Investment Primer: Part II

I know there is a substantial group out there that doesn’t really want to understand everything, so much as just know what they should do, and maybe a little why. While I am by no means an expert in wealth-building and management, I do feel comfortable outlining a basic plan that I am sure will work for anyone that adheres to it.

This was designed with a few things in mind: starting with a small amount of money, extremely long-term horizons (10 years or more), and low involvement from you. The long-term horizon is important as well as tricky. Active management (moving your money around a lot to try to allocate it in whatever way will return the most at any given time) is expensive (in terms of fees AND time) as well as extremely risky, so the best option really is just to put your investments in place and then sit on them. Low involvement occurs because, while paying attention to this sort of thing all the time is both interesting to me, I know most people would rather deal with it as little as possible.

The basic strategy can be outlined as a series of do’s and do-not’s.

DO:

Start Saving Now, Keep Saving Often – This is stupid and obvious, but it needs to be said. The longer you save, the better. Compound interest is one of the miracles of the modern world. Not to mention it’s far far easier to put aside $100 a month for several years than to find $10,000 for your down-payment on a house out of your paycheck. Take as much of your savings as you are comfortable with, and start investing it now. You’ll probably find a way to spend it otherwise. Furthermore, make sure you withhold a small amount from every paycheck, if at all possible, and regularly add on to this investment. Most of the investments I will outline later will allow monthly deductions from your bank account, which is an easy way to do this.

Take Free Money – If your job offers any kind of matching in a retirement plan, maximize this. THIS IS FREE MONEY. If you make $100 a month, and your employer will match up to 2%, by taking advantage of this you give yourself a raise to $102 a month, for all intents and purposes.

Stand by your Convictions – It’s easy to get discouraged. Watching your savings grow isn’t nearly as rewarding in the short-term as that HDTV plasma-screen and an XBOX360. Markets fluctuate and go through cycles. However, if you made the right kind of investments in the first place (more on this later) then the WORST thing you can do is sell an investment during a period of poor performance. Like I said, markets are cyclical, so a period of bad returns often means a period of great returns is just around the corner. Consider this, buying a total-market index fund, even at the peak right before the worst crash in history, still paid handsome returns if you held the investment for 20 years, and beat any other general asset class over that time period. (See: http://www.amazon.com/Stocks-Long-Run-Jeremy-Siegel/dp/007058043X)

Diversify – Putting all your eggs in one basket makes it even harder to stand by your convictions. If you have multiple classes that tend to move in opposite directions (e.g. bonds go up when stocks go down, etc etc) then you can be insulated somewhat from the day-to-day vagaries of the markets, and enjoy gains in a variety of assets.

Rebalance – This may be a little advanced, but it’s simple enough to do in a simple portfolio, and it’s an important concept that most people don’t bother with. Assume you own two investments; say a S&P Index Fund and an Asian Index fund, starting with an equal share in each, not overly committed to the American market, not overly committed to Asia, great. If one continues to perform far better than the other, say America has a very expensive war and rough economy, slowly your investment in Asia is 80% of your assets, so when asia goes back down, 80% of your assets go down, with a resurgent America benefiting you very little, as it’s a small percentage of your assets. This sort of simply riding market trends back and forth is no good. Better, is to re-balance your portfolio. As Asia performs well, keep whatever initial balance you felt was appropriate (50-50 in this simplified case) by either putting new investments into the lagging asset (which would be the easiest option, given that we’re talking about starting with a small amount of money, so monthly additions can have a big effect on distribution), or selling some of the outperforming one to put in the underperformer. Yes, this seems ass-backwards, but it keeps your risks balanced correctly, and can actually prove very profitable. The excess profits found this way come from essentially fighting market cycles. As one asset reaches a peak value, you’ll automatically sell it off to an extent, without even having to pay attention to market research or fundamentals, and you’ll use that income to buy an asset that is probably just about to rise in value from being depressed, again without having to pay overmuch attention to what’s going on in the extremely complex market. Just keep an eye on your asset distribution and adjust it when you make a monthly contribution.





