PRINT THIS ARTICLE OUT AND SAVE FOR REFERENCE

I started investing in my 20′s when I came into a small inheritance from a great aunt. My fear of the stock market and recollection of stories of the great stock market crash of 1929 led me to consider investing in bonds as a safer way to grow my money. Flash forward several decades, as I prepare the lectures for my university Investments class, I am struck by how easy it is to decide whether to invest in taxable or tax free (tax-exempt) bonds. Learn this quick and easy formula and you will never wonder again whether it is better to snatch up those state or city municipal bonds that are offered by your locale or stick with corporate bonds paying a higher yield.

What is a Bond?

First, a quick tutorial for those just getting started. A bond is a loan to a company, city, state, or federal government. In exchange for the loan, the borrower pays the lender a coupon or interest payment. When you purchase a corporate bond, you loan money to a company and pay tax on the interest income received. Corporate bond  taxable.

What are Tax Free Bonds?

A bond in which the income produced is free from federal, state and local taxes. Most tax-exempt securities come in the form of municipal bonds, which represent obligations of a state, territory or municipality. Investopedia

Purchase a bond issued by your state to improve the roads and the interest you receive is exempt from federal and state taxes. Sounds like a great deal doesn’t it? Since the bonds are tax- exempt, they usually sport lower coupon (interest) payments.

So how do you determine whether you are better off buying a 5 year municipal bond issued by your state and paying 2.5% or buying a 5 year corporate bond paying 3.5%?

Tax-free or Taxable Bonds?

There is an easy way to determine which bond offers a higher after tax return. Calculate the Tax Equivalent Yield of the tax exempt bond and compare it with the yield of the taxable bond. Then choose the one that offers the greatest after tax return.

Try it out

Let’s assume that your state and federal combined tax rate = 30%

You can purchase a 5 year taxable corporate bond with a yield = 3.5%

Or, you can purchase a 5 year tax-exempt municipal bond from your own state with a yield of 2.5%

Which is the better deal?

This simple formula will tell you in under a minute.

Tax Equivalent Yield

Compare which is higher:  municipal bond return/(1-combined tax bracket) = taxable return (or tax equivalent yield) 

Taxable return = 2.5%/(1-30%)=tax equivalent yield of 3.57%

A taxable bond must pay at least 3.57% in order to beat the 2.5% tax exempt return on the municipal bond.

Since the best return on a comparable taxable bond is 3.5%, the investor in the 30% tax bracket is better off purchasing a tax free bond paying 2.5% interest, as this yield is equivalent to a taxable yield of 3.57%.

With the Bush tax cuts expiring at the end of this year, it may be time to check out investing in tax free bonds.

Can’t Get Enough Tax Free Bond Info?

What are Muni Bonds and Should I Own Any? @ Oblivious Investor

7 Pillars of Investing in Tax-Free Bonds @ Kiplingers

Put on for my City; Tax-Free Bonds @ Young Adult Finances

Investing in Municipal Bonds @ About.com

Bond Investing-What are Tax Free Bonds? @YouTube-eHow Finance

Have you considered investing in tax free bonds? 

image credit; google images_scminvestment

Over the past several years, I’ve gradually moved my family portfolio and my corporate portfolio away from individual stocks and into Index Mutual Funds and Exchange Traded Funds (ETF’s). Although both portfolios have sported excellent recent double digit returns, not every holding was a winner. In the case of two stocks, I did not fare well.

First a bit of background, I have been investing for decades with excellent outcomes. Many years both the portfolios I manage have outperformed the S & P Index handily. I am not a frequent trader or market timer, but stick to a well thought out asset allocation in line with the goals of my family for our personal portfolio and the goals of the corporation for the professional portfolio.

As anyone in the investing field understands, no matter how many winners one holds in a portfolio, there are bound to be a few losers.

Over the years, I tired of the hours of research required to invest in individual stocks. On top of that, finance research convincingly supports the out-performance of index fund investing over that of stock picking. In fact, in a typical year, a majority of actively managed mutual funds do not beat the returns of their index fund benchmarks. And those managed funds that outperform one year, rarely repeat that performance year after year.

The takeaway is simple; it is quite difficult to beat the overall market consistently.

