Assess Your Risk Tolerance

EXCITING NEWS: I was selected to deliver a national training in San Francisco this November entitled: Personal Finance Solutions for Busy Mental Health Professionals. This 3 hour workshop includes material from my upcoming eBook. Stay tuned to get first crack at the NEW EBOOK. And it’s FREE to my readers.

“Risk comes from not knowing what you’re doing.” Warren Buffett

I’ve been investing for many many years. In my 20’s all I could think about was “the great depression” and how so many lost so much. Although I had a Bachelor of Science degree in Economics and had taken a class or 2 in the stock market, I was scared of stock investing. I was terrified of risk and I certainly didn’t know much about investing.

As I acquired some cash, I went to visit a stock broker who respected my preferences and introduced me to some bonds and bond funds. He introduced me to the dollar cost averaging  and answered my investing questions by loaning me his investing training manuals. After dipping my toe in the investing pool, learning a bit about investments, and watching my net worth grow for a while, I gained some confidence. A lifelong passion was born.

MAIN TOPIC; Risk tolerance THEN and NOW

Although my investment portfolio went up and down, I got used to the volatility. I was still afraid of “losing it all,” but learned through study, that if I diversified my assets, the ups and downs of my portfolio would even out. I didn’t know it at the time, but my RISK TOLERANCE was governing my investment decisions.

For those of you just starting out, or learning about investing, start with introspection. When your investment value goes down 10-15%, are you a nervous wreck? Does this small percent drop in your portfolio terrify you and keep you up at night? If so, you need to titrate your portfolio to honor your temperament.

WHAT THE HECK DOES THAT MEAN?

Riskier assets with more ups and downs usually offer HIGHER RETURNS.

Stock investments: Individual stocks, stock mutual funds, international stocks offer the possibility of greater returns along with more risk.

Bond investments: Individual bonds, bond funds, corporate, and government bonds offer lower returns and less volatility.

SOUNDS SIMPLE; JUST INVEST IN STOCKS, GET HIGHER RETURNS.

OR –  SCARED OF RISK? INVEST IN BONDS AND ACCEPT LOWER RETURNS.

Wait a minute, not so simple.

These investing maxims have held up over the long term IN THE PAST; but what about the last 5 years? According to Morningstar.com,  during the last 5 years, bonds outperformed stocks by a large margin.

5 YEAR RETURNS-annualized

Morningstar US Market Index-0.67%

Morningstar Core Bond Index-6.04%

Practical Application: What should I do?

Are you totally confused? To summarize, long term stocks offer higher return with more risk; bonds have lower returns and lower risk. But in the past 5 years, stocks had high volatility and low returns and bonds outperformed stocks by a huge margin.

Welcome: DIVERSIFICATION

Those rules of risk and return have held true in the past over the long term, > 10 years.

 NO ONE KNOWS WHAT TYPE OF RETURNS AND VOLATILITY THE MARKETS HOLD IN THE FUTURE.

Protect your investments by spreading around the risk.

During the past 5 years, if your investment portfolio looked like this:

50% STOCKS

50% BONDS

Your annualized return would have been 3.36% with moderated volatility.

The lesson is to choose investment funds in a variety of asset classes. The ups and downs will balance out and moderate the returns and risks.

Conventional wisdom recommends a greater percent of your investment in stocks if you are younger and can tolerate more risk. If you are older and/or more risk averse, raise the percent of bond assets.

Continue reading this series and you will learn how I invest our family assets.

BEFORE YOU INVEST YOU MUST READ 10 STEPS YOU MUST TAKE BEFORE BEGINNING AN INVESTING PROGRAM.

Caveat: This article is for information purposes only and may not be appropriate for your individual situation.

ACTION STEP:

Get a notebook and label it: “(your name) Personal Finance” and keep it by the computer. Use it to keep all of your personal finance goals, thoughts, activities, and plans.

Take a RISK TOLERANCE QUIZ or 2 and jot down whether to weight your portfolio more toward stocks or bonds.