DO NOT:

Chase Performance – The largest inflow of cash into a market usually occurs right before it peaks and crashes. People see everyone else has made a ton of money, and wants to get in on the game too. After several record years of profits in tech stocks, billions more was invested in 2000, right before the entire market blew up. Make smart investments and sit on them, don’t chase performance (or run from poor performance). Not only do you have a very good chance of missing ALL the good performance and simply buying into the bad, you are guaranteed to lose some amount to the costs of selling what you currently own and buying new assets.

Cash Out – Most people will change jobs many many times during their lives, and many of them will cash out their retirement plan every time they change, incurring huge taxes, and then wasting the money on big tvs or what have you. It’s obvious, but don’t do this. Maintain that plan, because the whole idea is to AVOID the taxes for as long as possible. (more on this when I get around to talking about various retirement accounts).

Buy a ‘story’ – this shouldn’t be a problem given the kind of investor my audience should be, but do not buy into something just because it has a neat story. You know, the guy starts telling you how gold trading is all the rage, or flipping houses makes unfair profits, or whatever. Do you know anything about the gold market? Neither do I, so why get involved in something you can’t understand? You’ll probably just get hosed by the people who actually know what they’re doing.

Stock Pick – Why would you think you know more about a stock than the institutional investors (Morgan Stanley, enormous mutual funds) that have already priced them? Not only do you have to out-pick all the experts, but you have an additional “hurdle” in that you incur large costs by buying individual stocks, which will erode your returns. Just please, don’t do it. To see large returns, you’ll have to buy a concentrated portfolio of only a few stocks, and then you’ll be subject to day-to-day variance in those prices, so your risk will be stratospheric. The only time I'd recommend your average private investor to buy and hold a single stock would be your own company stock, if you get preferential treatment on purchases of it.



Okay, now that we have covered do and don’t, buy the Vanguard S&P 500 index.

The Vanguard group is one of the largest mutual-fund groups in the world. It’s also one of the best. Somewhat uniquely, it is organized as a not-for-profit. That means most of the abuses/excess expenditures and general problems with mutual funds do not apply to its funds. Furthermore, any profit a company makes has to come out of your money somewhere, so if Vanguard makes no profit, you have an automatic advantage day-in and day-out for your returns. You’re getting more pennies from every dollar. Plus, the business is honest. “Pay-to-play” is a process where a broker gets a kickback in return for pushing a specific fund family. Fidelity gives your broker money (out of the pockets of its investors) in return for the broker recommending its funds. Many brokers will NOT mention funds that do not pay this bribe. Of the five largest mutual-fund groups, only Vanguard categorically does not take part in “pay-to-play”. Vanguard’s director of institutional sales, as quoted by the New York Times, “When brokers realize they won’t be compensated for placing our funds in a plan, they typically hang up on us.” (For more information on all kinds of problems with mutual funds read Swensen’s “Unconventional Success”). Vanguard’s S&P 500 index fund has an expense ratio of .18% other funds indexing the S&P 500 average .87% and may go as high as 2%. In general, this level of fee advantage is true across all of Vanguard’s funds.

Okay, so I’ve sold you on Vangaurd, why the S&P 500 index fund? Because it’s a simple investment, that anyone can understand. As I discussed, the S&P 500 represents the largest companies in America. Is it a safe bet to assume that on average, the largest companies in America are going to make money, expand, and find ways to make even more money, over long time periods? Yes. The Vanguard S&P 500 index fund not only outperforms every other S&P Index fund (by virtue of having cheaper expenses than they do), it also outperformed 80% of mutual funds over a 20 year period, with the average fund trailing it by 2.1%. These are actively-managed funds, where an expert manager is supposed to be BEATING the market. This also does not include the tax implications of the average mutual fund’s much higher capital-gains tax from more frequent trading. Considering tax implications, only 14% of mutual funds gave higher returns over the 1978-1998 period, with the average ‘winner’ beating the vanguard index by 1.3% a year, and the average ‘loser’ losing by 3.2% a year. So, there you have it. Over long periods, the Vanguard S&P 500 index, by virtue of its broad base across American businesses and low expense ratio, will beat almost every other investment. Plus it’s simple as hell.

