Drilling Down Into Your Portfolio Allocation-Part 2

Jun 18 2015

Part 1 was about mutual funds that invest in stocks. Now we switch to bonds.

The most familiar styles of Bond funds are short, medium and long. Similar to stock funds being small, medium and large-size companies, the standard bond fund strategy is to build a portfolio based on the length of the bonds maturity dates; short-term, mid-term and long-term maturities.

The maturity date is when a bond matures and pays you back its face value. Between the time you buy the bond and it matures, the bond typically pays an interest rate. I just described individual bonds but you are buying a bond mutual fund which will have thousands of individual bonds. Generally a short-term bond fund buys bonds with maturities 5 years or less. Mid-term is 5 to 10 years. Long-term is more than 10 years.

The maturity time matters because usually the longer the maturity the higher the interest rate. Well then you ask, “Why have short-term bonds?” Glad you asked…

Let’s say you buy an individual bond for $1000 and it pays 5% interest per year. As long as the country’s interest rates stay the same you have a bond valued at $1000 paying 5% a year. But suppose the nation’s interest rates change to 6%. Who would want your 5% bond if I can buy a new 6% bond? If you wanted to sell your 5% bond before maturity, to make it appealing to a buyer, you would have to decrease the price of your bond. The opposite is also true. If interest rates slipped to 4%, your 5% bond would be worth more if you wanted to sell.

The longer the maturities on your bonds, the more interest rate changes impact the bonds’ prices. Basically because you’re holding a bond longer with a positive or negative value. So managing the maturities on your bond funds can help control the impact of changing bond prices.

If you are looking for account value stability, a shorter term bond fund might be best. If bond fund value fluctuation isn’t a problem for you, you might choose to go with longer maturities for higher interest rate payments.

Another critical aspect of a bond’s value is its quality. Within the short-, mid-, long-terms is whether the bond is of high quality or low quality. Quality is determined by the organization that issues the bond. If the financial fundamentals of the organization are good, the bond’s quality is high. Financially unstable organizations issue lower quality bonds. The lower the quality, the higher the bond’s interest rate. This is because as the buyer you assume more risk. The risk being that you could lose your money if the organization defaults on its financial obligations.

The common terms to indicate quality are “investment grade” and “high-yield” or “junk” bonds. Another quality indicator is the bond’s quality rating. “AAA” is the highest quality and it goes down: AA, A, BBB, BB, B, CCC, you get it. BBB and up is considered investment grade.

There are also “insured” bonds which mean the organization insured the bonds to guarantee their safety and quality. Insured bonds are rated as high quality.

The type of organization that issues the bonds is another style category. Bonds are issued by corporations, governments at all levels, mortgage companies, and investment firms. Bonds issued by state, county and local governments can provide tax-free interest income.

There are special bonds issued by the federal government that offer protection against inflation.

And of course you can buy foreign bonds.

Put them all together and what do you have? You can buy a corporate, intermediate, investment grade bond fund. Or an insured short-term municipal bond from a specific state.

Each investment you own whether bonds or stocks is built and managed to meet a specific objective. You cannot choose any mutual fund until you have defined your objective. Here are some considerations to help define your objectives:

  • Long-term investment horizon
  • Short-term savings horizon
  • Liquidity
  • Safety
  • Interest payments
  • Capital gain and appreciation
  • Regular deposits
  • No regular deposits
  • Emergency funds
  • Retirement
  • Saving for a home, car, furniture, etc.
  • Consistent returns
  • Best long-term returns

What are you shooting for? You see by defining your objectives it helps you decide which investment is best suited to meet the objective. Never make your investment selections based on media, marketing, family-friends, or because you have a feeling about it.

As the saying goes, “People don’t plan to fail; they just fail to plan.” Define your objectives, develop a strategy to achieve the objectives, select the proper investments to complete the strategy and achieve the objectives.

Learn more about these processes from these MOAA articles:



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Rising Interest Rates and Your Bonds

Jun 15 2015

Published by under Investments

This is for you bond holders who may be worried about future interest rates rising. The reason is because when interest rates rise, bond values can fall.