MSN Money Risk Quiz 

 Risk Tolerance Quiz from Rutgers University site by 2 finance professors (Source: Grable, J. E., & Lytton, R. H. (1999). Financial risk tolerance revisited: The development of a risk assessment instrument. Financial Services Review, 8, 163-181.)

image credit; purplemattfish

RECENT PERSONAL FINANCE CARNIVALS & Link Round up

I am honored to have my work showcased at these sites recently. Why not stop by & check out the fine articles?  

 How to Design a Budget with Room for the Fun Stuff was selected for a link round up at KNS Financial

Carnival of Money Stories at Eventual Millionaire published No Brainer Money Management for College Students

Carnival of Wealth at Personal Dividends posted Follow these Instructions and Get Wealthy

YAKEZIE PERSONAL FINANCE BLOGS

After every article for the next several weeks, you will be introduced to several Personal Finance web sites in the Yakezie network. Each one has their own unique voice and style. The consistency in all is their desire to help others. Consider visiting a few each day!

My Personal Finance Journey
Narrow Bridge
Not Made of Money
One Money Design
Out of Debt Again
Parenting Family Money
Peak Personal Finance
Personal Finance by the Book

BONDS

Categories: investing, mutual funds, bonds

“The social object of skilled investment should be to defeat the dark forces of time and ignorance which envelope our future” John Maynard Keynes

One of the foremost economists of the last century succinctly states a reason to invest. Learn the simple principles of investing through this MBA series taken directly from the graduate course I’m teaching in Investing & Portfolio Management. Don’t be intimidated, grasp important investment concepts in an easy to understand format.

After reading this article you will gain a useable investing skill.

As I mentioned previously, please follow these steps before beginning any investment program.

Main Topic: What are BONDS & do I need them?

Last class we talked about risk versus reward. In investing, the greater the risk, the more opportunity for reward or a high return.  Risk means that your investment is going to go up and down in value; with higher risk investments  exhibiting greater volatility.

 A BOND is a loan to a corporation, municipality, or government. When you buy a bond you are making a loan to the bond issuer. In exchange for the loan, you receive an interest payment. The amount of interest you are paid is directly related to amount of risk you are taking. (The interest in bonds is called a coupon payment).

Buy a corporate bond from a corporation with financial troubles, you get a high interest rate because if that company goes bankrupt, you might lose all of your initial investment.

Buy a U.S. government bond, you get lower interest rate, because your money is invested with a secure government who will pay you back your original investment when the bond matures.

A government bond is the safest bond to buy; it also has the lowest interest rate. Riskier bonds pay higher interest rates.

Here’s why you need bonds:

Jose is 33 years old, married, with term life insurance, 6 months cash in a savings account, and pays off his credit card bill in full every month. Three years ago, he and his wife invested in 2 index mutual funds:

1. Vanguard total stock market index (VTSMX)
2. Vanguard total international stock index (VGTSX)

He believed that since these 2 funds held lots of different companies from various parts of the world, he was sufficiently diversified and did not need any other investments.

 Look what happened to the value of his investment portfolio from 2007-present.

 What if he added BONDS to the portfolio 3 years ago? 

 Notice, with no bonds, Jose’s portfolio LOST 8.97% over 3 years; with bonds, his portfolio lost only 3.45%.

PRACTICAL APPLICATION: What is the takeaway?

• Investing is only for money needed in 5 years or more, because in the short term, the returns are volatile. These last 3 years prove that point.
• As long term returns of stocks and bonds are almost always positive and greater than returns in savings accounts, these investments are beneficial for generating long term wealth.
• Combine bonds, stocks, and some cash to an investment portfolio to lower risk (volatility).
• A combination of stocks, bonds, and cash will likely beat the investment returns over a cash savings account over the long term.

Why invest at all, the 3 year returns were NEGATIVE?

• Historically long term returns for stocks are about 9%, bonds near 5%, and cash in the low single digits.
• Combine the three assets, reduce risk, and increase returns over cash alone.
• Invest in mutual funds to simplify. No need to pick individual stocks or bonds.
• Although 3 year returns were negative, had Jose continued to invest monthly, instead of just once at the beginning of the 3 year period, his returns would have been higher.
• It is highly likely that in 10 years and longer, his investment value will be much greater. 

Caveat: This article is for information purposes only and may not be appropriate for your individual situation.