In spite of my resolve to transition to mutual funds and exchange traded funds (ETFs), I did not immediately sell all of our individual stocks.  I decided to get rid of them gradually, after analysis and determination that their growth prospects were fading.

In the case of Nokia (NOK) and Best Buy (BBY), I waited a bit too long to sell.

Best Buy and Nokia = Terrible Performance

Best Buy has been a remarkable growth story over the years with nationwide store expansion and offerings of any electronic one could want, either in the store or online. With the closure of Circuit City, I thought Best Buy would go through the roof and pick up all of their growth. Several years ago, when I purchased Best Buy, it’s future looked promising and its growth initiatives and store expansion foretold an expansive future for the company.

Nokia a former technology darling seemed like a sure fire holding. With a market share topping 40% in 2008, how could the company falter? Here’s how, with the advent of the smart phone, Apple and the android, Nokia’s market share fell to its current 29%, with no rebound in sight. At present, the fortunes of this company are going in the wrong direction and suffered a $1.2 billion loss its most recent quarter.

Take a look at the five year performance of Best Buy and Nokia;

As the Yahoo Finance chart so graphically illustrates, both stocks have plummeted during the past five years.

When investing in individual stocks there are some key factors to consider;

• Accept that individual stock prices are random in the short run. Some will rise, others fall, and some prices won’t move much in either direction.
• Before purchasing an individual stock it is crucial that you study its growth prospects, competitive landscape, valuation, and financial statements.
• This type of analysis should be ongoing during the time you hold the stock.
• Before purchasing a stock, it’s important to write down the reasons to buy the holding and what would cause you to sell.

Investing Caution

 Can’t Get Enough Investing Information? Check out these websites;

Jeff Rose at Good Financial Cents inspired me to write on the Roth IRA movement.

I’m one of those dinosaurs that started her first IRA in her 20’s at the beginning of the IRA movement. At that time, there was no such thing as a Roth IRA, so I went with a traditional IRA. On top of that anomaly, I was the only 25 year old at a retirement seminar in a room full of 60 year olds.

Although my passion for saving and investing has stood me well over time, I am deeply concerned about the financial future of those who haven’t yet started to save and invest. Read on for some motivation to get started investing in a Roth IRA today.

A True Retirement Story

At 8:00 AM I receive a call from an older neighbor, just wanting to talk. She started off by recounting the details of her husband’s firing from his job. My neighbor, June, believes he got fired because of his hot temper. Strike one, keep your temper in check at work.

The saga continues as she tells me about the new blinds she is buying for the home. I casually mentioned, that she might postpone this purchase since HER HUSBAND, THE MAIN SOURCE OF FAMILY INCOME JUST LOST HIS JOB. June replies, that expense was already planned so she will get the new blinds. Strike two, don’t add more financial stress after a job loss.

To top it off, June continues her financial mismanagement by sharing how she paid a consultant $100.00 to explain Medicare coverage to she and her hubby. Unable to keep my big mouth shut, I said that Medicare will explain their system FOR FREE. Strike three, don’t pay for information readily available for free.

The final blow came when she mentioned she has NO ROTH IRA, NO TRADITIONAL IRA, and not much saved up for retirement.

She stated “We don’t need retirement savings, we’ll have social security soon.” 

What is she thinking?

Why You Must Start a Roth IRA Today

I understand that retirement seems a long long way off for those in their 20’s and 30’s. Yet, the earlier you start saving, the less total money you need to save, and the more you will have at retirement time.

There is uncertainty in the future of social security. At best, benefits will be smaller and start later than they do now. Long term employment with a singular employer is practically nonexistent. So, if you fail to take responsibility for your future, you face a scary life in old age. As we all live longer, we need more assets to ensure that we don’t outlast our money.

I beg you to explore the data so you don’t end up old and poor.

Check out the facts:

Joleen’s Story

At age 25, Joleen began investing $200.00 per month in a Roth IRA and her employer added another $100.00 per month bringing the total up to $300.00 per month.

