Types of Orders

I frequently point out to new DIY investors that buying an index fund is typically simpler than buying something off of Amazon. Generally it is a matter of clicking a "trade button", putting in a ticker symbol and figuring out the number of shares. This merely requires dividing the dollar amount to invest by the share price.

The process is made straightforward and simple for a good reason. The brokers want you to trade.

But a part of the process that may seem a little tricky at first is the type of order. Most orders are put in "at the market". This means that whatever the price is at the time of the trade that is what the buyer or seller will get.

It is good practice though when getting set to do a trade to eyeball the bid and ask prices for whatever you're buying, whether it is a stock or an exchange traded fund. For example, as this is written the exchange traded fund SCHX, a Schwab large cap index fund has a bid-ask spread of $57.03 - $57.05. This spread is usually given as part of the info from the quote box.

This spread means you can buy SCHX at $57.05/share or sell it at $57.03/share. If you are buying a few hundred shares you'll likely pay $57.05share but if you have a few hundred shares to sell you'll get $57.03/share.

If you're thinking this is like a used car dealer you've got the idea. The used car dealer gives you $4,000 for your car and then wants to sell it to me for $6,000. Thankfully the bid- ask spread in financial markets are not this big!

Sometimes you'll want to buy for less than the ask price. For example, maybe you would like to buy at $57.00. Here you would put in a"limit order" at $57.00. You could leave it as an open order or make it good for the day. I always just do a day order. I don't want to be on vacation 6 months from now, long after I've forgotten about the particular Fund or stock and see the order get executed.

The big deal in putting in a limit order for the day or as an open order is that you may not get it done. This is worth thinking about because typically a few ticks are not a big deal. If you're a long term investor and you pay $57.05 versus $57.00 isn't really significant. In fact, you may not get the trade done and 2 days later you give in when the Fund is trading at $57.50.

Been there, done that!

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!

What's a P/E ratio?

Source: Capital Pixel

The story is told of  René Descartes getting a flash of brilliance as a young teenager that led to the Cartesian co-ordinate system that brought together algebra and geometry.  Young Descartes gave a visual depiction of algebraic equations by plotting points relative to an origin.  In this, he developed a concept that belongs in a broader family of concepts that compare and classify things - something that humans love to do and that is necessary for any type of analytical work.

Here's another example:  suppose one basketball player makes 79 of 112 foul shots and another made 57 of 89.  Who has the better record?  The comparative device here--the device that puts them on the same footing--is the percentage calculation.  The first player made 70.5% of his or her shots and the second player made 64 percent.  Percentages make comparisons of these types simple, and they are used almost without thinking.  Take a stroll through Costco and you'll see people with calculators figuring the per ounce cost of 2 different cans of tuna.

For investment analysts, the most widely-used comparative metric is the P/E ratio.  Ask whether stock ABC is a better value than stock XYZ and, invariably, the very first number you will get is the P/E ratio, where P is price and E is earnings.  In fact, as you read views on the likely direction of the overall market, you will frequently see references to the market P/E relative to historical P/E.

So let's back up and think about this.  Suppose I told you that stock ABC is earning $1.50 per share and stock XYZ is earning $.75 per share.  Is ABC the better value?  When you reflect on this a bit, you realize that you really can't say.  ABC may have a price of $30 and XYZ a price of $10.  The price of ABC is 3 times the price of XYZ, but its earnings are only 2 times as much.

All of this is equalized and put on a comparative basis by the P/E ratio.  For our example, ABC has a P/E ratio of 20 and XYZ 13.33.  We say that for ABC "you have to pay $20 per dollar of earnings," etc.  Thus, from this perspective, it is easy to see that ABC is more expensive, i.e., you have to pay up for a dollar of earnings for ABC.

But this is just the first step.  It may very well make sense to pay up for ABC.  It depends on its expected growth.  Studying P/Es is just the first step.  But it is a huge first step.

As you study P/Es, you quickly come to realize there are various measures.  There are P/Es based on trailing earnings (ttm stands for "trailing 12 months") and there are P/Es based on expected earnings. There are also P/Es based on normalized earnings that use adjustment techniques to get at the underlying trend.

Here, for example,  is what you get on Yahoo! Finance for Johnson & Johnson:

Source: Yahoo Finance

CLICK IMAGE TO ENLARGE   Check that the P/E ratio of 23.08 is correct by taking the price 70.45 and dividing by EPS of 3.05.

P/Es are also used to classify investment approaches.  For example, value managers focus on lower-than-average P/E stocks whereas growth managers focus on stocks that have higher P/Es whose earnings are growing faster than average. 