The interest rate rise has been in the news for years. Future rises will be fractional increases. Even if we think worse case and assume a rate rise that will rock the bond world, what’s the worst that can happen?

If you hold individual bonds and you intend to hold them until maturity, you’ve got nothing to worry about. Interest rate hikes only impact your individual bond portfolio if you sell prior to the bond’s maturity date.

Bond mutual funds on the other hand could see their share price decrease and therefore your account value will decline a bit. How much?

Pull up the details of your bond fund on the Yahoo Finance page (http://finance.yahoo.com/). Note the search box on the left that states “Quote Lookup” and plug in your bond fund ticker symbol. If you aren’t sure of the ticker symbol, type in the name of your fund. Try VBMFX. On the left margin under “Fund” click on “Holdings.” Scroll down to the bottom to the box “Bond Holdings” and note the “Duration.” While not exact, generally this means for every 1% rise in interest rates, this fund’s value will decline by about 4.83%; or the value will rise by that much if interest rates fall.

Changes to interest rates will not occur in 1% increments. They will be in fractional amounts over long periods of time.

Proper investment management is about the management of the risk per Benjamin Graham, not the management of the return. So let’s manage the risk.

This potential loss in value can be offset by another fund that mitigates the drop in value or actually thrives in rising interest rate environments.

You can choose a bond fund with a smaller “duration.” A lower duration number means a smaller drop in value. You can probably sustain a smaller drop over the long haul.

There are investment choices that allow you the opportunity to establish a portfolio that will probably increase in value. Consider balanced funds; combination stock and bond funds. Maybe consider a more conservative stock fund like an equity-income type fund. This is a fund that holds dividend paying stocks.

These concerns and issues are addressed in this article: Portfolio Allocation (http://moaablogs.org/financial/2015/02/the-importance-of-the-proper-portfolio-allocation/). Pay close attention to the example of the 50/50% portfolio at the end of the article.

The key to all this is your portfolio allocation; not the news or world events. A proper allocation is stronger than media, marketing and history.

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Drilling Down Into Your Portfolio Allocation-Part 1

Jun 11 2015

Published by under Investments

I received feedback from a reader. “You’ve written a lot about how to diversify among stocks, bonds and cash savings. What about diversifying within a category like stocks? What’s all this blend, growth, big and small?”

Excellent questions and thank you Willow!

She is spot on. I’ve written often about the general categories of allocation; stocks, bonds and cash. Let’s drill down into these categories a bit. Each of these categories has many separate categories within them so realize that even this article only hits the high points. I suggest you use http://www.Investopedia.com to get into the details.

This article describes mutual funds since most of us invest in mutual funds through our TSPs, 401ks, IRAs and other investment accounts. Mutual funds are ready-to-purchase portfolios of stocks, bonds or other investments designed so you don’t have to select individual stocks or bonds on your own.

Generally the funds come in two flavors: “managed” (someone manages the fund and makes investment selections for you) or “indexed” (the stock selections represent a “canned” or “cookie cutter” portfolio like buying the S&P 500 or DOW Index; not requiring a manager). In a managed fund, the manager follows a strategy (explained below) and makes trades (buys and sells) on a regular basis to maintain the strategy and to try for the best rate of return. Most managers don’t beat the indexes. What!? True. Just following the natural flow of the various markets is usually your best bet and cheaper.

Each fund charges a management fee to pay the staff and company that manages the fund. As far as fees go, the less the better. Inexpensive funds charge less than 1% and expensive is anything more than that. Pull up the fact sheet on your fund and look for the “expense ratio” or maintenance fee on the sheet to see your fee percentage. Or go to http://finance.yahoo.com/ and do a search (see the “Quote Lookup” box?) for your fund by its ticker symbol. Try “VFINX” for practice. Scroll down to see the “Fund Basics” box and the “Expense Ratio.” You don’t get any cheaper than that–except in the TSP.

You need to realize that all stocks, bonds, investments in general, fall “in-” and “out-of-favor.” This means anything and everything goes up and down in its own given time all the time. Please, please, do not try to out-guess when an investment will be up or down. You can’t do it. No one can. If you try, you lose; plain and simple. Not even the professionals can do it. If they could, all the managed funds would beat their indexes and the vast majorities don’t. You must implement an investment strategy that expects and exploits this natural up and down market movement. Go back to my previous investment articles that Willow mentions to learn about these strategies.