She invested the monthly retirement money* this way:

• 40% ($120.00) in Vanguard Total Stock Market Index Fund (VTSMX)
• 30% ($90.00)  in Vanguard International Stock Index Fund (VTIAX)
• 30% ($90.00) in Vanguard Total Bond Market Index Fund (VTBLX)

She started investing at age 25 and stopped at age 65, for a total of 40 years.

At age 65, Joleen’s contributions plus her employers’ grew to $787,444.00*.

Jamar’s Story

Jamar, Joleen’s brother wanted to spend his earnings and didn’t think about the future. No retirement investing for Jamar, he was having too much fun; Jamar figured social security would take care of him.

At age 40, Jamar had a change of heart. He woke up one morning and realized that he had nothing invested for his future; and he was scared. He decided to start investing and chose the same investments as Joleen, but decided to try to catch up. Jamar invested $400.00 per month, twice as much as Jill’s $200.00.

Jamar’s employer matched his $400.00 per month with an additional $100.00, just like Jill’s. This brought his total monthly investment to $500.00.

*Assume: Portfolio average annual return of 7%

At age 65, Jamar’s contribution plus the employers’ grew to $405,036.00, while Jill’s lesser contributions grew to almost twice that amount at $787,444.00.

INVEST IN A ROTH IRA

The Takeaway

My friend June is living in denial. When social security comes, it won’t match her husband’s former income. As her savings are small and she didn’t plan for the future she faces major lifestyle cuts as she ages.

The alternative to old age is death. If you expect to get old, own up to reality, and invest through work or a discount broker in a Roth IRA and start contributing today. Even if Social Security continues, don’t expect it to pay for a comfortable retirement. You can choose not to invest for the future, but be aware that social security is uncertain, and you will be poor in your old age without investing in an IRA.

Start now, you won’t miss the money and you’ll appreciate the financial security later.

You do need IRA, Social Security won’t be enough to support your retirement.

Have you started your retirement investing yet? If not, what are you waiting for?

Three Ways to Benefit from the Low Interest Rate Environment

In part 1 of What do Low Interest Rates Mean?, I talked about the cyclical nature of interest rates and the economics behind the interest rate trends. Today is advice day where you get some tips about how to benefit from the current interest rate environment.

It is a certainty that economic environments change. The low interest rate environment will not last forever. At the outside, you have less than two years before interest rates will rise. After reading Part 1of this article you understand a bit about the economic and monetary policy behind the interest rate environment. Next learn how you can profit. After all, I can’t write an article without giving strategies for wealth building.

Time to buy a home?

3 Strategies to Grow Your Wealth in Spite of Low Interest Rates

1. In How to Get a Decent Return on Your Cash, I wrote about options for savers. The best savings option right now for cash you won’t need for a year or more are Government I (Inflation) Savings bonds. The I bonds pay 3.06% until April 30^th when they will reset for their six month adjustment and reflect the current rate of inflation.  The return on these investments has two parts; a fixed rate of interest which does not change and an adjustable rate of interest that moves along with the inflation rate. The beauty of I Bonds is that there is no chance of default and your investment is guaranteed to keep up with the pace of inflation. In other words, the purchasing power of your investment is protected.

Buy these risk free investments on line at Treasury Direct. You can purchase up to $10,000.00 worth of these bonds annually in increments of $25.00.I bonds are even available for purchase with your tax refund. Except for paying off debt, there is probably no better use for your tax refund.

2. For lenders, I recommend peer to peer lending. This type of loan is about lending money directly to folks who need it. The peer to peer lending investment cuts out the bank and directly matches lenders and borrowers. I am loaning money to other borrowers through a peer to peer lending site and so far am earning 10.69% Returns With Prosper. 

I started investing in October, 2011 with Prosper.com. You can read about my initial experience in this article; My Experience with Peer to Peer Lending. In contrast with government bonds, please realize that this is a risky investment. Borrowers might default on a loan in which case, you would lose your total investment in that particular loan. For that reason, I only invest $50.00 in each loan that I fund. There is also the option to invest $25.00 per loan, further reducing the default risk of the loans. Although I currently have over one hundred loans, our total invested capital in peer to peer lending is only a very small portion of our investable assets.