As mentioned above, P/Es are also used to assess the overall value of the market.  One of most popular is the Shiller P/E 10 ratio.  This measure uses 10 years of earnings adjusted for inflation.  It is used by so-called tactical asset allocators and market timers to assess entry and exit points in the U.S. stock
market.  Here is an update Shiller P/E ratio graph from gurufocus:




Homework Problems:

1. Find the P/E ratios of VZ, MON and MSFT.  Which of these stocks do you believe is the value now?  (Hint:  go to Yahoo! Finance and put in ticker symbols.)
2. According to the Shiller Price/Earnings Ratio, is now a good time to invest in U.S. stocks?

What's a Basis Point?

Source: Capital Pixel

One time, a few years ago, I was explaining to a couple the importance of diversification and why I prefer exchange traded funds to mutual funds and how different funds are used to satisfy an asset allocation.  Basically, an explanation I had given numerous times.  As usual, I ended up by asking if there were any questions. The man said "Just one - what is a mutual fund?"

This taught me the basic lesson that most advisors (but not all!) learn at some point, which is that the jargon that we so glibly use is not familiar to a lot of people.  Furthermore, I'm convinced that it is the single most important point fund reps making 401(k) presentations could work on.  I've attended presentations where reps have droned on and on, enamored with their power point graph, about Sharpe ratios to groups comprised mostly of people who have no idea of the importance of the risk/return tradeoff in portfolio construction much less the ratio between a risk-free rate and a standard deviation.  These meetings remind me of a time when I wandered into a conference seminar on "Advances in Linux" - or something like that.  As far as I was concerned, it could have been a seminar on speaking Swahili - unlike the rest of the audience, I had no idea what the presenter was talking about.

One term that could confuse the layman is "basis point."  We like to say, for example, that a single-A corporate bond yields 111 basis points more than the corresponding U.S. Treasury note.  What the heck does this mean?

A basis point is simply one one-hundredths of a percent.  If one bond yields 5% and another bond yields 5.25%, then the difference is 25 basis points.  You can easily see that talking in terms of basis points is better and more convenient than saying the bond yields 25 one one-hundredths more. Sometimes basis point is shortened to "bips" as in "the bond yields 25 bips more."

Basis Points and Investment Costs

An important area where basis points comes up is in thinking about investment costs.  Investment costs is an aspect of investing that an investor can control.  As is often pointed out, there are parts of the investment process that people obsess over that they, in fact, can't control.  The prime example is the markets.  No amount of gnashing of teeth and towel wringing will change what the market will do.  It is better to focus on what you can control.

Most investors, with a small bit of effort, can reduce investment costs by up to 50 basis points (or bips-- your call on the jargon) by paying attention to expense ratios and talking to an advisor to see if 401(k)s can be rolled over to where less expensive funds are available, etc..

But is it worth it?  Well, consider $100,000 over a 25-year period.  50 bips over this period compounds up to 13.3%, i.e. $13,279 in our example.  Here's the kicker - that money will go into your nest egg or the broker's pocket - your choice.  Furthermore, most investors have a longer time frame - they just don't think it through.  Suppose you are 50 years old.  There is a real good chance that part of your nest egg will be funding your retirement even 35 years from now!

Homework Questions

1. How many basis points difference is the yield between the 10-year Treasury note and the 5-year Treasury note?  Hint:  Go to Bloomberg.
2. What is the basis point difference in the expense ratio between FLCSX (Fidelity large cap stock fund) and SPY S&P 500 exchange traded fund?  Hint:  Go to Morningstar.

What Cancer and Investing Have in Common - from Andrew Hallam

Some really good advice from someone who has "been there and done that."  Andrew Hallam tells you all you need to know to beat the pros at their own game in the investing world.  His ability to get at the essence of the best approach to investing is why I continually recommend Millionaire Teacher:  The Nine Rules of Wealth You Should Have Learned in School.  Get it for your kids, get it for yourself.  Read it!

How to Learn DIY Investing

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

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

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

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

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

How to Get a Stock Quote

Dusty in Alaska

The best way to start thinking about investing is to get a list of stocks and follow them on an ongoing basis.  Start very basic and build up.

A good way to start is by following stocks you are interested in.  If you have young children who might be interested in stocks, get them to think about the producers of the products they like:  who produces the movies they go to, the cell phone they may have, the sports equipment they use, the cereal they eat in the morning, etc.

