CD Update

Certificate of Deposit (CD) rates have decreased a bit since I first wrote about the Ally Bank 5-year CD and the PenFed 7-year CD. As of today, the Ally Bank 5-year CD APY is 2.40%, and the PenFed 7-year CD APY is 3.25%. The Ally 5-year CD still works well for taxable accounts, but I now prefer the PenFed 5-year CD at 2.75% APY for IRA accounts because of the smaller early withdrawal penalty (explained in more detail later).

PenFed 7-Year CD

I recently initiated the process to do a partial rollover (transfer) from a money market in my Fidelity IRA account to a 7-year IRA CD at Pentagon Federal Credit Union (PenFed). The CD rate is 3.5% through the end of November 2010, and the withdrawal penalty is one year of interest (if you withdraw funds from the CD before one year, you sacrifice all interest, but get all of your principal back). Following is a summary of my experience with PenFed so far, and the reasoning that led me to go for the PenFed CD.

Financial Illiteracy, Procrastination and Inertia

"... it is difficult to make wise decisions about retirement savings and investment. The mistakes people make about their retirement savings have been attributed to financial illiteracy and to a number of psychological biases: misperceptions of risks; procrastination; inadequate self-discipline; inertia; and overconfidence, which leads most active investors to the illogical conclusion that each can outsmart the others." This quote is from The Squam Lake Report: Fixing the Financial System, a new book based on the work of 15 of the world’s leading financial economists. I’ve highlighted in bold the points I want to focus on in this blog post.

Ally Bank 5 Year CD

With interest rates so low, one of the best deals for fixed-income investing in a taxable account is a 5 year CD from Ally Bank. One advantage of Ally CDs is that the penalty for early withdrawal is only 60 days of interest, as compared to 6 months to 1 year of interest at other banks and credit unions. Currently Ally Bank doesn’t offer CDs for IRA accounts (although they plan to in the near future), so the 5 year CD I’m recommending only makes sense if you have quite a bit of money in a taxable account. Following are some more details about why this CD might make sense for some of you.

A Single Fund Solution

If you can’t find the time, interest or energy to learn much about investing and to manage your investments, perhaps you would be interested in investing in a single mutual fund that will provide broad diversification, and will be appropriate to invest in for the rest of your life. Types of funds that are intended to meet these goals are known as target-date, target-retirement, or life-cycle funds.

In general, target-date funds gradually lower risk by reducing the allocation to stocks each year. This is consistent with the widely recommended approach of taking more risk when you’re young, and decreasing risk as you get older. As with most other mutual funds, my favorite provider of this type of fund is Vanguard, and they are in the process of making some changes to these funds that make them even more attractive from my perspective. I’ll use Vanguard’s Target Retirement funds to illustrate how target-date funds work, and why they may be an appropriate investment for people who want a low-maintenance, prudent approach to investing.

Paying Down Debt as an Investment

Paying down debt should always be considered in making investment decisions. For example, paying off high-interest credit card debt is almost always your best investment. Paying down lower-interest debt, especially if the interest is tax deductible, is a harder decision, but it should be considered. Let’s look at some examples to illustrate the tradeoffs.

Your International Stock Allocation

By investing in stocks or stock mutual funds you are investing in businesses. Should you invest only in the businesses of your home country, or is it wise also to invest in businesses in other countries?

Investment Return: Price Change, Dividends, Inflation and Taxes

Investment return consists of price change and dividends (or interest), but you also must consider the impact of inflation and taxes in determining your true return. In this post, I look at the impact of price change, dividends, inflation and taxes on an investment in the Vanguard Small-Cap Value Index fund over the 10 years ending 8/2/2010. In the remainder of this post, I’ll refer to the fund by its ticker symbol, VISVX.

Costs Matter

A seemingly small difference in mutual fund costs can make a huge difference in how your investment grows over many years. A 1% or 1.5% expense ratio may not sound like a lot, but compared to the 0.2% or less you will pay for a low-cost index fund, your investment returns are most likely to be severely diminished by the higher costs over an investing lifetime of 50 years or more.

