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 the percentage noted under your fund’s ticker symbol; 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.

6 responses so far

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.

5 responses so far

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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TSP/401k or IRA. Which is best for you?

Apr 22 2015

The advice is all over the map when discussing which type of retirement account is best for accumulating your retirement wealth.

One common pearl of wisdom I hear is:
“Contribute to your 401k/TSP to get the company match money but that’s all. Contribute the rest of your money to your Individual Retirement Account (IRA).”

Generally, when you hear advice, follow the money. Ask whose getting paid by following the advice so you understand the source of their advice.

Just so you know we have no conflict of interest in this debate. We are not a financial service firm. We don’t sell investment products nor do we provide any types of accounts. We don’t have clients so we are not trying to recruit you. We are counselors and educators. We don’t care where you go for help or what you purchase. Our desire is to help you be a better investor and make the wisest consumer selections for your needs.

Below is a breakdown of various account features. I suggest a winner for each feature. Follow along and see how your situation fits in the discussions below.

Contribution amounts: 401k/TSP wins.

The maximum contribution for a 401k/TSP is $18,000 (or $24,000 for age 50 and older).

Traditional IRAs only allow contributions up to $5500 ($6500 for age 50(+)).

Roth IRAs are the same as Traditional IRAs until you start hitting the annual income restrictions. The income restrictions are $116-131k for single tax filers and $183-193k for married tax payers filing jointly. The income restrictions slowly decrease the maximum contribution amount until contributions are prohibited after exceeding the highest amount in the income range.

Granted the income restrictions on the Roth IRA are not hit by most folks but there are still limits. Neither version of 401k/TSP has income restrictions. On the other hand, anyone can contribute the maximum amount to either version of 401k/TSP regardless of income.

There are a few IRA-type company retirement plans and self-employed plans that allow more than $5500/6500 but they are still less than $18/24,000. One only accepts employer’s contributions.

Employer matching funds; the icing on the cake. If your employer matches, you have an immediate positive return on your money and you are compounding larger amounts over time—think of a snow ball rolling down a mountainside. Be aware of your employer’s vesting schedule. A vesting schedule determines how much of the company’s matching amount you get to keep if you leave the firm. The amount you keep goes up the longer you are employed.

Tax advantages: 401k/TSP wins.

Roth: People who contribute to a Roth want their tax advantage in retirement; not now.

You get a greater future tax advantage contributing to a Roth 401k/TSP with the $18/24k maximum contribution amount and no income restrictions like a Roth IRA as explained above. Given the ability to contribute over 3-times more to a Roth 401k/TSP per year (almost 4-times as much if you are age 50 or older) than an IRA, the compounded tax advantage in retirement is remarkable.

Roth 401k/TSPs do have mandatory Required Minimum Distributions (RMD) at age 70½. Do a direct transfer of your Roth 401k/TSP to a Roth IRA and the tax benefit can go on for life since Roth IRAs have no RMD.

Traditional: People who contribute to a Traditional plan want their tax advantage now; not later.

A Traditional 401k/TSP gives you the full deduction off your current taxable income up to the $18/$24k maximum contribution unlike a Traditional IRA.

Traditional IRA contributions can be deducted off your income taxes up to the $5500/$6500 maximum but there’s a catch. First neither you nor your spouse can be covered by an employer retirement plan to get the full deduction. If you or your spouse is covered by an employer retirement plan, your deduction decreases based on your income amount. Single tax filers start to lose their IRA deduction starting at $61k in income and after $71k you lose your deduction for IRA contributions. For married filing jointly the income range limit starts at $98k and after $118k you cannot deduct your contributions.

You can still contribute up to the $5500/$6500 maximums but the contributions aren’t fully deductible or they cease. In this case, your non-deductible contributions will not be taxed at withdrawal in retirement. Any gains from the non-deductible contributions are taxable.

Investment options: IRA wins.

I’m basing this IRA win on the assumption that you have the right IRA. Your IRA should have access to all possible investment options even though you won’t use all the options. We know the TSP is limited to six options (C, S, I, F, G, and L) so in this competitive category a TSP should be easy to beat.

If you have a CD IRA (a CD in an IRA wrapper), this isn’t a win for your IRA. Neither is an IRA linked to one or a few mutual funds. If your IRA is in a life insurance or annuity product (why would you do this?), it depends on the options made available to you in your insurance plan.

Costs: TSP wins hands down.

The TSP is so inexpensive it’s practically free.

If you don’t have a TSP, things can get competitive between 401ks and IRAs. It depends on your IRA primarily.

Your 401k expenses depend on your program and how much your employer makes you pay to cover the administrative fees. You don’t control these costs. These expenses can be all over the map. If your 401k is with an insurance company, you are probably paying more. This is why I believe the IRA comes in second after the TSP.

You can control your IRA expenses by opening the right IRA. While the right IRA will be a bit more expensive than a TSP, it will still be very inexpensive.

Ease of management: IRA wins.

Again I have to make the assumption you have the right IRA. The right IRA is easily managed on-line. The account set-up, investment transactions, money transfers are all at the touch of a few key strokes.

401k/TSP can be easy in some ways because many functions are on-line but you also have the administration involved with the employer’s policies and the plan documents.

Required Minimum Distributions: Roth IRA wins.

Every retirement account other than a Roth IRA has a RMD obligation at age 70½.

If you have a Roth 401k/TSP, you can manage around the Roth 401k/TSP RMD by directly transferring the Roth 401k/TSP to a Roth IRA prior to age 70½ and thereby eliminating the RMD requirement.

Wealth building potential: 401k/TSP win.

No question here. Up to $18/24k compounding each year or $5500/6500 compounding each year. Roth IRAs contributions will be restricted even further by the by the income restrictions noted above.

• $5500 a year by 20 years at 7% return equals $225,500.
• $18k a year by 20 years at 7% return equals $738,000.

The final tally.

The bottom line for me is that you max-out your 401k/TSP each year before you contribute to an IRA. Because most employees can’t max-out 401k/TSP contributions each year, you should have a plan to get there eventually. Every cost-of-living-increase, promotion, raise, job change, anytime you have an income increase, increase the amount of your 401k/TSP contribution until you are able to max-out your program.

That’s it. Where do you stand? Are you questioning whether you have the proper IRA for your needs?

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