bond yields drop. The idea then boils down to this:  buy corporate bonds when yield spreads are wide and you are getting paid to take on risk, and sell and go into Treasuries when the reward-to-risk is not so appealing. Professional bond traders spend a lot of time doing exactly this - studying yield spread graphs in their search for value.

Data Analysis
 
So, to begin I first found some historical yields.

I collected monthly yields on Moody's Baa rated bonds (Baa is actually the bottom of the investment grade category) and the 5-year constant maturity Treasury note going back to November 2005.  I then took the difference in the monthly yields and calculated the average.  At the end of November, the Baa yield was 5.14%, the Treasury note yield was 0.91%, and so the spread was 4.23%.  The average over the whole period for this spread was 3.58%.  So, as a first cut, a bond trader would say the Baa corporate "has value."

On the other hand, if the spread was less than the average of 3.58%, bond traders would typically prefer the Treasury.  In other words, they would say an investor is not getting paid enough to take on the risk of the corporate issue.

2011-04	6.02	2.17	3.85
2011-05	5.78	1.84	3.94
2011-06	5.75	1.58	4.17
2011-07	5.76	1.54	4.22
2011-08	5.36	1.02	4.34
2011-09	5.27	0.9	4.37
2011-10	5.37	1.06	4.31
2011-11	5.14	0.91	4.23
		AVG.	3.58

 Again, the above is a partial listing of the data.  The column headed by 6.02 is the Baa yield, the next column is the Treasury note yield, and the final column is the "spread," i.e. the difference.  The average is for the whole period going back to the of 2005.

Hopefully you get the idea at this point - the adept trader who sold corporates on 4/2011 at a spread of 3.95% could buy them back considerably cheaper on 11/2011 at a spread of 4.23%.

Let's go a step further and think about the best way for a DIY investor to exploit spreads.  For this purpose, I collected price data, back to 4/2007,  on HYG (high yield bond ETF) and IEF (7 - 10-year Treasury note ETF).  A significant positive here is that these are low-cost, highly-diversified investment instruments appropriate for the DIY investor.  HYG is a good choice for up to 5% of a portfolio for the fixed income portion of most DIY portfolios.  The question is when is a good time to buy?

Below is a partial listing of my data.  The difference here is that we are looking at prices.  The prices of the funds go up when bond prices rise, i.e. yields fall.  If yields on high yield corporates fall more than yields on Treasury notes, then HYG will rise more than IEF will and vice versa.  The spread reflects confidence in the economic recovery, etc.  When the spread is large (on an absolute basis), it means you have to pay a lot (example:  10/2010 at -12.52) for the safety of Treasuries - this is the time to buy HYG! As you can see, by early 2011, HYG had appreciated in price (from 83.04 to 86.93) and IEF had actually declined!  If you go to the earlier chart and collect the yield data, you'll find that the spread over the same period dropped from 4.59% to 3.92%! 

Hopefully this gives you a bit of an idea how spread information can help position the fixed portion of the portfolio.  There are, of course, other areas of the market, including mortgage-backeds, single-A corporates, etc., where this approach can be used profitably.  Keep in mind that the yield advantage of sectors relative to Treasuries brings time into the process.  This post is intended for educational purposes. Individuals should consult with a professional and do their own research.  I hold ETFs mentioned above.

	HYG	IEF	SPREAD
2010-10	83.04	95.56	-12.52
2010-11	81.99	94.7	-12.71
2010-12	84.26	91.45	-7.19
2011-01	85.67	91.43	-5.76
2011-02	86.9	91.24	-4.34
2011-03	86.93	91.1	-4.17
2011-04	88.32	92.78	-4.46
2011-05	88.44	95.1	-6.66
2011-06	87.93	94.62	-6.69
2011-07	88.25	97.62	-9.37
2011-08	85.84	102.16	-16.32
2011-09	81.29	104.45	-23.16
2011-10	88.19	103.1	-14.91
2011-11	86.05	103.7	-17.65
		AVERAGE	-10.42

A Good Source of Investment Information

Source: Capital Pixel

One of the challenges today for DIY investors, who actively manage their own assets, is handling the vast amount of information at their finger tips.  A key is to find good sources.  One worth checking out is "Market Currents" at Seeking Alpha.

Scanning recent lists you'll find many reports on the troubled Europe region.  This, of course, is where investors are presently focused.

Other reports will grab your attention as well.  For example, from yesterday's items, we find this tidbit worth thinking about if you are contemplating buying or selling banks' stocks.

6:50 PM Fitch has it wrong, U.S. banks could actually wind up benefiting from Europe's debt crisis, says Rochdale's Dick Bove.  He cites two reasons:   first, U.S. banks have a relatively low level of exposure to European banks.  Second, the problems facing European banks could actually drive business to seek healthier institutions in the U.S.  His top picks: PNC Financial (PNC) and Fifth Third Bancorp (FITB).  Both get hit when Europe erupts, but neither are heavily exposed to European banks.  [Quick Ideas, Global & FX, Financials]

The reports, as you can see, have numerous links making it easy to further research the information presented, if necessary. 

You'll also notice the search box in the upper right of the page.  Here is where you can type in a ticker symbol and get recent stock specific reports.  Do this today for Intel (INTC) and you'll find reports ranging from Buffett's 13F filing showing he bought chip companies (which is news because he previously has famously avoided tech altogether) to industry projections on the inventory and profit outlook.

If you buy individual stocks or make general market bets, this kind of information can be invaluable.  Not that long ago it would have taken days to garner the information now available at the click of a button.

Full Disclosure:  I recommend that at least 80% of retirement assets be invested in index funds aligned with a carefully selected asset allocation model reflective of risk tolerance.

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.