A Game of Odds

There are no guarantees with investing.  Well, I guess I can almost say there are guarantees with federal bonds, but that’s about it.  FDIC insured CD’s, too.  That’s about as close as you can get.

With anything else, the value can rise and fall sometimes, drastically.  No one…no one…knows the future.

I think this is something that is hard for a lot of people to grasp. Because Fund X has earning 11% the past 5 years, it very well may not this year.

For example, you’ll often see the disclaimer “Past performance is not a guarantee of future performance.”  That’s absolutely true.  It is always true.  Any particular investment can lose money.  Any index can lose money.  Any method or technique can lose money.

We are used to a lot of things that are more cut and dried.  When you go to a store, you pay a particular price, and you get a particular thing.  Investments aren’t the same way.  No one can see the future and so no one really knows what’s going to happen and how investments will perform.

I remember at one of my first companies, many of us started around the same time and started in to the 401k at the same time.  And it was a bad year, I believe one of the more aggressive stock funds lost 30%.  People were asking, “Why are we doing this?”  Unfortunately, I suspect some learned the wrong lesson, and stopped investing, or invested in overly conservative assets.

I remember a radio station that had a report on the stock market for the day and cynically called it “The Legalized Gambling Report.”  That’s too bad.  It sets a really negative expectation.  Investing and gambling are not the same.  With gambling, on average, over time, you lose.  With investing, on average, you win.  You don’t win every time.  And in some circumstances, you could lose repeatedly.  But it’s pretty unlikely, if you’re diversified and stick with it.

Be careful not to judge the concept of investing by single instances that went well or poorly.  Some investments won’t do well in the short term.

So we want to think somewhere in the middle here.  It is important to take some risk, buying stock funds, because over the long run, stock funds get the best return.  But is important to diversity to balance the risk, both by having a broad stock index, and balancing with bonds, which have lower return but less risk.

Being too conservative, and buying all bonds, CD’s and such, feels safer, but in the longer run has a much lower return, and most likely we’ll end up behind.

Being too aggressive, buying all stocks, perhaps even “hot” stocks, is risky.  You may do well with some.  But there is a substantial possibility that you’ll lose a lot of money, perhaps very quickly.

What we’re looking for is improving our odds of having a decent return, but also lower the odds of losing money.



Here’s an investment choice you’ve likely never heard of.  Why?  Because no one can sell them to you.  No one has a reason to advertise them to you.  It is between you and the federal government on this one.

And, they’re “boring.”  Not going to get instantly wealthy over these guys.  You’re not going to watch a ticker during your work day and speed your heart up.  But they are a compelling piece to have in your portfolio.

I-Bonds are a flavor of US Savings Bonds.  It is debt.  You are loaning the federal government money.

Here’s some attributes of I-Bonds:

  • They are inflation adjusted.  Inflation goes up, you get a higher return, which helps you contain some inflation risk.
  • I-Bonds have a fixed and variable component.  The fixed part is determined when you buy the bond, and they vary for different 6 month periods they are sold.  The variable part is determine from the CPI (Consumer Price Index), a measure of inflation.  Something to note is that the fixed rate is not an absolute.  If the CPI indicates negative inflation, that is subtracted from the fixed rate.  The good news is it can never go below zero, so once you earn money, you can’t lose it.
  • They are backed by the full faith and credit of the US government.  If that’s a concern for you, maybe gold would be a better investment for you.  (I’m being a little sarcastic…in my opinion, gold is a rock that doesn’t create additional value.  As you will!)
  • They do not float in the market and so cannot lose value.  It’s been you and the government.  When you’re ready to sell, they cash you out.  There is no middle man.
  • You can buy a maximum of $10,000 per year.
  • You cannot withdraw the first year.
  • If you need to withdraw your month between 1-5 years, you lose 3 months interest.
  • Tax deferred.  You can also avoid federal tax altogether if the proceeds are used to pay for higher education.
  • They stop accruing interest after 30 years
  • You can only buy and sell electronically through the TreasuryDirect® website.  Your account can be linked to your checking account.
  • Compounded semi-annually.
  • They are tax deductible if the proceeds are used for education.
  • There are no costs.  There is not up front transaction fee, there is no expense ratio.