You can invest online, through their website, and I would advise you to do it when you have the cash on hand (the minimum investment is $3,000)

While you can automate further deposits, even the S&P 500 isn’t ALWAYS going to be a great performer, so I would advise saving up for investment in an international stock fund from Vanguard, rather than just increasing your investment in the first fund. As before, the most important things to watch (far more important than past performance) are expense ratio and portfolio turnover. But further investments will be covered later, I guess.

Basic Primer on Investing: Part I

So most of us have jobs now and may want to start putting some money aside for retirement/buying a house/that realdoll that is going to replace the embarrassment of trying to date. So I thought I would use my supposed expertise to explain some concepts etc that some people might not know about. I’m sure many of you already know many of the things I’m going to say, so just skim on. Part II will be more strategy related.

I’ll try to start at the most basic level and work my way up.

Bond – a bond is a promise to deliver a specified amount of money at a specific date. For example, $100 on December 1, 2009. Bonds are used to raise money in the short term in exchange for long-term debt. A bond that pays $100 in the future (a ‘face value’ of $100) will sell for less than $100 today. Bonds are issued by the US government (the least risky bonds) as well as corporations (with varying degrees of risk). If the company should go bankrupt, bond investors have the first claim on any company assets to repay their debts, so bonds are generally less risky than stocks, as all bond debt must be repaid before stockholders can make a claim.

Stock – popularly regarded as nothing more than a piece of paper that changes in value, stocks actually represent a share of ownership in a company, with rights to affect its decisions, enjoy its profits, and claim its assets, in proportion to the share of ownership. If you own enough of a company’s stock, you control the company. If a company goes out of business, you can go and claim assets, be they leftover inventory or office furniture, in proportion to your share of ownership. (In reality the company will sell all of these assets to pay off its debtors, and distribute remnants among the stockholders). Stocks can vary greatly in value over the short term, and are generally seen as more risky assets than bonds. Stocks and bonds are the two most important types of investable assets.

Inflation – Inflation can have a huge effect on the value of your savings. Inflation represents the tendency of the purchasing power of money to decline over time (an artifact of the United States banking system). That is, $20 today will buy you a lot more than $20 thirty years from now will. Inflation is why putting all your money in a mattress is not a good idea. Stocks represent hard assets and profits made from selling them (at a price that is effected by inflation), so in the long run inflation will have little effect on stocks, although short run effects can be very strong. Bonds, which represent fixed nominal values of money, are very strongly and permanently affected by inflation. If inflation increases, the value of that $100 payment in the future goes down.


Return – Return is simply the change in value of your investment. If you paid $90 for that bond, when it pays $100 you have gotten about a 11% return. This is usually expressed in annual terms, so if it took two years for you to get that $100, your annual returns were about 5.5% (which isn’t very good). These are almost always ‘nominal’ returns, meaning they are just in the increase in the NUMBER of dollars, not the actual value (which is decreased by inflation every year). Inflation usually sits around 3-4% in the United States, so that bond was paying 1.5% to 2.5% a year in real terms, which, again, is not very good.

Risk – Risk represents the chance you’ll lose an amount of the value of your investment. Usually you have to take on greater risk to expect a greater return. However, you don’t want to take on too much extra risk just for a slightly better return, as you’ll be boned in the long run. How much risk to take on is very much up to the individual investor.

Volatility – Volatility is the day-to-day change in an asset’s value over time. Stocks are very volatile, in that, while the market as a whole usually goes up, it can change in value by a percentage point in more every day. This can turn your hair gray if you pay extremely close attention to the value of your stock every day, as it can go down for no discernable reason and keep going down, only to go UP even more the next week. “Day traders” supposedly make their fortunes trading on volatility.

Stock Index – Indices are an easy way to track the overall stock market. Simply put, they are weighted averages of a number of stocks on the market. Some indices track only specific kinds of companies, like agricultura or biotechnology. Other indices simply track a large number of the largest companies, or as many stocks as reliable pricing information is available for. Common Indices are: NASDAQ, Dow Jones Industrial Average, the S&P 500, the Russell 1000, the Russell 2000, and the Wilshire 5000. There are many more.

S&P 500 – The S&P 500 essentially the 500 largest publicly-owned companies in the United States, with a few exceptions. While there are more than 5000 stocks in the entire market, 80% of the value of all stocks in the country is represented by these 500 companies, so it is a very easy way to track how corporate America is valued at any time.