Let’s start with the stock funds.

Within stocks, we have large-, mid-, and small-cap funds. These names represent the size of the companies the funds invest in. When I say “cap”, it’s the term used to indicate the size of the companies. It stands for “market capitalization.” A fancy way of stating the size of the firm as determined by this formula: stock price times (x) the number of stock shares available.

Large companies are well developed firms and their growth is less dynamic because they are mature companies. Large means $10 billion in market capitalization and larger. Of the stock funds, these are usually somewhat conservative…”conservative” as far as stocks go.

Mid-caps as the name implies are companies that aren’t small and not large. Usually $2 to $10 billion in market capitalization. Mid-caps tend to be firms that have proven their ability to survive and grow. More growth is anticipated so appreciation (rising long-term stock prices) is expected.

Small-caps are…you get it. Market caps are less than $2 billion. These funds are the most aggressive because the financial status of the companies can change on a dime. The companies can either explode in a good way or a very bad way. Historically over the long-term, these small companies provide the greatest growth (appreciation) potential.

To sum-up the fund size issue, small-cap funds are the most volatile. Volatile meaning the share price of the fund rises and falls more often over time and usually at greater degrees. Historical data show that over long terms (15+ years), small-caps average approximately a 12% return and large-caps around 8%. Finally, in terms of the volatility, remember from previous articles that if you are “averaging down” (investing every pay period), volatility is your friend. Averaging down and volatility work well together to increase your wealth over time.

Drilling down further into funds, beyond the various sizes of the companies, there are categories of investment strategies describing the growth potential of the stocks. These strategy categories are known as “growth”, “blend” or “core”, and “value.”

The growth strategy is a category that describes picking stocks determined to be on the way up. You might ask, “Doesn’t that describe all successful stock selection methods?” If only. Remember that all investments are on a roller coaster; up and down all the time. Growth fund managers try to pick stocks that have already shown their upward movement. Sometimes these are called momentum stocks. Picture the roller coaster. Growth stocks have come off the bottom and started the climb. The risk with growth stocks is you don’t know how close you are to the top.

The value strategy is a category where the manager tries to pick stocks at the bottom anticipating future growth. On the roller coaster, these are at the bottom of the dips. This value strategy is like buying clothes while they are on sale. The risk with value stocks is that we don’t know if they will come off the bottom at all or when. They could be at the bottom for good reasons like maybe that shirt in the bargain bin has a small hole in it.

Blend or core funds mix the growth and value styles of investing.

Whether growth, blend/core or value, there are data available that claim one style is better than the others. The essence of traditional investing is buying low and selling high right? This being the case, value style is classic and growth is more speculative. Suggestion…have a combination or go core.

Just a few more categories to round-out this part of the series.

The equity-income or dividend fund category. These are funds that select company stocks that pay a dividend. These are typically well established companies because only a well-developed company tends to pay dividends. Companies that are still establishing themselves cannot afford to pay dividends to stock holders. That makes these funds even more conservative (for stocks) than the large-cap funds mentioned above. The dividend payments are passed-on to the investors as income on top of any stock price gains (AKA capital appreciation) that may come your way.

International versus global versus emerging markets. International funds are only invested in foreign companies. Global funds invest in companies throughout the world including the U.S. Emerging market funds invest only in foreign countries in the earlier stages of a country’s development.

Some funds allow you to invest in specific countries and other funds allow you to invest in specific business sectors like real estate, biotechnology, computers, or health care.

You see how mutual funds allow you to get very specific when building your portfolio. You probably don’t want to drill down that deep. To build a functional allocation, you should probably have an assortment of a few major styles; core large, some international, and a small or mid-cap fund.

Reason being is that they are all on different roller coasters. If you are “averaging down“, each style would be offering you a chance to buy their style at bargain prices at various times. Buying in the dips is where average income investors build their wealth.

Go to Part 2 here. It’s about bond funds.