ACTION STEP:

Get a notebook and label it: “(your name) Personal Finance” and keep it by the computer. Use it to keep all of your personal finance goals, thoughts, activities, and plans.

Learn more about bond investing at Money Chimp. 

Yakezie Short Carnival: Personal Finance Lessons Learned from Bambi @ Personal Finance Firewall;  The Cost of Making your House a Home; Average Spend in your First Year of Home Ownership @ Frugal  Confessions; Post Transaction Marketing; Helpful Links or Ripoff @ The Millionaire Nurse

Categories: investing, bonds

 “Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man.”  Ronald Reagan 

Since we haven’t had much inflation in recent years, it’s easy to forget about it’s VIOLENT IMPACT.

One of President Reagan’s (1981-1989) political challenges was combating the rampant inflation of the time. He entered office after record inflation levels of inflation!

Check out what Reagan was talking about. These are the inflation rates from 1975 to 1986: 

Just so you get an idea of what it really means, if you bought a video game in 1975 for $47.38, that same game would cost $100.00 in 1985. Don’t get complacent and think that we will never have high inflation again. It’s quite likely, that higher inflation levels will return in the future!

MAIN TOPIC: Protect your Money from the Ravages of Inflation

The previous post  talked about buying I Bonds as a way to invest and make sure that your investment keeps up with the impact of inflation. Even with 3% inflation per year (the historical average), your $10.00 meal out will cost $13.44 in 10 years. Now, bump inflation up to 5% and watch that $10.00 meal go up to $16.29. Now, apply those inflation increases to EVERYTHING YOU BUY. Don’t think you will avoid inflation in the future.

Here’s another investment which keeps up with inflation and is also issued by the government: TREASURY INFLATION PROTECTED SECURITIES. They have the same goal as Series I Savings Bonds, TO PROTECT YOUR CASH FROM INFLATION RISK so when you need it in the future, the purchasing power hasn’t been eroded.

 TIPs are bond-like investments issued by the US government. They have a fixed interest rate… BUT they keep up with inflation because when INFLATION RISES the principal amount of the security (bond) also goes up. On the flip side, when inflation drops, so does the principal amount of the bond. At the treasury direct website there is lots of information about TIPS.

PRACTICAL APPLICATION: What are Treasury Inflation Protected Securities (TIPS)?

Government Bonds 101

Buy a government bond and you are making a loan to the U.S. Government.

In exchange for the loan, the government pays you interest.

 FACTS ABOUT TIPS:

You can buy them on-line here. They can be purchased in increments of $100.00.

TIPS have maturities of 5, 10, & 30 years.

You can hold it until it matures OR you can sell it in the open market thought an investment brokerage company like Charles Schwab, E*TRADE, Fidelity, Vanguard, or TD Ameritrade.

They are subject to federal tax only, NOT state or local. You pay the tax in the year it is earned.

 THE EASIEST WAY TO BUY TIPS:

There are several mutual funds which hold many TIPS in various maturities. It is really easy to buy them, through one of the Investment Companies listed above. This article offers a comprehensive list of advantages to purchasing a TIPS mutual fund

How do I Bonds & TIPS compare?

RISK is always a factor in investing.

 Inflation risk manifests insidiously by causing the same dollar to purchase LESS & LESS product(s).  Another way to look at inflation is; the identical goods cost MORE and MORE. A savings account or CD (Certificate of deposit) is subject to inflation risk as the interest rate stays the same even though inflation may be rising.

 Series I & TIPS government bonds protect your money from inflation risk.

ACTION STEP:

Get a notebook and label it: “(your name) Personal Finance” and keep it by the computer. Use it to keep all of your personal finance goals, thoughts, activities, and plans.

Jot down the advantages and disadvantages for this investment for you. Visit the treasury website  to get more information about inflation protected investments.

 Caveat: This article is for information purposes only and may not be appropriate for your individual situation.

Category: investing, bonds

 “Inflation is the one form of taxation that can be imposed without legislation.” Milton Friedman

 One economic problem we avoided in recent years is the inflation monster. As Milton Friedman, the famous economist mentioned, inflation is just like a tax and makes EVERYTHING YOU BUY MORE EXPENSIVE! It is really painful when the soda 12 pack you bought last year for $2.50 costs $4.50 this year. That’s the sting of inflation.