For example, market's darling du jour is Apple Computer.  As a first step (field trip time...Yay!!!), I would suggest visiting an Apple Computer store to get a sense of the excitement surrounding their products.  Watch the sales people write up sales tickets.  Hang around the "genius bar" and eavesdrop. Examine the peripheral products lining the wall.

All of this is brought to mind because I just went through this experience with my wife--replacing her dead computer with a Mac Pro.

Thus, yesterday when Apple released its earnings and the sales number on iPods and iPads, etc. were released, I, for one, wasn't all that surprised.  The store was jumping each time I and my wife visited, and the surrounding mall stores were pretty much without customers.

So, anyways....if you want to follow a stock, the first thing you need is a ticker symbol.  Yahoo! Finance is as good a place to start as any.

Source:Yahoo

If you don't know the ticker for a particular company, click "Finance Search."  Do this and you'll find the ticker for Apple Computer is AAPL.

Just as an FYI:  stocks, mutual funds, and exchange traded funds all have ticker symbols.

Once you have the ticker symbol in hand, you're in business, so to speak.  Type it in the "Get Quotes" box above and you'll get the most recent price and, typically, much more information.  Doing this for AAPL, for example, gets you the following:

Source: Yahoo

CLICK TO ENLARGE  As you can see, you get a lot of information on the stock, including the price of the last trade, the 12-month range, and bid and ask prices.  Puttering around a bit on the page will show you that there is a tremendous amount of information at your fingertips.

Many people today don't appreciate this info-at-your-fingertips-thingy because they weren't around back in the day when you had to call your sleazy broker to get the price of your stocks. More often than not, that came along with a sales pitch to sell it for something else.

As a first step, you want to focus on the last trade price and maybe start tracking it on a daily or weekly basis.  If you're working with a student, you might get them to set up a spreadsheet for this purpose.  This will give them something to do during the summer.

Notice the last line of the above graphic that shows ticker symbols of other stocks that people interested in AAPL viewed.  For homework, get prices on these stocks and find the company they represent.  Can you guess  what AMZN might be?

DIY Newbie - Portfolio Analytics - Part 5

The DIY investor typically has at his or her fingertips powerful technology. This technology is easy to use, is indispensable in setting up and tracking a portfolio, and saves a lot of time in monitoring the portfolio. The way to learn it is to get your hands dirty and play around with it. Spending a bit of time now will pay huge time-saving dividends in the future.

Those of a certain vintage will recall days of keeping much of the data by hand. Today the novice has available much more than the institutional investor of even 15 years ago. The trick is to learn to use it.

I tend to use Schwab, so I'll illustrate it here; but similar tools are available at most major brokerage firms. But again, I find that people tend to approach brokerage inline sites like the old VHS systems where we learned how to play a tape and that was about it. We were ignorant of its other functions.

It is easy to get on Schwab, consolidate your accounts, and select a model portfolio. The model portfolio, in turn, will specify targets for various classes of assets. For example, it will specify a target for small cap stocks. Then one of the important tools is the asset allocation pie chart and table which shows you how far off target you are for each asset class both in dollar terms and percentage terms. In other words, it shows you where you have to take action and by how much to get closer to target. It simplifies the whole process of rebalancing.

Suppose you want to go one step further and drill down to see a listing of assets by account and sector? Click "Schwab Portfolio Checkup," "View Holdings," and "Asset Class Details." You get this table for each asset class.

CLICK TO ENLARGE Notice the information provided. Here we have "Large Cap Funds." You get the "gross expense ratio," the "asset class," "% of portfolio" etc. Also the account numbers, which have been erased here, are provided.
Notice the "multi-class" funds. These are allocated to appropriate sectors on the basis of Morningstar breakdowns.

Learning to use this technology simplifies portfolio management and is worth the time investment.

A License to be Nosy

One advantage to being a financial advisor is that you get used to being pretty nosy about people's finances. It is, however, depressing because, like so many things in life, you find that there is what economists call a type of adverse selection going on. The people who read personal finance and investing blogs and attend investment workshops are not those who need it most. And the people who need it most are walking around clueless.

This past week my TV went out as I was channel surfing, so I got the Comcast guys to come out. One was in his early 30s and the other was in his early 40s.

My nosy financial side (and business side as well!) surfaced, and I asked them if they were participating in their company 401k. From their expressions, I could tell they had never been asked this on a call; and I could just as well have asked if they thought there is life in outer space.