I only recommend this for folks that can afford to take a loss on their investments in the expectation of receiving out sized gains. The Social Lending Network is a blog devoted to peer to peer lending. If you’re interested in the topic, it is a great place to learn more. If you do decide to loan through peer to peer lending, make sure that you only invest a small portion of your investment funds in this type of opportunity.

3. Take advantage of the historically low interest rates and borrow. Don’t borrow on your credit cards as those rates are way too high (and probably always will be). But if you are considering buying a home or refinancing your current abode, now is the time to do so. Home prices have sunk across the country and mortgage rates are at all time lows. There are even FHA loans with low down payments available for those that lack enough saved up for a 20% down payment. The FHA website has a handy calculator to help figure out if you qualify for a low down payment FHA loan.

For those looking to lock in a low interest rate loan or refinance their current mortgage, according to Bankrate.com, a 30 year fixed mortgage can be had for about 4.0% and a 15 year fixed mortgage for 3.27%. In many parts of the country, your house payment would equal or be less than a comparable rental.

Although we just bought our condo seven months ago, we are refinancing with a low interest rate 15 year mortgage. Our thinking is that when retirement rolls around, it will be a bonus not to have a mortgage to worry about. So even though our new interest rate will be lower than that on our current 30 year mortgage, the payment on the 15 year loan will be  a bit more. The monthly increase is worth it to us to save over $100,000.00  in interest payments over the life of the loan and pay it off in half the time.

Don’t forget to check out the first article in this series, What do Low Interest Rates Mean?

Please add your strategies to capitalize on the current low interest rates.

image credit; Madison short sale.com

My Inflation Panic During a Trip to Target

I made the deliberate decision to get a Target credit card because they automatically give you a 5% discount on everything you purchase in the store. Add that to the fact that I like the trendy Target merchandise and the grocery items. Sounds like a great plan, right? Target isn’t known as a high end retailer, so why did I have a panic upon visiting Target this week?

Prices are Skyrocketing on Many Consumer Products

I pride myself in being an economically savvy consumer. I know the shopping tricks; buy in season fruits and veggies, check out the per unit cost, buy in bulk, shop with a list, and avoid impulse purchases. But when I got to the bathroom cleaner and saw the $3.49 price on an item I am certain recently cost $2.50 recently, panic began to emerge. Then I went to the grocery section and couldn’t find a box of cereal for less than $4.00. Yikes, what happened to the $2.99 generic brands? And the price shock continued from section to section.

I am certain price inflation is here. I lived through periods last century of tremendous inflation and remember the effect. It’s like you are getting a salary cut.

Gas Prices and Inflation

As an economics major in college and a finance professional, I have my finger on the economic pulse of our country and the global marketplace as well. But you don’t even need to be very smart to figure out that goods are transported to their destination by air and land. And fuel powers the vehicles. With oil prices sky rocketing, it is virtually impossible to avoid inflation. One cannot expect the corporations to absorb the increased fuel and transportation costs. The consumer must pay more.

Add the rising oil prices to the certainty that during the next several years, interest rates will rise. Rising oil prices and interest rates will create a perfect climate for inflation to continue to rise. After all, when interest rates rise, it costs corporations more to borrow money to finance their operations. The increase in interest costs are subsequently passed on to the consumer in the form of higher prices.

Now that I’ve sufficiently shared my anxiety with you, let’s look at some coping strategies for dealing with inflation.

How to Handle the Coming Inflation

Fortunately, since inflation is a common occurrence, there are reliable coping strategies. Following are some of my inflation busting strategies, for consumers and investors, as well as tips from across the web.

Shopping Tips

REINVEST YOUR DIVIDENDS

With interest rates at historic lows and increasing volatility in major stock indexes, dividends have become the rallying call for investors. Blogs devoted to dividends proliferate and investors believe that dividend stocks are the best equity investment. Don’t get me wrong, dividends are fine, but just because a stock pays a hefty dividend does not mean it is a great investment. And the dividends the stock throws off are not “free money”.

What is a Dividend?

Dividends are earnings a company is electing to pay to the shareholder in lieu of reinvesting in the company. If the company does not pay a dividend, the earnings are used within the company to fuel growth initiatives, which if successful, will lead to higher share prices. If a company pays out a portion of those earnings, they are communicating that they believe you have a better use for those funds than the company does.