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How Much Are You Paying?

May 20 2015

Unlike most consumer purchases, figuring out the cost of financial advice and investing can be like an Indiana Jones expedition. Do we really know how much we pay?

Some advisers quote a fixed price for the job desired. Suppose you want a comprehensive financial plan that considers savings, investments, retirement, insurances, taxes, and estate planning issues. That might be $3000 for example. The price varies based on the job’s complexity. Or you may be stated an hourly charge and told it will take 8 hours.

Some places charge a percentage based on assets under management, e.g. 1%. It is common for the percentage to decrease as asset amounts increase. Think volume discount.

Commissions may be charged by your adviser. This is a sales charge applied to each transaction like a buy or a sell. This could be a favorable payment method if you don’t expect to have many transactions. For instance, you buy an Exchange Traded Fund through your on-line broker for $8. A full-service broker will charge more but you get extra service for the extra cost.

Some investments and products charge an up-front sales charge; called a ‘sales load.’ This up-front charge is applied by the company who offers the product not your financial adviser. Say you buy a mutual fund in your account. An up-front sales charge may be applied by the mutual fund company and not your adviser.

There are also back-end or surrender charges applied by companies offering products. If you buy a mutual fund or an annuity for example and later sell all or part of it, you are charged a fee to get out of the product.

Your investment or insurance product charges fees to own or hold the product. Mutual funds have annual management fees. Insurance products have administrative and insurance fees. In the mutual fund business these include annual management fees, 12b1 services (marketing fee) and possibly other miscellaneous fees. Insurance products include the insurance charge (called M&E or COI fees), surrender fees, option/rider charges, and management fees within the mutual funds within the insurance product.

This is an abbreviated primer. There could be other charges. Most likely, you are paying several layers of these fees. Example; you could pay 1% of assets under management, an up-front sales charge and costly mutual fund annual management/12b1 fees. Hopefully not. Insurance products in IRAs can get expensive.

All of this is spelled out in the fine print of your account contracts and prospectuses. Your fees should best match your planning objectives.

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Life Insurance Considerations

May 08 2015

Published by under Insurance

Financial issues can get complicated easily. And when they do, the added complexity and stress can cause us grief.

Let’s talk insurance. It’s pretty simple on the surface. Insurance is protection against a risk you can’t or don’t want to afford. Car gets totaled; it’s money for a new one. House burns down; ditto. Need home health care; there’s long term care insurance. You probably wouldn’t buy the insurance if you could afford to cover these costs out of pocket.

After death, your family needs assets to continue a life style or pay taxes and fees to settle an estate. Where will these assets come from? Maybe you have assets on hand. Perhaps a spouse has personal means. You may have family ready to step in. Or you have life insurance.

Warren Buffett has a way of explaining the complex in simple terms. He states that when it comes to financial situations, risk comes from not understanding what you are doing. Life insurance products can be very confusing to people. It’s important to understand what you are doing.

Who isn’t confused? There are so many types and names of life insurance; term, annual renewable term, level-term, decreasing term, whole life, permanent life, universal life, variable universal life, variable life… On top of this, life insurance can be used for more than just a death benefit. Plus beyond life insurance there are annuity products with insurance features. It’s so complicated.

After conducting an investment class, people usually hang around to talk about investment issues. During the discussion I realize their “investment” is a life insurance product. I mention this to them and ask what was their reason for purchasing a life insurance product as their investment program? It is not unusual that they are not aware of the insurance situation or that they can’t explain why or that they can’t explain the investment benefits of the insurance product they bought.

Don’t get me wrong, I’m not implying there is a problem with the life insurance product above. There could be valid reasons for the insurance product as their investment vehicle. My point is complexity and risk come from not understanding the tool, why you have the tool and how it works to achieve your objective.

To keep your financial life simple and prevent complications, understand your financial objectives. Manage by objectives. Separate your financial life into your objectives; liquid emergency savings, insurance issues, long-term investments, retirement, college, etc. Pick the tools that best address your separate objectives in the simplest and most cost efficient manner possible.

Hey check out MOAA life insurance options here if you are a MOAA member or call (800) 247-2192.

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