Having said all that, the interest rate has not usually been real high.  But they are very close to no risk at all, and do make income.  They are very safe.  They are tax deferred.

Being tax deferred, they are a viable instrument if you’ve maxed out 401k’s, Roth’s, and IRA’s (lucky you!) and are looking for another vehicle to put money in to.

I-Bonds are worth a look as a portion of the bond portion of your portfolio.  They are a unique investment that you are unlikely to hear much about.

Front Loads. Just say no.

While writing the last blog, I realized I wanted to follow on and briefly discuss Front Load fees.

I hadn’t thought about front load fees for a long time.  This is something that I thought had largely disappeared decades ago.  But I ran across some articles that were talking about a well-known financial commentator who uses a network of “advisors” that push mutual funds with front load fees.

I really don’t see a justification to get such funds.  I actually think they are pretty rare these days.

A front load fee is taken out as soon as you invest.  And they are steep.  I believe 4% is common, and from what I read, they can be 7%.  So, you invest $100, they take $4, or $7 right off the top, before you get to earn anything.  It is a one time fee.

The cuts your investment off right off the bat.  You’re only making money on $96, not the $100 you put in, and it’s going to take some time to bring that back up.

If this was your only option, you might just have to put up with it.  But it absolutely is not.

I haven’t seen funds with front loads in a long time, so my guess is that this usually occurs when you are being sent to an advisor.  In the case I read about, the talk show host recommends you to a local advisor, who probably kicks back money to the talk show host for this privilege.  Then, the advisor steers you to these front load funds.  If you buy, this is a nice juicy profit for the advisor right off the top.  Doesn’t matter if the fund ever performs for you, they get their cut right now.

I think these funds are to be completely avoided.  No front load funds are so common that is hard to imagine some fund would perform so wonderfully that this could be justified.

Keeping Costs Low

It seems like spending 1% or even more, annually, for a mutual fund or ETF should be no big deal.  It’s only 1%.  In fact, isn’t this a “you pay for what you get” thing?  Wouldn’t you want to pay a little more for a team of “sharp young fellows” who are crack investors, and deliver a great return for you–an actively managed fund?

Well.  Okay.  If you really want to!

It matters more than it seems.

You need to know about “expense ratios”.  When you buy a fund, you may have a transaction fee.  But beyond that, there is an annual cost to operate a fund.  These companies don’t go out of their way to make this obvious.  You won’t get a statement that says “your fee was $50.”  It is more or less skimmed off the top fairly transparently.  But this information is disclosed publicly if you know to look for it.  If you read a prospectus, this is detailed there.

It takes some work on the part of humans and/or machines to run a fund.  Therefore, yes, there are some costs.  That’s fair, they have to keep the lights on.  The expense ratio is how much the fund company skims off the top to pay for costs and make some profit,.  They don’t do this for free.

Actively managed funds take a lot more work from humans, who like to have salaries, coffee, and such.  They spend a lot of time analyzing individual stocks (or bonds) to make good decisions about which ones the fund should own, when they should buy or sell them, and how much they should pay for them, or sell them for.

Passively managed index funds take much less work.  An external entity determines what stocks are in the index (usually).  The fund just tries to keep up with matching what’s in the index.  That still has some cost, but not nearly as much.

If you have had a few years where a fund makes 10%+, a 1% or more expense ratio may not seem like much.  But over the long haul, your average is probably going to be well under 10%.  Taking a full percentage, or worse, even more, cuts it down further.

What’s even worse is, the margin between your return and inflation is even smaller.  If you earn 7% on average, and inflation is at 3%, that’s only a 4% real return.  So a 1% expense ratio is cutting that off at the knees, knocking your return down 25%.  Compounded over the years, that is a whole lot less wealth for you.

One of the big “total US stock” funds, which hold the entire broad market, often have a razor-thin expense ratios like .04%. That’s pretty amazing.  You can own the whole market, with very little effort, and only pay .04% for that privilege.

More specialized asset classes, such as MicroCaps, perhaps junk bonds, are going to have a higher expense ratios, but you can find them for well under 1%.

