The Decade From Hell For Investors?!

Time Magazine has called it the "decade from hell". CNBC recently ran a one hour special entitled The Bubble Decade detailing ten years of boom and bust cyles. Politicians have foreshadowed apocolyptic financial doom around every corner. Has it really been that bad of a decade for investors? I would argue no if you are a long term buy and hold investor that invests primarily in low cost index funds, and apparantly I am not alone. Forbes recently published an article by Richard A. Ferri detailing the relatively solid decade most disciplined long term investors had.

We all agree that US stocks were not a fun ride, but that is not the most important question. Rather the questions to ask are these: How did you perform over the past decade, and how did a diversified portfolio of index funds perform over the same period?

Index fund investors who remained disciplined and stuck to a simple strategy of diversification and rebalancing fared pretty well.

Ferri goes on to give actual 10 year annualized returns for a few different asset allocations. Mostly broken up by percentage of stocks and bonds. All of his examples acheived at least a 3.1% return. Not great? Well that may be true but he makes a good point.

All the portfolios outperformed the CPI, and that means all portfolios made money in real terms. Since this is true, was the first decade of this millennium really an investor's hell? Not as I see it. Yes the volatility was unnerving at times. Yes, the performance of US stocks was well below its historic average. However, a diversified and disciplined index investor weathered the past decade just fine.

I would go a step further in that we do not know what the future holds. What if the next decade sees a great rise in the annualized return of the market. Then the disciplined investor who continued to invest in index funds throughout the "decade from hell" was actually not experiencing hell at all....they were merely buying on sale! Although this decade was undoubtedly hard on some who were approaching retirement or needed a large portion of their savings, the reality is the majority of people out that not only have an investing time horizon that is long enough to recover, they may actually thrive. I would also be interested to see what the alternative to the disciplined investor looked like in the past decade. What was the 10 year annualized return for the guy who listened to the 'experts', the guy who took the stock tip from his neighbor, the woman who paid hefty commissions and fees for someone to manage their money? How did they fair? My guess is much, much worse....

Money Tips - Asset Allocation Continued

Last Money Tips post we spoke about Asset Allocation. It was more of a crash course on what asset allocation is, and it gave very general ideas on what to consider when creating your strategy. This post I am including my current asset allocation strategy for my Roth IRA, some other concepts to be aware of, and some examples of what I do to ensure that I am carrying out my strategy. Above you see a pie chart detailing my ideal asset allocation for my Roth IRA. I currently have all my investment holdings in funds from USAA and Vanguard. Both are renowned for their low expense ratios, customer service, and ease of use and I can attest that their reputations are well earned. As I touched on a bit in my other asset allocation post, I have a few different asset classes represented in my portfolio. I have mutual funds made up of stocks, bonds, real estate, and precious metals and minerals. Typically, these different asset classes are not heavily correlated, but in times like these it seems that way! Within those classes I have large, mid, and small cap holdings, foreign and domestic holdings, and every sector from financials to technology. What am I trying to illustrate here? Diversification and lack of correlation as to limit variation and lock in gains.

Here is my basic justification for what I am trying to do. I have 5% in my income fund which is a bond fund. I did this because bonds typically aren't correlated heavily with stocks and they are less volatile with regard to their returns. With lower risk comes lower returns and the bond fund is no exception, although many are predicting that the near future could be a great time for bonds. Since I am young and far away from cashing out my retirement fund I have a small percentage of bonds in my portfolio opting instead to take stocks that, although are more variable in their returns, provide a higher historical rate of return. 70% of my holdings are funds that are made up primarily of stocks. As we become more intertwined in the global marketplace I think more and more growth opportunities are going to be available overseas. For this reason, I probably have more of my portfolio than most people invested in foreign securities. I figure with a long term time horizon this is a safe play as well. I am also probably exposed more than most people to small caps and technology assets. This also goes back to time horizon and my ability to tolerate risk and accept short term losses. The largest fund in my portfolio is the S&P 500 fund. This fund is represented by the largest 500 publicly traded companies, and it serves as a very good indicator of how the economy as a whole is performing. If you think investing is too hard or you don't know where to begin, invest in an index fund like the S&P 500 or a total market index fund and you will likely be ahead of many people who try to outperform the market through buying and selling. I make this a large portion of my portfolio because it represents the market as a whole and traditionally it is a good diversified fund of large cap stocks. The rest of my portfolio is made up of a REIT fund and a valuable metals and minerals fund. I chose a REIT a while back because it is not normally heavily correlated with stocks (except in our current crisis when real estate caused the crisis), REITS are required by law to pay 90% of their income back to shareholders, and REITs are a low cost option to diversify into the world of real estate. REITs are also great to put into a Roth IRA (taxed on the way in, not on the way out) because the income returned and reinvested by the shareholders into the fund dodges what would be taxable income. The metals and minerals fund serves as a diversification fund that is not heavily correlated with my other holdings, and also serves as an inflationary hedge.