Wait a minute. Dividend paying companies are out of growth ideas?

Not exactly, usually dividend paying companies are older more established firms with a decent track record. These companies are confident that they will continue to grow into the future and decide to allow shareholders to participate in their profits now  instead of waiting until the shareholder sells their stock to benefit.

Why You Shouldn’t Spend Your Dividends?

Let me preface this statement by saying, if you are in the retirement phase of your life and living off of your investments, there is absolutely nothing wrong with spending your dividends. This message is directed at those in the accumulation phase of their lives and building their net worth.

Case Study

Marlon holds shares in Awesome Industries. He bought 100 shares at $10.00 per share, for a total outlay of $1,000.00. Awesome pays a 1.5% dividend. Annually, Marlon receives $15.00 from his investment in Awesome.

If Marlon spends that $15.00 per year, that’s it, the money is gone!

If Marlon is a savvy guy and decides to reinvest his dividends and use them to purchase more shares he’ll have a lot more cash at the end of 10 years. Assume that both the company and its dividends grow at 7% per year.

After 10 years, at 7% annual growth, if Marlon spends his dividends, his stock is worth $1,967.00.

But Marlon decides to reinvest his dividends each year in more shares of Awesome.

At the end of 10 years, Marlon’s initial $1,000.00 investment is worth $2,282.60. For an annual compound rate of growth of 8.6%.

By reinvesting his dividends, he earned an additional $315.60 or 1.6% annual  return.

The Takeaway

REINVEST YOUR DIVIDENDS AND YOUR MONEY WILL MAKE MORE MONEY. Spend your dividends and the money is lost.

Some of my Favorite Dividend Blogs

Dividend Ninja

Buy Like Buffett

Dividend.com

Dividend Monk

For those out there with dividend income, do you spend or reinvest?

MSN Money selected their Top Money Stories of 2011. Initially, I began to dissect their list and intended to write about them all. But, I got stuck on the low interest rates for savings. This is a huge topic and decided it warranted an entire article. In fact, The Huffington Post suggests this environment, instead of helping the economy is actually keeping consumers from spending.

ANEMIC RETURNS ON SAVINGS

This one impacts anyone with money to invest in a savings account, CD, or short term bond. The historically low savings rates are slashing retirees lifestyles. All the folks looking to earn a return above 0.9% on their savings need to do some digging around.

LOW INTEREST RATES

As I updated our familys’ asset allocation this week, I was smacked in the face with the deplorable return. As we keep a hefty 20% of our portfolio in cash investments and 20% in bond type investments, I relentlessly searched for some sort of return on the fixed portion of our portfolio.

TIPS

I decided I would pursue investing in Treasury Inflation Protected Securities (TIPS). After all, at least they will keep up with inflation. Much to my dismay, Charles Schwab had none yielding a positive return. I certainly am not investing in a TIPS fund right now, because as soon as interest rates rise, the principal value of the fund will fall, netting a certain loss. In fact, the TIPS fund we currently have is priced at $117.00. Fortunately, we bought the shares when it was priced at $100.00. I decided to wait and put in a bid for the April auction and hopefully, buy individual TIPS at par. With individual TIPS, you always receive the principal payment back when the bond matures plus an adjustment to compensate for inflation.

SERIES I GOVERNMENT BONDS

Series I (for inflation) Governement Bonds are similar to TIPS. With I bonds you not only get a FIXED (does not change) rate of interest, but you get a BONUS; you receive an ADJUSTABLE rate of interest that changes along with the inflation rate. So the combined interest rate includes a fixed interest rate (currently zero) plus an inflation adjusted rate for a new combined interest rate which adjusts every six months. These bonds can be bought at your bank in small denominations up to $10,000.00 per year. They are among the best choice for inflation protection.

SHORT TERM BONDS

Next, I went on to Schwab and searched their fixed listings for bonds with terms of between 2 and 4 years. I found a great A rated bond paying close to 3% and maturing in  2013. When I went to purchase, I realized the minimum investment was $100,000.00. That was a bit steep for us! None of the other short term bonds paid more than 2%.