A year ago I did the math on my expenses on my 401k at work.  How I did this was to take the balance of each fund and multiply it by the expense ratio.  I was shocked at how much money was being spent on them.  I was able to persuade my company to provide a bigger selection of low-cost index funds, and now I am nearly all in such funds.

You should always check your funds expense ratio’s.  A site like Morningstar will show you the expense ratio, as well as a lot of other information about the fund.  Here’s an example of Morningstar’s quote for VTI, Vanguard’s Total Market fund: VTI.  The expense ratio is .05%.

Checking for a low expense ratio is a very important component of low-cost index investing.

The Case For Index Funds

What is an index fund?  What’s the difference between active and passive funds?

An index fund mirrors the stocks in an index.  The best known index is the S&P 500.  It is a group of 500 of the largest stocks.

So an index fund holds the stocks that are contained that index, usually weighted by market cap–the total market value of that stock.  Index funds can also hold bonds, other investments.

The beauty?  The fund company doesn’t determine what that list (index) is.  They just have to maintain a balance of the stocks in the fund.  They don’t have to do any research to choose which stocks are in the fund.  They don’t have to impress you with which stocks they have in the fund.  They don’t sell losers at year-end, at a low price, just because they don’t want you to see the losers in their prospectus.  They do have to keep it balanced.  If a stock goes up, they’ll need to sell some so it maintains it’s percentage in the fund.  But I would expect quite a lot of this is automated.

Index funds are often called passive funds.  An active fund is one where a manager or team study the stocks and decide which ones are good to buy and sell, and when.  A passive fund takes much less of this work.

What do you think is an advantage of an index fund?  Cost.  Index funds generally have much lower expense ratios (we’ll get to more about expense ratios in a future article).  That’s more money you earned rather than giving to the fund company.

But actively managed funds must perform much better than index funds right?  They have all those sharp financial folks working hard to find the best stocks.  It doesn’t work out that way as often as you’d think, particularly over longer periods like 10 or more years.  I’m sure in many cases, the folks running those funds are really sharp.  But predicting what a stock, or the market, is going to do in the future is really hard.  You can’t really do it consistently.  If someone could, they’d be really rich   Some will do well compared to the index for a streak, but it is hard to do that consistently.

Between index funds matching the market’s return, avoiding the variability of active fund returns, and having lower fees, they are hard to beat.

These days there are quite a lot of different indexes, and index funds.   You can invest in many different asset classes (such as “US Large Cap” or “Foreign Bonds” or “Emerging Markets”).  You can be quite diversified and you can easily balance between these classes using such funds.

The individual funds themselves offer quite a lot of diversification.  For example a “total US stock” fund contains all listed US stocks.  That mitigates some risk for you.  If one stock goes down, or even goes bankrupt, that doesn’t matter that much overall.  Actively managed funds tend to have less diversity, although they are still pretty diversified, certainly quite diversified compared to holding individual stocks.

Here’s a thought from Warren Buffet about low-cost index funds:

“Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund (I suggest Vanguard’s). I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions, or individuals – who employ high-fee managers.”

– Rakesh Sharma, 3/24/2016.  Warren Buffett’s Love Letter to Index Funds.  Investopediahttp://www.investopedia.com/articles/investing/032416/warren-buffetts-love-letter-index-funds.asp

I’ll give a few more details about index funds, but it would be good if you do some research/reading to convince yourself.  I’ll put a few links at the end of the article.

It’s been said that index stock funds beat 70% of actively managed funds.  One article I came across says more like 80%.  It would depend on the time period measured, both which one and how long of a period.  How likely is it you’ll find one of those active funds that will beat the market going forward?  How likely that it will beat the market even after expenses?

A lot of the difference between active managers that beat the market, and those who don’t, is likely simply chance, probabilities.  If a manager or fund does really well for a few years, they look really good.  By what measures would you select an actively managed fund, with a high level of confidence you’ll beat the index?  If you don’t have a high confidence of that, might buying a fund following the index be a better bet?

The costs make a bigger difference than it would seem.