My portfolio is far from perfect and I would love to hear some comments on your recommendations. However it is a strategy that I created on my own that I follow and enjoy working with. And as I have said before, my returns are currently beating all the major indexes in the current economy so I am doing better than I would have by putting it all in the S&P and probably better than I would have turning my money over to an actively managed account with a broker. Some concerns that I have about my portfolio are that my funds have overlap. Some of my Emerging Markets holdings may be represented in my International fund or one of the other funds. I am sure the same holds true in most of my funds. This skews my actual percentages and naturally diminishes some of the diversification I am attempting to achieve. I also replicate some of my Roth funds in my non retirement holdings which alters my overall exposure to a certain asset class, segment, fund, or holding. I could probably track down funds with higher historical performance as well. However, all things considered with the time I put in I am fairly content with the strategy I have.
The chart above shows where my actual holdings are. They are off my ideal asset allocation based on a few factors. First reason is the gains and losses (mostly losses) over time. It also stems from adding new funds, and not investing up to the ideal amount based on IRA limits or lack of money. And finally it can become unbalanced due to a change in strategy. So what do we do about it? We can re-balance! Re-balancing is key to buying more when prices are low and less when prices are high alongside with another concept know as dollar cost averaging. Re-balancing is just what it sounds like. You are adjusting the amounts you have in each fund to return them to their ideal percentages. You can do this by shifting money from fund to fund, or by adding more to the lacking funds. Obviously you don't want to remove money from your retirement investments. As you can see, my REIT and Metals funds are the ones that are drastically lower than their ideal percentage. I like to look for the ones that are lower instead of ones that are over their ideal percentage because it forces me to add more money instead of just shifting money around. It makes the math a little more difficult but I just play with it in excel based on how much money I have to invest until I get close. Some people recommend re-balancing every quarter. I must admit that I typically do it around the end of the year or tax time as I am either putting last minute funds in to max out my contribution for the year, or I am putting money that I got back from my taxes into my next year's contribution (not a good habit as I should figure out my W-4 withholding and make that money work for me all year). The re-balancing shows you which funds have performed well since your last re-balance and which funds have not. When you buy more of the ones that have not to bring them to their ideal percentage you are buying when the fund is cheap. By buying less or none of the funds that are over their ideal percentage you are avoiding funds that are priced higher.

The other way to effectively buy low is through dollar cost averaging. Dollar cost averaging refers to investing the same amount each selected time period no matter how the market is performing. So if you invest $50 per month in each fund you will be buying fewer shares the higher priced they are and you will be buying more shares of the lesser priced funds. This is an excellent way to avoid timing the market while mindlessly, intelligently investing. I must say that I have not been dollar cost averaging as of late as I have been striving to reach another financial goal which requires more liquid assets. In this market I am actually making more on my money market anyway, but as a contrarian I want to take advantage of the sale the bear market has created. I have almost reached my cash equivalents goal and plan to start my dollar cost averaging habit again for my other investments.
The chart above shows what I described above. As you can see I added money to my REIT and Metals fund in order to get my percentages closer to the ideal state. I am expecting some money back from Uncle Sugar in taxes (again a bad habit I plan on breaking) and I will likely max out my Roth contribution for the year which is set at $5,000. I am sure if you Google asset allocation you can find a wealth of information out there, some good some bad and some that probably doesn't fully match all that I have told you. My advice as always is find what works for you. Is my method the most efficient and highest earning strategy in the world? Highly unlikely. But I am maxing out my Roth and learning a bit along the way and that is what truly matters. Like I said before please leave comments on my portfolio or request feedback on your own portfolio and start investing!

Money Tips - Asset Allocation

Welcome to another post in the series known as Money Tips. So far we have addressed that being rich is a mentality and keeping more than you spend, that you must have a budget to know where you are, and that you must have goals and a strategy to get to where you want to be. All that is great but what exactly do I do? Well the next step is to design an asset allocation that will allow you to most effectively reach your goals.