CERTIFICATES OF DEPOSIT

On to CDs to find out what type of interest rate I could snare for the next 2 to 3 years. At Bankrate.com the best interest rate I found was 1.29% for 2 years. For a 3 year CD, the top rate shot up to 1.53%. Although the Federal Reserve Bank alluded to keeping rates steady into 2013, there is something upsetting about settling for such a low rate.

Personally, I would rather keep our uninvested cash and fixed funds totally liquid in case rates rise in the next six months. Or maybe I’ll bite the bullet and buy a one year CD. I’ll keep you posted.

SAVE THIS ARTICLE

Although the returns on these investments are presently quite low, they will go up. Print this list out and save it. These are some good ideas for your short term funds. One thing I’ve learned from decades in the financial markets, rates go up and down. For those borrowers out there, there will come a time when you are crying for these low interest rates. For the savers and fixed investors, rates are bound to rise.

In sum, get the best rate you can but don’t tie your money up for too long as rates will eventually go up.

Where are you parking your short term cash?

image credit; Doug88888

Many of my readers have specific personal finance questions. The extra information in the WEALTH TIPS NEWSLETTER (sign up on right) seems to spur even more questions. I love sharing my financial experience with others, so here is this weeks question.

John wrote in and asked for advice for himself and his daughter;

HISTORICAL RETURNS

I would like your opinion and advice on how I should allocate my investments and my daughter’s investments among mutual funds. Both our accounts are with Fidelity. I am 56 and plan to retire at 60. I have $400,000 in IRAs (Traditional and Roth). My daughter is 24 and has $65,000 in an individual acct and $50,000 in both Roth and rollover IRA. There are so many funds to choose from and I feel overwhelmed. Any suggestions would be helpful.

Caveat; This article will touch on the topics to consider when choosing mutual funds. Please do not take this as personal advice for your individual situation. There are many considerations when planning an investment portfolio. For any specific investing information, please contact your own investment advisor or CPA. Fidelity has advisors on staff that can help with investment questions as well. Personal disclosure-I have an account at Fidelity.

Too Much Information is Not Always Better

There is scientific evidence that it is more difficult to make a decision when confronted with a large number of choices, than when given just a few choices. I think this is particularly true when it comes to investing in mutual funds. Did you know there are more individual mutual funds than individual stocks? How is someone able to decide among the over abundance of offerings?

Determine Your Risk Level First

Before considering how many and what type of funds to choose, you must figure out how much volatility or risk you can stomach. Those who cannot sleep when their investment portfolio goes up and down, should have less invested in stock investments and more in fixed or bond type investments. Additonally, the more time available before you need access to your funds, the more agressively you can invest.

Stocks and stock mutual funds are quite volatile and over the short term (which can be up to five years) can go up or down in value. Over periods of more than ten or twenty years, their normal trajectory is upward.

Never put any money in stock type investments which you will need within the next five years.

Bonds are less volatile, yet long term historical data suggests that they offer lower levels of return than stocks. Contrary to the past few years.

In general, if you are close to retirement and cautious about risk you should have a more conservative portfolio with a larger percentage of your funds in bond type investments than stock type investments.

John’s 24 year old daughter has a long working life ahead of her, time to make up any investment losses and should think about investing a bit more agressively.

Which Mutual Funds to Choose?

Actually, this is a much easier question than you would think. You only need a few index funds to have an optimal portfolio. Since John’s accounts are at Fidelity, I’ve included some Exchange Traded Funds (ETFs) which can be bought commission free at Fidelity. Most of these funds and ETF’s are generic index funds with low expense ratios.

Most low cost, broad based index funds of the same type are comparable. Vanguard has the largest selection of low fee index funds.

Pick an index fund from each category:

Total U.S. Stock Market Index Fund

• Vanguard Total Stock Market Index Fund (VTSMX)-Fidelity charges a fee to buy this mutual fund
• Russell 3000 Index Fund (IWV)- Exchange Traded Fund with no commissions from Fidelity

Broad-based International Index Fund

• Fidelity Spartan International Index Fund (FSIIX)

Diversifed Bond Index Fund

• Vanguard Total Bond Market Index Fund (VBMFX)-Fidelity charges a fee to buy this mutual fund.
• Barkleys Aggregate Bond Fund (AGG)-Exchange Traded Fund with no commissions from Fidelity

The percentages invested in each fund depend on your risk tolerance and preferred asset allocation. To learn more please sign up for my Wealth Tips Newsletter and get a free e-copy of 20 Minute Guide to Investing (top right of this site). There are sections on determining your risk tolerance and asset allocation.