Risks of Investing in Individual Stocks

For the vast majority of individual investors, investing in individual stocks, as opposed to mutual funds or ETFs, is a losing strategy. This assertion is based on financial theory and vast amounts of empirical evidence. Unfortunately, most of my own experience also is consistent with this assertion.

Equity Index Fund Basics

In this post I’ll cover a number of concepts related to mutual funds, using the Vanguard Total Stock Market Index fund to illustrate. I use this fund because it’s an excellent fund that everyone should consider including in their portfolio. You can learn a lot about this fund at the Vanguard web site. In the remainder of this post, I’ll refer to the Vanguard Total Stock Market Index fund by its ticker symbol, VTSMX.

High Returns, Low Risk! (or Financial Porn?)

On the cover of a recent issue of a major national financial magazine, written in big block letters was: HIGH RETURNS – LOW RISK. This is a blatant example of what many financial authors refer to as financial pornography. I already discussed my disdain for most financial news in my February 2010 post Financial News: Worse than Useless!, but this headline was so appallingly ridiculous that I couldn’t resist commenting on it.

Stock Basics

In this post, I’ll cover some of the basics of stocks, illustrating some of the concepts by using real examples for a specific company: Google. I chose Google because it’s well known and is a relatively new company. I’ll discuss shares, stock, IPOs, market capitalization, growth/value, etc.

Portfolio 6 Update

In my May 8 post, Implementing Portfolio 5: A Current Example, I discussed a plan for a particular investor to migrate from a simple portfolio to a more complex portfolio (more asset classes). This is an update on the execution of that plan (you may want to scan the May 8 post before reading this post). Since the allocation is slightly different than Portfolio 5, I’m renaming this portfolio Portfolio 6. If you need a refresher on stock asset classes (e.g., large-cap, small-cap, growth, blend, value, international, etc.), please read my January 2010 post, Asset Allocation: Part 2.

Keep in mind that this is a fairly complex portfolio, and that the investor is taking a very active approach to building the portfolio. This approach probably is not suitable for most investors, but is being presented for those who might be interested in dealing with the additional complexity. The most important point is that the investor has made decisions on how to proceed, and is taking action to execute her plan.

Lumpers vs. Splitters

Among investors who agree that using low-cost index funds is the winning investment strategy, there is an ongoing and unresolved debate. On one side the lumpers believe that since markets are very efficient, the best approach is to use a few total market index funds; e.g., a total US stock market fund, a total bond market fund, and perhaps a total international stock fund. On the other side, the splitters believe that the academic research justifies slicing and dicing the stock portion of your portfolio into more asset classes; e.g., large-cap, small-cap, value, growth, developed (foreign) markets, emerging markets, REITs, etc. Depending on which book you read or which web site you visit, you can find compelling evidence for each point of view. Let’s briefly explore the debate.

Your Retirement Goal

Setting goals and targets is part of the investment process. Retirement is a goal for most people. How do you determine your target for your retirement savings? This isn’t something that can be fully answered in a short blog post, but it’s something that most people probably should think more about. Here are some guidelines that may help.

US Corporate Bonds Are Holding Up

The US stock market is down about 10% in the last month, and before today’s bounce, non-US stocks were down about 15%. This is nothing compared to the 50%-60% drop in 2008-2009, but another difference is that US corporate bonds have not dropped along with stocks. This is one indicator that the fears of today are nothing like the panic of the 2008-2009 financial crisis.

Winning The Loser’s Game

Winning The Loser’s Game, by Charles D. Ellis, is one of the books on my recommended reading list. It’s not the first book I’d recommend for a novice investor, but it’s definitely worth a read if you’re serious about learning about investing. I don’t own it, but recently checked it out of the library to re-read, and thought I’d share a few key points from the book.