“The average cost of an actively managed fund is more than [1 percent], said Fran Kinniry, principal and head of portfolio construction at Vanguard. “What that means is that active management needs to outperform the market by at least that much to outperform at all.”


But no big deal, right?  It’s just 1%.  If your fund makes, say, 12% a year, who cares, right?

Let’s do the math.  For the first scenario, we’ll assume you get a 12% annual return (that’s dreaming, but we’ll discuss that later).  For our index fund, we’ll use a .04% expense ratio.  That’s realistic for a broad stock index fund.  And 1% for the actively managed fund.  We start with $10,000 and go for thirty years.  Note that this is a one time investment; no additional investments.

After 30 years, we have $296,405.80 in the index fund, $228,922.97.  The index fund is worth nearly 30% more.  12% is unrealistic, but I find with different growth rates, the difference in the resulting amount is pretty similar percentage wise.

I’m feeling like at this point I should mention this: you are not going to get a flat 12% annual return every year.  First because 12% would be an awfully good return.  On average, you might get 7-8% annually.  You may do a little better.  But more to the point, your returns are going to be variable.  You may get 30% one year, but you may get -30% another year.  You will lose money some years.  But over the years, on average, you should be able to get a decent return.

Part of the goal is to make you feel confident enough with the method you use so that you’ll stick with it in the bad years.  It is very, very easy to freak out when the market is down, give up and sell…right at the worst time…locking in your losses.

To summarize: why use index funds?:

  • Lower costs (but always check that for the individual fund)
  • Comes close to meeting the return of the index, which often outperforms comparable actively managed funds
  • Fantastic diversification
  • Easy to have a particular asset class
  • Simple rebalancing
  • Less research on your part

Some other resources relating to index funds:

Ilana Polyak, 10/4/2016.  Passive investing is on a tear, and for very good reason.  CNBC.  http://www.cnbc.com/2016/10/04/passive-investing-is-on-a-tear-and-for-very-good-reason.html

Ferri, Rick, 10/13/2011.  Buy, Hold, and Rebalance Works.  MorningStar. http://www.morningstar.com/cover/videocenter.aspx?id=397752

Christopher B. Philips, CFA; Francis M. Kinniry Jr., CFA; David J. Walker, CFA; Todd Schlanger, CFA; Joshua M. Hirt.  The Case for Passive Investing.  Vanguard.   https://personal.vanguard.com/pdf/s296.pdf

This Isn’t That Much Fun

Do you think investing is boring?  GOOD!  You’re probably doing something right…assuming you’re doing something.

Investing isn’t supposed to be, and doesn’t need to be, fun.  That’s not the purpose.  I’d even argue that if it is fun for you, you’re going to spend too much time dwelling on it and mess it up.

I think I’ve been there. In my various periods of different techniques, I’ve enjoyed it.  I think trading stock options, for me, was particularly fun.  It is somewhat mathematically challenging.  And there is the potential for relatively big, quick gains is there, although it’s not terribly likely.  This is probably a topic for another article, but I really think with stock options, it’s easy to get overly excited about your successes and not realize that overall, you’re losing.  Unless you really measure.

The goal of investing is to build wealth for you and your family, with a reasonable amount of safety, over the long haul.

The industry wants to make this exciting.  They want you engaged.  They want you to watch tickers, pore over the scary or thrilling news every day.  They want you to believe that you have to do something complicated.  They want you to discuss things at cocktail parties, get new ideas, and sell your old stocks and get new ones.  They want you to trade as often as possible, because they want that commission revenue.  That’s how they make their money: when you trade often.  Even better: hire someone to do this for you.  They really like that!

I once heard on a radio show that unclaimed funds that were held by people who have passed away and no one’s found an heir for the account, typically perform very well.  Because no one is trading.  It’s left alone to grow.  Costs are very low because there’s no transaction fee’s, and taxes are minimized.  Also, there’s no problem with selling low.

If you’re looking for a style of investing that is fun, exciting, and intellectually stimulating, low cost index investing is probably not it.  You should care!  You can, for the most part, set it up and not think about it most of the time, and spend your time doing something useful.  A once a year balance is probably pretty adequate, as well as making sure you continue to contribute adequate amounts to your 401k for example.