The most important factors in investment wealth building are to pick an asset allocation and stay invested through thick and thin. The chart of historical returns illustrates that long term asset performance is generally positive. If history is any guide and if you believe the USA and world economies will continue to prosper, your investments will increase in value over time.

For more commentary on Index Funds:

Save Money with Index Funds at Invest it Wisely

Index ETF’s vs Index Mutual Funds; Which are Better? at My Personal Finance Journey

Money Help for Christians provides a Beginner’s Guide to Index Funds, Mutual Funds, and ETFs.

Are Actively Managed Funds a Fools Game Compared to Index Funds? at Squirrelers.

Consumerism Commentary offers a sophisticated debate; John Bogle and Jeremy Siegel Debate Index Funds.

What are your preferred investments?

SIMPLE ASSET ALLOCATION

MBA Series #1

“Don’t put all of your eggs in one basket.”

The beginning of the year is portfolio rebalancing time for investors. I write a lot about investing as I believe it is an achievable path to long term wealth. If you don’t know what asset allocation is or much about investing at all, then this article is for you.

Modern Portfolio Theory is the science that drives most of the writing about investing today. As I put the finishing touches on the university class I’m teaching this winter in Investments, I’m going to share some of the basics with you; FOR FREE!

Tried and True Investing

Diversification in investing means don’t put all of your money in one investment or one type of investment.

Why?

When that investment goes down, there goes the value of your invested assets-down.

Buy different types of investments, so that when one goes down in price, the others may go up, or at least remain stable.

Diversification smooths out the ups and downs of the value of your investments.

For example, it is rare for bonds and stocks both to go down at the same time. During the past decades bonds have outperformed stocks, an historically unusual occurrence. Over long periods of time stocks have outperformed bonds, but a combination of both asset classes reduces your portfolio volatility.

There are all types of asset classes such as, international stocks, country specific stocks, small cap stocks, commodities, real estate, corporate bonds, government bonds, international bonds and many more. All of these types of assets can be bought as individual holdings, or combined in mutual funds and exchange traded funds (ETF). But, you don’t need to worry about the wide variety of asset classes unless you are passionate about investment management. You can obtain a satisfactory amount of diversification with just  two ETFs or mutual funds.

Asset Allocation means selecting specific asset classes and choosing the percentage amount invested in each asset class. The chart above illustrates a simple asset allocation model.

Simple Portfolio Management

The research abounds that a basic asset allocation of a certain percent in stock investments and a certain percent in bond investments has led to long term wealth creation.

With annual rebalancing to make sure the percentages in each asset class remain in alignment with your stated preference, you can grow your assets with little time spent in managing them.

Index funds and ETFs are perfectly suited to a simple and effective portfolio management approach. The two asset portfolio shown in the chart above combines a world stock market index ETF with a total US bond fund. Depending upon your age and risk tolerance, place more or less in each asset class.

Rebalance your portfolio at the end of the year to get back to your originally selected asset allocation. In other words buy or sell from each holding to get back to the desired percentage amount invested in each fund. Paul B. Farrell of Market Watch has a wonderful series called the Lazy Portfolios with several asset allocations and performance metrics. For more ideas on this topic, it’s worth a read. The ten year annual returns of the 8 Lazy Portfolios ranged from 4.8% to 6.8% versus a ten year return of the S & P Index of 2.86%.

Consider this easy approach to investing to grow your wealth over time. This method is ideally suited for use with a workplace retirement fund.

For more on this topic, subscribe to my Wealth Tips Newsletter and receive a free ebook, 20 Minute Guide to Investing. (Sign up on the right)

Caveat; This article is for information purposes only and is not a recommendation to buy or sell any specific securities. For investment advice see your own personal advisor.