Implementing Portfolio 5: A Current Example

The investor who currently is invested in Portfolio 1 [about 50% Vanguard Total Stock Market Index (US) and 50% in Vanguard Total International Stock Index (non-US)] has decided to diversify into a more complex asset allocation, along the lines of Portfolio 5 (see my April 25 post, Some Real Portfolios). Here are my thoughts on how to implement this change.

Every Now and Then …

Today was a reminder that every now and then the financial markets go nuts. In case you missed it, there was a major panic in the global stock market today. At one point the US stock market was down about 10% from its high of the day, but recovered to end the day down a bit over 3%. There were price swings (down, then up) of more than 5% within 5-10 minutes.

A Vanguard ETF (VEU) that tracks the non-US market had prices ranging from 40 to 34 within a 5 minute period (that’s almost a 20% difference!), ending the day down about 4.8%. There were even crazier swings in individual stocks, but you can read about that elsewhere if you’re interested.

It’s natural to feel fear when things like this happen. The parts of our brain that react emotionally and physiologically to perceived threats evolved long before the rational parts. It takes discipline to bring your rational mind to bear when your emotional mind doing the thing it evolved to do. With investing, it helps to put things in perspective, and remind yourself that investing in stocks is a long-term proposition.

Vanguard Offers Commission-Free ETF Trades

As of May 4, Vanguard is offering commission-free trades of its 46 Exchange Traded Funds (ETFs), and has lowered brokerage commissions on purchases of other stock and ETFs to $7 per trade (and even less if you have $50,000 or more with Vanguard). I’m thrilled to see this, as it makes them competitive with Schwab and Fidelity in terms of ETF trading costs. It’s now feasible for a small investor to create a low cost, highly diversified portfolio using Vanguard ETFs.

A Conservative Approach to Investing

Not everyone agrees that you should invest in stocks to meet critical financial goals. It’s probably a good idea to at least consider this viewpoint, and familiarize yourself with a conservative alternative investment strategy. In the end, you must decide for yourself how much risk is appropriate for you, and make your investment decisions accordingly.

Portfolio 2: The rest of the story

In this post I conclude the story of portfolio 2. I review how the portfolio has performed, discuss some aspects of managing the portfolio, and talk a bit more about the asset allocation.

Portfolio 2: Genesis

In this post, we look at the genesis of Portfolio 2. This may be of interest to those of you who are currently relying on an investment firm or broker to manage your investments, and who are interested in moving to a lower cost, more efficient solution.

Portfolio 2 (simple, moderately conservative): the fixed-income story

In this post we start digging into Portfolio 2 (from my post Some Real Portfolios). There are several interesting aspects to this portfolio, so I'll use more than one post to discuss the portfolio. In this post, we focus primarily on the fixed-income portion of the portfolio. This is likely to be of more interest to retired investors, or investors who are investing for shorter term goals (less than 10 years).

Portfolio 1: Simple, aggressive, global equity

In this post, we explore Portfolio 1 from my post, Some Real Portfolios. This portfolio is extremely simple, consisting of only two Vanguard index funds:

• 50% Total Stock Market Index (US stocks)
• 50% Total International Stock Index (non-US stocks)

We might call this as an aggressive, global equity (stock) portfolio because it is 100% invested in stocks (no bonds -- very aggressive), and has a relatively high allocation to international (non-US) stocks (hence, global).  First, let's consider the investor's willingness, ability and need to take risk, and see how this portfolio fits.

Risk Tolerance

Before I get into details of the portfolios presented in the previous post, it will be useful to discuss risk tolerance, since it's so fundamental to making investment decisions.

In his book, The Only Guide to a Winning Investment Strategy You'll Ever Need, Larry Swedroe breaks down risk tolerance into three components:

1. The willingness to take risk
2. The ability to take risk
3. The need to take risk

Some Real Portfolios

I thought it might be helpful to discuss some real portfolios that I've been involved in developing. I'll start with the simplest portfolios, and then move to the more complex. The idea is to expose you to a variety of asset allocations, each having been designed based on the willingness, ability and need of the investor to take risk, along with ability and willingness to handle portfolio complexity.