What is asset allocation? Asset allocation is exactly what it sounds like. It is determining how you are going to apportion your invested capital to manage risk and realize gains. Think pizza. You can get all pepperoni, or half pepperoni half sausage. How are you going to cut your investment pie? Asset allocation is merely exercising the age old adage of not putting all your eggs in one basket. The concept is the same.

As I have said before, your asset allocation should be based on your financial goals and where you are at in achieving those goals. For that reason I am not going to go too far into depth on what the appropriate percentages of various investment vehicles and/or asset classes are, although feel free to contact me if you want some free advice. Instead I am going to cover some simple, yet key concepts of what to consider when determining your asset allocation.

Risk - How much risk are you willing to take? Only you can answer this question. However, here are some things you might want to consider. First off, what are you investing this capital for? For instance if you are investing in a Roth IRA for your retirement, your risk tolerance may be lower than the risk you are willing to bear for the extra money you got back at tax season that you want to play with. Another thing you should consider is how quickly you need access to the capital. Someone who is close to retiring will be much less willing to incur risk than a 20 something saving for their retirement. Lastly you need to do a little gut check. How conducive is your personality and overall demeanor to dealing with risk? The goal is to keep putting money in, not panicking and constantly buying and selling.

Reward - What kind of return do you need to realize in order to achieve your financial goals? How long do you have to achieve those goals? Different asset classifications have different historical returns. Below is a chart showing some historical returns of various asset classes. The numbers may be a bit different from other sources due to different time periods and assumptions but the overall disparity between the classes is fairly indicative of most statistics.


Now that you have analyzed your goals and current situation you should have a decent idea of what type of risk/reward trade off you are willing to accept. Let's use my retirement portfolio as an example for some other things you should be thinking about. So I am 26 years old. Lets assume that I want more than a million dollars in my retirement by the time I am 65 (here is a retirement calculator you can play with that may help you determine how much return you need, how much you need to save, etc. to reach your goals). I know that I am fairly tolerant of risk and I have a long investment horizon to reach my goals. Why don't I just invest all in small cap US stocks? The answer is volatility. Although small cap US stocks may have a 12% return over a period of years it may have a -40% (probably this year!) in any given year. So what, isn't that just part of the risk you accept in the market? Yes, but what if half of your portfolio lost 40% and the other half was an asset class that gained 40%? You would be even. Or better yet what if the other half of your holdings gained 50%? You get the idea. This concept is called correlation. How correlated are the historical performances of your holdings? The goal is to reduce variation of return by diversifying your holdings to achieve a constant, steady, and most importantly greater return than if you did not diversify your assets. So in my case I know that I want to achieve the most return possible for a long term timeline. I will not be concerned with the day to day activities of the market, yet I want to be diversified enough so that a scenario much like the current market doesn't destroy me. Don't get me wrong, the current state of the economy has done some major damage to most people's portfolios including mine, however Mint.com is showing that my current asset allocation is outperforming the NASDAQ, S&P 500 and the Dow. The moral of the story is that it could be worse!

So my asset allocation will be distributed mostly amongst equities, a small portion of bonds, REIT's, and Precious Metals and Minerals funds. Within my equities I am diversified between foreign and domestic, as well as small, mid, and large cap stocks. I am trying to not get too in depth or too technical, because I am not writing a book here and there are plenty out there that do a better job than I do of explaining and recommending asset allocation models. The point is that you should be diversified appropriately based on your goals, risk/reward tolerance, and your timeline.

Here is an example of what an older person's asset allocation may look like. Since they have a much shorter time frame to retirement their goals and risk/reward tolerance will be much different than mine. And therefore their asset allocation looks much different as well. This person is likely concerned with preserving the capital they have while protecting it from inflation. Hence, the larger concentration of bonds and cash equivalents. The current state of the economy surely gave a rude awakening to many baby boomers on the lessons of asset allocation, as many of them who had large portions of their portfolio in stocks have lost significant amounts of their retirement.

Hopefully this post has served as a guide to know what you don't know. It is far from all encompassing but hopefully it gets the gears turning. If some of this is new to you don't feel bad, feel empowered and start educating yourself on the topic. I recommend reading "A Random Walk Down Wall Street" and "The Art of Portfolio Investing and Management: A Proven 6-Step Process to Meet Your Financial Goals" both of which are on my bookshelf on this blog. Once I re balance my Roth IRA and make my asset allocation excel sheet look pretty again I will post more in depth analysis of my portfolio. I would love to open up discussion and get tips from others as well. Keep checking in for more Money Tips posts, and if you are interested in writing a guest blog for my Guest Bloggage installment write me a comment or email me.