If You Can’t Get Enough Asset Allocation, Here’s More

Asset Allocation by Age at Couple Money

Doug Warshau wrote about Asset Allocation for People in their Twenties at Sweating the Big Stuff

The Absolute Importance of Asset Allocation at Money Help for Christians

My Personal Finance Journey shares his Asset Allocation

For those asset allocators out there, what is your asset allocation and why?

Many readers, especially those recipients of my Wealth Tips Newsletter (sign up on right) write in with money questions. Recently a reader asked What to do with Retirement Funds When I Switch Jobs?

Today, SN wrote in asking about investing in bond funds. This is a really important topic right now.

Dear Barb,

While re-reading your simple but powerful book – 20 Minute Guide to Investing (free when you sign up for Wealth Tips Newsletter on right)– I came across the list of Bond Index Mutual Funds. For the last few weeks, I have been thinking about and researching different options of investing in a bond fund, and so the list was quite handy and timely.

My current overall portfolio asset allocation has grown lopsided over the last two years, and is skewed more toward equities – 90% equities and 10% bonds. My target asset allocation was 80% stocks and 20% bonds. To get back to my target allocation, I am not planning to sell off my equity portion; instead, I am planning to direct my new cash toward bond/bond fund purchases.

It’s with this backdrop that I am planning to direct my Roth IRA contribution of $5,000.00 toward the purchase of a bond fund. As I already have a total bond fund in my account, I am considering buying inflation protected securities, i.e., Vanguard Inflation Protected Securities Index (VIPSX), as recommended in the guide.

I’m not sure what I should do at this stage, and so would like to seek your
expert advice. SN

Bond Characteristics and Interest Rates

Bear with me while I switch on my “professor” hat. A basic characteristic of bond investing is that when interest rates fall, bond prices rise. Conversely, when interest rates rise, bond prices fall. As any savings account owner realizes, interests rates are at an all time low. Thus, when interest rates rise, the direction of any bond fund net asset value is down.

Bond returns consist of two parts;

1. Coupon payment (similar to interest payments)
2. Price appreciation or depreciation

For example, buy an individual bond and hold it until maturity, your total return consists of the coupon payments and the return of the principal purchase price. Unless the bond issuer defaults, you are promised the coupon payments and return of principal. Although while you hold the bond, the actual “price” may go up and down, if held to maturity you won’t lose any principal value. If you sell before maturity, you might garner a capital gain or loss.

Bond Funds versus Individual Bonds

Buy a bond fund and there is no end date like with an individual bond.  For example, buy ABC Bond fund today for $10.00 per share. At the time of purchase the fund pays dividends of 3% per year or $0.30 per share. But here’s the difference, if interest rates RISE, the price for the bond fund will FALL. Thus, assume interest rates go up a percent or two over the next few years, the bond fund price will most likely decline from $10.00 to a lower price. You will experience a LOSS when you sell the fund.

So, if you buy a BOND FUND when interest rates are very low, when interest rates rise and the bond fund price falls, you will experience a loss on your initial funds when you sell since there is no end or maturity to a bond fund!

To Invest or Not in Bond Funds?

Currently, I am not investing in any bond funds. For the “bond” portion of a portfolio I would recommend buying individual Treasury Inflation Protected Securities (TIPS). These are the same investments that are included in the Vanguard Inflation Protected Securities Index (VIPSX) you mentioned in your question. The only difference is that when you buy the individual bonds, you can hold them until maturity thereby avoiding the decline in principal value.

How does the TIPS investment work?

• With TIPS, the interest rate is set at the purchase date. It always stays the same. Today, the interest rate will be negligible.
• PRINCIPAL value of the investment goes up and down with the inflation rate.
• When the principal increases (decreases) you will get a LARGER (smaller) interest payment on the new principal amount.
• When the TIPS security matures, you get the higher or original principal amount; At maturity, you never get a smaller principal.

Buy TIPS directly from the government at TreasuryDirect.gov.

If you are looking to fund the bond or fixed portion of your asset allocation, buying TIPS will ensure that your funds match the inflation rate thereby preserving your principal contribution and matching future increases in inflation.

If you have a personal finance or investing related question, write in and it will be considered for a future column.

How are you funding the fixed portion of your portfolio today?

image credit; chicken tender