The expressions didn't alter one iota when I asked if Comcast has a company match. Maybe I'm extending my financial boundaries a bit here, but this is a question every employee should be able to answer for their particular company. If you've ever wondered why most financial advisors are bald, it is because they have lost their hair or pulled it out because people can't answer this question.

To state the obvious, taking advantage of the company match is free money; and one day, when we have stopped drawing a paycheck, all of us will be highly appreciative of this free money.

I could tell you the response later in the day from the lady who gave me the eye test at the Maryland Department of Motor Vehicles, but I'll spare you.

Hopefully I've made my point.

Still Paying 1st Class For Coach?

Most individuals who use advisors pay outrageous fees for investment management- and yet the historical evidence clearly shows that at least 8 out of 10 under-perform the market. Individuals are paying 1st class rates and sitting in coach. Some don't even know their performance. I know because I ask them. Just as important, they have no idea what Wall Street, and its many layers, are siphoning off from their asset performance --much of it deftly hidden. Fees are taken before results are reported,, and then many advisors automatically deduct their charges.

Take for example, an advisor who invests your assets in mutual funds. What kind of costs are involved? Consider the following chart from Bernstein, "The Investor's Manifesto:"


CLICK TO ENLARGE As shown, even the most basic large cap active fund has fees that average 2.2%. This is before your advisor takes his cut of 1 to 2%! Don't be surprised 20 years from now if you've severely underperformed. But then, hey, who knows? Maybe you'll get lucky and have the 1 out of 10 or 2 out 10 managers who outperform. But there is a way to get into 1st class; and it's straightforward, it doesn't take a lot of time, and, best of all, it helps you get a fix on exactly what is happening with your investable assets. On the basis of historical performance data, it puts you into 1st class. It uses a low cost, low turnover, indexed portfolio, well-diversified portfolio.

Yesterday's post reported on the version reported by BlackRock that provides long-term performance data. The year-to-date performance of the low cost, low turn-over, well-diversified portfolio was 5.47%. Again, do you know what your performance was? The cost of the portfolio is 0.22% and uses sectors of the market that Bernstein's table shows charges over 4%!

Furthermore, this week's posts showed that it is not that difficult to get solid, lost-cost performance with your investable assets. Something worth thinking about: this is an area where you can go 1st class and pay coach pricing.

Portfolio rebalancing

One of the tasks facing the do-it-yourself investor is portfolio rebalancing to get back in realignment with the desired allocation. There is a good article on this at Smart Money. In the article, David Wray, president of the Profit Sharing/401(k) Council of America, says the two biggest mistakes 401(k) participants tend to make is to go more than a year before rebalancing and not contributing enough to receive the full employer match.

Coming up with the contribution to receive the full matching amount can admittedly be a problem sometimes. The rebalancing part is actually easy - especially in this age of low-cost exchange traded funds and available technology - if you willing to take a deep breath and deal with percentages and a pie chart.

I first look at the overall allocation- percent in stocks and percent in bonds. If it is 5% out of whack, I look to rebalance. So, for example, if 70% stock and 30% bonds is the desired allocation and markets have moved the portfolio to 75% stocks and 25% bonds, then we need to reduce stocks and add to bonds. Over the long term, this is a subtle means of buying low and selling high - it adds incrementally to return. In a simple portfolio, sell at least 5% of your SPY (etf tracking S&P 500) and buy AGG or BND (etfs tracking the bond market) with the proceeds.

Once this is determined, I look inside the broad classifications. If small cap stocks did especially well, then that would be the stock sector that would get most of the reduction. In the fixed income area, if the high yield portion had underperformed, that's where I'd add.

All of this sounds a bit more complicated than it is. In fact, I have to admit that I am surprised at the implied procrastination by David Wray's points. With Charles Schwab (as I would assume it is with most brokers), it is trivial to set up a portfolio of all your accounts, pick a desired asset allocation and then, by hitting a button, see the allocation in percent terms or as a colorful pie chart. In a matter of seconds, you can determine if you're off by more than 5%.

If you're not sure how to set this up and do it, you should contact your rep and have it explained to you. After all, this is your retirement that we're talking about.

Inflation/Deflation Wassup?

I just finished going through comments where a so-called "Master Po" argued against TIPS and in favor of gold. Parts of his argument were flat out wrong, and commenters let him know. Hopefully today ol' Master Po is considerably wiser.

In any event, there was some commentary on inflation and deflation, and since I cover this with my Econ 101 students each semester, I thought it was worth a post.
In fact we go over all the "flation" words used in economics: inflation, deflation, disinflation, hyperinflation and stagflation. Whew! I think that's all of them. If anyone knows of another one, please let me know.