MAIN TOPIC; Be Prepared When Inflation Hits 

I received this letter recently and it got me thinking about inflation:

Linda wrote:

Q. – I read in the AARP magazine about Series I Savings Bonds.  Right now they are a little over 3% and they are variable depending on the market.  You have to keep them in for 1 year, and after that if you take the money out you lose the three most recent months’ interest. Any comment?

 Even though we don’t have much inflation now, it’s certain to increase in the future!

Let me disclose that I started buying inflation protected investments for my daughter in 2000. I exchanged some EE bonds she received for gifts for inflation advantaged bonds. At that time, I looked at both SERIES I SAVINGS BONDS and TIPS (Treasury Inflation-Protected Securities). Even in the recent tame inflation environment, these inflation advantaged investments performed well.

 RISK is always a factor in investing.

Inflation risk manifests insidiously by causing the same dollar to purchase LESS and LESS product(s).  Another way to look at inflation is; the identical goods cost MORE and MORE. A savings account or CD (Certificate of deposit) is subject to inflation risk as the interest rate stays the same even though inflation may be rising.

Series I government bonds protect your money from inflation risk.

Although we have low inflation in our economy currently, it will likely increase in the future. These inflation advantaged government bonds are sensible investments to look into if you’re interested in preserving the purchasing power of your investments. They are more conservative than an investment in the stock market; unlike stocks, you don’t have the chance for an outsized gain (or loss) with I bonds. On the other side, you are assured that your purchasing power won’t decrease. If your soda expense goes up, so will the investment value of your I bonds!

 To give you the full INFLATION FRIENDLY INVESTMENT PICTURE, I’ll talk about I bonds in this post and TIPS in the next. That way you have a few days to digest the information.

 PRACTICAL APPLICATION: Get all the Facts

 Government Bonds 101

 Buy a government bond and you are making a loan to the U.S. Government.

In exchange for the loan, the government pays you interest.

It’s Quite Simple!

 The fixed interest rate is set when you buy the bond.The fixed interest rate stays the same for the life of the bond.

 The adjustable part of the interest rate:

            Changes every six months

             Is based on the Consumer Price Index for Urban Consumers (CPI-U)

The fixed and variable interest rates are combined.

Every six months the composite interest rate changes for the I Bond.

From November, 2009 through April, 2010 the I BOND’S EARNINGS RATE was 3.36%.

            Fixed rate = 0.30%

            Adjustable rate = 3.06%

 How much do they cost?

 You can buy them on-line here  or at a bank. They can be purchased for $50, $75, $100, $200, $500, $1,000, or $5,000. You can even set up an automatic direct purchase for the bonds. You buy them at face value (i.e. you pay $50 for a $50 I bond).

When are earnings added to the I Bond?

The I Bonds increase in value on the first day of each month as they earn interest and increase in value.

The interest is compounded (add link to the magic of compounding) 2 times per year.

When can I cash the bond in and how long does it continue to earn interest?

You can cash the bond in anytime after 12 months, BUT-if you redeem the bonds within 5 years of purchase, YOU LOSE 3 MONTHS OF INTEREST PAYMENTS.

The bonds continue to earn interest for 30 years.

When you cash the bond in you get the original purchase amount of the bond + all of the compounded earnings. Learn about the wonderful benefits of COMPOUNDING.

Since you don’t want to loose interest, it’s a good idea to purchase these investments if you can hang onto them for at least 5 years.

What else do I need to know?

They are subject to federal tax only, NOT state or local. And you don’t have to pay the tax until the bond is cashed in.

 Here’s a great flyer that compares I government bonds with Series EE government bonds.

ACTION STEP:

Get a notebook and label it: “(your name) Personal Finance” and keep it by the computer. Use it to keep all of your personal finance goals, thoughts, activities, and plans.

 Jot down the advantages and disadvantages for this investment for you. Visit the treasury website to get some more information about these investments.

 BE SURE TO WATCH FOR MY UPCOMING ARTICLE ABOUT TIPS (Treasury Inflation Protected Securities) for another inflation beating investment.

Caveat: This article is for information purposes only and may not be appropriate for your individual situation.