On the other hand, don’t let the fact that it’s boring prevent you from moving forward and investing.  You owe it to yourself and your family to store away some nuts for winter.

Chevreau, Jonathan. 6/28/2011.  Investing is boring: If you want excitement, go to Vegas.  Financial Posthttp://www.nationalpost.com/Investing+boring+want+excitement+Vegas/5017520/story.html

Gordon, Whitson.  6/28/15.  “Good Investing Is Usually Quite Boring.”  Lifehackerhttps://lifehacker.com/good-investing-is-usually-quite-boring-1714188969



Now that we have the concept of having at least two low cost, diversified funds in our portfolio (from the previous article, Jumping Right In), the next concept is rebalancing.

Rebalancing is simply the idea that periodically, we bring the portion of our funds back to the balance we initially intended.

Let’s say you start with 30% bonds, 70% stocks.  Over the year, stocks do really well.  Bonds plod along like they do.  So now bonds are at 27% of your portfolio, stocks are 73%.

So you sell that 3% of the stocks, and buy bonds, bringing the balance back to 30%/70%.

Why do you do this?  For one, you decided 30%/70% is a good balance for you.  So in the long run, that’s your target.  It’s not good to let the balance slip too far.

Another benefit here is that you are inherently doing some selling high, and buy low.  Your stocks took off a bit, getting up to 73%.  So you’re taking a little profit there.  Bonds lagged a bit, so now you’re buying a little more at a good price.

Here’s another scenario.  Stocks plummet.  Your allocation is 45%/55%.  Stocks are cheap.  Rebalancing causes you to buy those stocks while they’re cheap..and you have funds available in your bond portion, ready to go.

Sticking to the method introduces some discipline to your portfolio.  Often, one a stock or fund is going up, it’s psychologically hard to sell it.  It’s doing so well, why would you want to sell it?  And that’s a trap, because eventually it’s going to head back down.  It’s easy to get too attached to your winners (less so with a fund than a stock, though).  This helps you methodically take some money off the table and put it somewhere where you’re more likely to get a better return.

The flipside is, when an asset class drops severely, like in 2008, it is really difficult to convince yourself to buy.  It feels like the world is crumbling, and seems crazy to buy something dropping.  But it’s the best time to buy.  Sticking to a rebalancing plan helps you do that.

Many things I’ve read say to do this annually.  Leave it alone the rest of the year.  Don’t mess with it; allow it to work.  Even ignore your portfolio entirely.  When you rebalance, depending on the type of account and funds, you may incur some costs.  You could have transaction fees.  Possibly even some taxes if this is in a taxable account.  Rebalancing more frequently will raise these costs, so doing it less frequently has some benefits.  Sometimes rebalancing when you have mutual funds has no added cost.

If you really can’t stand it, you could probably rebalance quarterly, but it’s not clear there’s really a lot of benefit to doing that.

If your portfolio is spread across multiple accounts, things get a little trickier.  You likely have a retirement account like a 401k or SEP.  But you may also have a Roth account, a rollover IRA from a previous employer’s 401k, or a taxable brokerage account.  You should rebalance the whole of these, not individually.  The goal is to have 30%/70% (for example) across the whole portfolio.

This can get a little more complicated with a 401k because often 401k’s have limited choices, especially when trying to get low cost index funds.  You may have to focus on the types of assets you can get in the 401k, then fill in other class in other accounts.

If your funds are only in a 401k, some 401k’s have a nice feature for rebalancing.  You can put it on autopilot.  You choose the allocation you want, and annually, it rebalances for you.  This could be a good option for some people.

Another possibility is to rebalance when an asset type is off your target by a given percentage.  Maybe you go with 5%.  So if your goal is 70% and it hits 75%, you go ahead and rebalance.  That takes more monitoring.

Rebalancing is an important strategy for your portfolio.  If you do it annually, which is not unreasonable, it takes very little time.



Jumping Right In

Let’s jump right to the point.  The way I’ve chosen to invest is by using low cost index funds (either ETFs or Mutual Funds), and rebalancing them periodically, in my case, annually.