The two that get most confused are deflation (overall price level is actually dropping into negative territory- ex. CPI down 2% year to date) and disinflation ( overall price level is increasing but at a decreasing rate - going from +3% rise to a +2% rise).

2 Quiz Questions
1. Has the U.S. ever experienced hyperinflation?
2. When did the U.S. experience stagflation?

EXTRA CREDIT ESSAY: Is deflation good or bad for the country? Who is helped and who is hurt?

Important Money Ratios

Free Money Finance has interesting posts and comments based on the book "Your Money Ratios: 8 Simple Tools for Financial Security" by Charles Farrell.
These ratios are important for the DIY investor not so much for their specific recommendations but more for people to see where they stand with their finances and to think concretely about the important questions.

What always strikes me about these blogs and financial seminars is that most of the people reading them and attending already have an interest in the subject and know much of the information. Where this is really valuable is for those who haven't thought about insurance, investments etc. These particular posts at Free Money Finance are very useful, especially for these kinds of people.

How A Second Grader Beats Wall Street by Allan S. Roth

Don't let the title put you off. "How A Second Grader Beats Wall Street" is worth reading and adding to your library, especially for those not happy with their investment performance, those tired of paying excessive fees to investment advisors, and DIY Investor Newbies. Complex topics are simplified. The chapter on locating investments to minimize taxes by paying taxes at the lowest rate and avoiding taxes until they have to be paid will save many readers a lot of money.
Full disclosure: the book is centered on the investment philosophy I believe most investors should follow - focus on asset allocation, invest with low cost indexed exchange traded funds or mutual funds, and participate in broad markets.
It presents an approach that has handily outperformed professional managers over the long-term.
A portfolio constructed by applying the ideas in the book can be found at Paul Farrel's lazy portfolio site.

DIY Investor Newbie - Constructing the Portfolio

This is another step towards managing our own investments. We go back to the asset allocation post and use that allocation to talk about implementing it with an actual portfolio. Recall that the allocation was arrived at after making specific assumptions. As always this is intended solely for educational purposes.

DIY Investor Newbie-Risk Tolerance Quiz

These are all the questions together on the risk tolerance quiz. I tried to make them a bit more readable per a viewer request. I strongly urge you to try it out to see if it gives you some insight into your risk tolerance. Next, we will look at building a portfolio.

DIY Investor Newbie - Risk Tolerance

These are the final questions on the risk tolerance questionnaire. I strongly urge you to try it out to see if it gives you some insight into your risk tolerance. Next, we will look at building a portfolio.

DIY Investor Newbie - Step 2 Risk Tolerance

In the last DIY Investor Newbie post, we derived a specific asset allocation . This required a judgment on risk tolerance. Risk tolerance has to do with how well you take the up and downs of the market. Every investment advisor had clients who literally freaked out in the market downturn of 2008/early 2009. Freaking out isn't good because it usually means people sell out (capitulate) when prices are near their lows and getting ready to move higher.

DIY Newbie - Step 1 (cont.) - asset allocation

To finish up with the asset allocation tool, let's take a specific example. We'll use these results in later posts. You may want to do this for your specific situation. The end result will help us set up an actual portfolio.

The assumptions we use for our specific example are as follows:
Age: 35
Current Assets: $100,000
Savings/year: $10,000
Marginal tax rate: 25%
Income required: 0%
Risk tolerance: middle
Economic outlook: middle

With these assumptions, we get 28% large cap, 19% mid cap, 14% small cap, 15% foreign stk. This represents the stock allocation. In total it is 76% stock.

On the fixed income side, we get 10% bonds, 0% municipals, 14% cash. In total then, the tool suggests 24% in fixed income.

A couple of comments are in order. As Grouch noted in an earlier post, there are "rules-of thumb" that are often used. He specifically mentioned Bogle's view that bond percent should equal age. Another more aggressive one is 120 - age equals stock position. One I recently came across is that stocks should be twice the loss that would make you uncomfortable. For example, if a 25% drop in your portfolio would get you to move aggressively to a defensive posture, you should have no more than 50% in stocks.

The bottom line is that asset allocation isn't as scientific as it can be made to appear. Go to 3 different financial advisors and you'll come away with 3 different allocations. The point is know yourself and constantly monitor your allocation. As many observers have noted, we all learned a lot about our risk tolerance in 2008.

In the next post, we'll take a look at a risk tolerance questionnaire just to get a flavor for the type of questions typically asked and to pick out the important ones.