Mutual Fund – A mutual fund is a pool of money contributed by a large number of investors, managed by a professional. This professional will buy and sell stocks with this pooled money in an attempt to make more money, according to various strategies and theories. Supposedly this way private investors can have access to top-grade investment advice, and see ‘market beating’ returns. In reality, giving huge piles of money to a professional who loves money provides a massive incentive for him to find ways to take the money, and most mutual funds are poor investments, nevertheless, mutual funds are how most private investors get involved in the stock market.

Index Fund – Similar in construction to the Mutual fund, and Index fund simply tries to replicate a specific index. A S&P 500 Index fund will try to buy a portfolio of stocks that very closely matches the S&P performance, if not exactly replicating its distribution.

Load – Some mutual funds charge a ‘load’ fee when you first put money into them. This essentially is a percentage of the money you have given them, which they just take home and buy nice cars with. The simply fact that very many successful mutual funds charge no load at all should be enough to prove that charging a load fee is nothing more than a bald cash-grab by mutual fund managers.

Management Fee/Expense ratio – The expense ratio is how much of a mutual funds assets go to commissions, kickbacks to your corrupt stockbroker for not telling you about no-load or low-fee funds, advertising so that the mutual fund can sucker more people into investing in them, and legitimate expenses like payroll, office space, research costs, etc. For example, a fund with the relatively high expense ratio of 2% spends 2% of whatever amount of assets you have given them, every year. That means they have to get an average return of 2% in order to avoid LOSING money, before they can even start making you any money. Generally, funds with lower expense ratios are more profitable for investors, which should come as no surprise, since they have lower hurdles to jump to break even and start making profits.

Capital Gains – Sadly, the government wants its cut, so whenever you make a profit on selling a stock, you incur capital gains tax, to the tune of several tens of percents of your profit. This can be an issue if you have very high turnover.

Turnover – A mutual fund manager is constantly trying to make a profit in the short-run, selling stocks he thinks will go down, and buying the ones he thinks will go up. Every time he sells a stock that has gone up, that is capital gains. Many mutual funds are managed as if capital gains were not taxed, so they can further reduce their performance by building up a lot of capital gains tax in this way. A fund’s turnover is the percentage of its assets that are sold on an annual basis. So a firm that has a turnover of 50% a year will typically sell all of its stocks and buy new ones every two years. A very low (~15%) turnover usually means that the manager is picking stocks for the long run, with an eye to long-term returns, which is a very good thing for his investors. Poorly-constructed index funds, or funds following poorly-constructed indexes can see a lot of turnover as they constantly struggle to match the index. This, along with expense ratio, is far more important than historical returns in gauging where to invest.

That does it for now

In part II I will cover a generalized investment strategy and part III will be an overview of different types of retirement accounts.

The verdict:

Quizno's prime rib sandwich (even the 'normal' size) is an absolute orgy of beef. (see second bullet point below)

Thoughts for today:

• I stopped writing this because I got no feedback on it. If anyone actually cares, respond once in a while. This isn't a plea for attention, but if nobody cares, I'll just talk to you guys in real life instead of over the internet.
• The 6" subway sandwich is a cocktease, big time. Although I do enjoy that I can get avocado now.
• I'm pretty sure I'm going to move, and I don't know if I should move to evanston or farther north.
• Work has gotten really busy for me, but my free time has cleared out so it's pretty slow. Weird, that.
  

So this represents the official reactivation of my blog.

Yet another reminder of how frickin weird Japanese culture can be:


Mascot of misery

Thousands are flocking to watch a timid dolphin fail to perform tricks at Tokyo's Aqua Stadium, an aquarium. “Lucky”, as the Pacific white-sided dolphin is known, is the latest creature to win national affection for being a loser—it is part of a grand tradition of noble animal failures that includes a racehorse with the world's longest-ever losing streak.

Many see Lucky as an indicator of Japan's increasing economic polarisation. In a society that is steadily dividing into “haves” and “have-nots”, those who see themselves in the latter category have seized upon animals such as Lucky as mascots. The more tricks the hapless dolphin fails to perform, and the less gracefully he jumps, the more his reputation grows as a talisman of the downtrodden.