What is a fund?  A fund is a basket of stocks or bonds, possibly other investing vehicles.  You buy the fund and the fund management company manages what investments are in that fund.

At its simplest, you could have only two funds: one in stocks, one in bonds.  Both should be very diversified.  The stock fund should be an S&P 500 index fund, or a “Total US market.”  I actually prefer the total market funds to S&P.  They diversify into more of the different “sized” stocks, like small- and mid- cap companies.  The S&P 500 is all large cap stocks, the big ones.

It’s amazing when you think about it.  In one transaction you can buy a piece of the entire US stock market, at very low cost, and with very little effort on your part.

The bond fund should be a similar broad index of US bonds.  I admit it: I’ve never been crazy about bonds.  They seem boring.  And it’s true, they aren’t going to have the long term return that stocks do.  But they also don’t have the risks that stocks do.  That is not to say there is no risk with bonds, but they tend to not swing as wildly as stocks can.

Stocks and bonds tend to be non-correlated, also.  That means, when stocks go up, bonds go down, and vice versa.  It’s not always the case, but over time, this non-correlation smooths out your overall portfolio valuation, and dampens risk.

You’ll need to determine what % of your portfolio you want in stocks, and in bonds.  This, again, gets pretty personal.  It depends a lot on your own risk tolerance and your age.

As you get older, especially getting close to retirement age, less volatility in your portfolio becomes important.  You don’t want your portfolio slashed just before you retire.  That would not be a fun way to start things out.  In fact, it could mean you need to change your plans, working longer.

Risk tolerance is also important here.  Are you going to be able to stand it when the stock market drops precipitously?  Or are you going to panic and sell at a low price?  If it’s the latter, it may be better to have a higher percentage in bonds.

From what I’ve read, even the youngest, most risk tolerant investors should have at least 10% in bonds.  I didn’t believe this just a few years ago.  There is a concept called the “efficient frontier”.  Somewhere between 10-25% in bonds is a sweet spot because it lowers risks without lowering expected long term returns all that much.  By filling in the valleys of market dips somewhat, your losses are more controlled than they would be with a pure stock portfolio.

The BogleHeads site has a great example of a super simple 2 fund portfolio:

2 Fund Portfolio

This page shows 40% in bonds.  That’s a little higher than I prefer at my age.  I’m at about 30% now.  I still want a bit more return and am willing to accept the risk.  We’ll see if I hold true to that the next time the market has a downturn.

A two fund portfolio is about as simple as this stuff gets.  You really don’t need to do much at all.  If you’re really not interested in investing, not really interested in reading much about it, this could be a good way to go.

However, you likely could get some long term benefits from adding more asset classes.  That is, adding more funds that contain other asset classes.

You’ll need to rebalance the portfolio periodically, perhaps annually.  That will be the topic of the next post.

It’s Personal

Investing is so personal.  Over the years I’ve meandered around with different philosophies and techniques.  When all is said and done I’ve landed on a way of doing things that is simple and takes little time.  The thing is, it may be hard to convince yourself that it’s that simple if you don’t have some background.

There are a lot of pitfalls with investing.  The industry does a lot of things that sound good but often aren’t in your interest, but make them money.  Even if it’s as simple as getting you to think you need to trade more often–they get commissions.  Or buy special advice, newsletters, even have a broker or advisor manage things for you.  Cable channels will convince you you need to watch the market daily, even hourly.  They drive you to fear then euphoria and back.  Buy!  Sell!  Maybe you even need a watch that tells you when quotes change when you’re at lunch?  Maybe you need to be able to trade from your cell phone?

There can be casual advice from friends that isn’t necessarily helpful.  It’s really easy to think there’s some special way of doing things, some secret that will work for you.  Or question what you’re doing.  It’s easy to create self doubt.

There’s so much noise.  But ultimately it’s so personal.  Ultimately, you are responsible for your financial life, and you are responsible to make good choices about it.

But it’s important that you invest, and that you do it right.  Right isn’t about making the maximum amount of money possible.  It’s about giving yourself good odds of getting a reasonable return without taking excess risk.

You owe it to yourself to do a good job of having your money work for you.