What Do You Want to Learn More About?

I'm often thinking about different investing topics I'd like to write about, but want to write something that is most likely to benefit someone (which of course means someone has to at least read it!).  Here are some topics I've been thinking about:

Time, Inflation, and Uncertainty

This article discusses a little of the theory behind why investors expect to make money on investments, and why they expect to make more money on some investments than others.  This post is a bit more theoretical than most so far.

Tax Reporting Basics for Taxable and Tax Privileged Accounts

As an investor, you should understand the difference between your taxable and tax privileged accounts with respect to tax reporting.  I've noticed that novice investors sometimes get confused about this, especially when they have both taxable and tax privileged accounts at the same financial institution (e.g., Vanguard, Fidelity, Schwab, etc.).  For example, they may hold the same mutual fund in both a tax privileged and taxable account, and they wonder why they got a 1099 tax form for one and not the other.  This article doesn't get into details about tax reporting for earnings from taxable accounts, but just tries to distinguish between tax reporting for taxable and tax privileged accounts at a high level.

Financial News: Worse than Useless!

I first thought I'd title this article Financial News: For Entertainment Only, but then as I thought more about it, I concluded that for most investors, watching or listening to financial news is probably not that entertaining, and more likely is detrimental to their investment success.  If the news is pessimistic, it probably will cause you to worry about your investments, and worst of all, change your rational investment strategy.  If the news is optimistic, it may cause you to be somewhat greedy, and again, change your rational investment strategy (in a different way of course).  As Warren Buffet said, as an investor, you're better off being fearful when others are greedy and greedy when others are fearful; here's the exact quote from his 2004 letter to stockholders: "Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful."

Stocks, Bonds, Markets

This article is a primer on stocks, bonds and their respective markets.  It's not necessary to understand all of this material to be a successful investor; this is intended for people who are interested in building up their knowledge of the fundamentals of investing.

Dow, S&P 500, Nasdaq

If you read or listen to financial news, you can't avoid hearing how many points the Dow gained or lost today.  You also may hear how many points the S&P 500 and Nasdaq gained or lost.  For a number of reasons, you should ignore these reports entirely (I do), and I'll explain why if you continue reading.

IRAs: Traditional vs. Roth, Part 2

I'm always trying to learn more about investing, and although much of what I read covers material I already know and understand, sometimes I run across information that increases my understanding significantly.  I recently ran across a couple of articles on IRAs on moneychimp.com (mentioned in my last post on useful investing websites) that increased my understanding of the tradeoffs between traditional and Roth IRAs.  Based on what I read, I started working on a spreadsheet to further deepen my ability to analyze the tradeoffs.  Based on this work, I revised and added to my original post on IRAs: Traditional vs. Roth (December 16, 2009).  For those who may have already read it, I'm repeating the main additions to that post here, in case you don't want to reread the original article.  I'll also include some examples to demonstrate the tradeoffs.

Useful Financial/Investing Websites

I just ran across an interesting financial/investing website, and thought I'd use a blog entry to list various sites like this that you may want to visit.  I'll update this entry as I run across other sites of interest.

UPDATE:  Rather than updating this blog entry with new sites, I've added sections with links to investing blogs and web sites I like.  See the navigation bar to the right, under the blog archives.

Asset Allocation: Part 2

Introduction

In Asset Allocation: Part 1, I discussed some of the thinking behind diversifying your portfolio among stocks, bonds and cash.  You can accomplish this quite simply with 2 or 3 low cost index mutual funds, and some highly respected financial authors and researchers recommend keeping it simple, and doing exactly this.  However, other highly respected financial advisors/authors/researchers recommend splitting your portfolio into more asset classes, and cite research that demonstrates that this has often (but not always) provided higher return with lower risk over the long run.  This is what I'll be discussing in this post.