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?

We have records of the performance of the stock market dating back to 1870. During that time we have experienced four stock crashes. The market tops came in: (1) 1900; (2) 1929; (3) 1965; and (4) 2000. Stock returns were poor for the 20 years immediately following each of the first three crashes and so far for the first 12 years immediately following the fourth crash.

Crashes obviously hurt all investors (and, indeed, even non-investors — the losses suffered in crashes cause economic crises which dramatically diminish economic growth for the entire society in which they occur). But they don’t hurt all investors to the same degree or in the same way.

This column looks at how crashes affect investors at four stages of the investing life cycle in different ways. The four stages are:

(1) Young Investors (age 25 to age 45)

(2) Investors Approaching Retirement Age (age 45 to age 65)

(3) Investors in the First Decade of Retirement (age 65 to age 75)

(4)Investors Beyond the First Decade of Retirement (age 75 forward).

 Young Investors (Age 25 to Age 45)

The dollar hit delivered to these investors is minimal. In fact, looking only at the dollar hit, it can be argued that stock crashes benefit this group.

An investor close to retirement age might have $1 million in his portfolio. A price drop of 65 percent would cost him $650,000. That’s a devastating hit. It’s far better to take the hit at a time when you only have $100,000 in your portfolio. The $65,000 loss might seem like a big deal to the person with only $100,000 of life savings. But crashes only occur once ever 35 years or so. So getting the crash out of the way when you are 35 means not needing to worry about the next one until you are 70. The investor who experiences a crash early in his investing lifetime will see huge gains uninterrupted by crashes in the years of greatest wealth accumulation (the late 40s, 50s and early 60s).

There’s another side to the story. Crashes cause economic crises. Younger workers are far more in need of job opportunities than older, better established workers. Experience a crash in your 20s or 30s and you may never see the career growth you need to see to be able to retire at a reasonable age. It’s good to experience your stock crash when you are young if you have a good job before the crash hits. If the crash hits before you are established in your career, it could be that the hit you experience from not being able to obtain a good job will be far larger than the hit you experience as a result of a drop in your portfolio value.

For young investors who have established themselves in good careers before a crash hits, the crash can actually be a big plus. Stock valuations always go to one-half of fair value before the bear market comes to an end. When stocks are priced at one-half fair value, the most likely annualized 10-year return is 15 percent real. Young investors experience small dollar losses in a crash and are then positioned to experience huge gains in the years when they are earning enough to invest heavily in the market.

Investors Approaching Retirement Age (Age 45 to 65)

Since crashes only come once ever 35 years or so, those experiencing crashes in the years leading up to retirement enjoy a good number of years of compounding returns before the crash takes place. This gives them the opportunity to accumulate large amounts of wealth.

The problem is that investors who accumulate large amounts of wealth without suffering a crash often come to believe that they are immune to the market laws that insure that we will see crashes ever 35 years or so. Investors who enjoy big gains for decades often ramp up their spending on the presumption that there will never again be a crash. This hurts them in three ways.

One, they become accustomed to a living standard far beyond what they will be able to afford after the effect of the upcoming crash is taken into consideration. Two, they lose the ability to see gains on their portfolios once the crash hits (remember, stocks provide poor returns for 20 years following a bull market top). And, three, these investors take their hit at the worst possible time for doing so, when their portfolio values are nearly large enough to finance a middle-class retirement.

Investors in the First Ten Years of Retirement (Age 65 to Age 75)

This is the worst time to experience a crash. The historical data shows that retirees that survive ten years without being wiped out in a crash almost always work until the investor’s death. But even portfolios that appeared on the day the retirement began to be plenty large enough to support a long retirement can fail if there is a big hit in the first ten years of the retirement.

The problem is the compounding returns phenomenon. Investors who count only direct dollar losses greatly underestimate the price they pay for living through a crash. Each dollar lost is a dollar that would have been generating compounding returns for many years to come had the crash not taken place.

Non-retired investors can mitigate this effect by making new contributions to their portfolios, contributions likely to earn big returns because the market always dishes out truly mouth-watering returns in the years following the end of a bear market. But retirees are not able to make new contributions. They suffer all the downside of a crash and none of the upside.

Investors Who Have Been Retired More Than Ten Years (Age 65 and Up)

These investors suffer the smallest hit. It’s scary to see a huge drop in your portfolio value at an age when you are not able to return to the workforce. But the financial reality is that, if your retirement was adequately funded at the outset and you went 10 years without seeing a major hit, you have experienced enough gains that your plan should work even if you live a long life.

The one big downside to a crash for investors who have been retired for more than ten years is that it reduces the amount that they will be able to leave to heirs and to charities.

Barb’s comments; I would be remiss without giving a remedy to the chilling impact of large scale stock market investment declines. Asset allocation, tailored to your age and risk tolerance will soften the blow of market drops. If you are in retirement, you should have a large portion of your investment dollars in cash and fixed assets, so that when the stock portion of your portfolio falls, the impact will be cushioned by the stable value of cash investments.

How have the recent stock market delines impacted your investing strategies?

image credit; astrycula

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?

 You must subscribe to my WEALTH TIPS newsletter on the right. You get invaluable wealth building information and a FREE e-copy of my award winning 20 Minute Guide to Investing. Do not hesitate!

On Wednesdays I answer Reader Questions. If you have a money question, write in. You may be considered for a Wednesday column.

Here’s a thoughtful question from Buck Inspire from the article, Contribute to a Roth IRA Today

Buck Inspire: Thanks for the reminder to get more into my Roth!  I also fund my rollovers and Individul  401k.  Which do you think should be maxed out first?  Roth or 401k’s?

This is an excellent question, which to max out first, a 401K or a Roth IRA?

The easy answer, max out both the 401K and the Roth IRA!

What if I Can’t Max out Both My Roth IRA and 401K?

Obviously, if you had unlimited funds, you wouldn’t be reading this blog! In the real world we all need to make financial choices. Where to allocate retirement funds is a common question for investors.

The simple answer is, if your company matches your investment in a 401K, make sure to contribute enough to get the employer match.

After you receive the FREE employer money, then the decision whether to go with the Roth or 401K depends on your answers to these questions:

• What is your tax bracket now?
• Do you think you will be in a higher or lower tax bracket upon retirement?
• Do you like the investments offered in your workplace 401K?

Predicting the Future

I don’t know about you, but my fortune telling skill is limited. Although I believe that tax rates will be higher in the future, I’m not sure if my personal tax rate will be higher. After all, in retirement, my salary income will be gone and I’ll be

How Rich Will I Be?

living on pension, social security, and our invested assets! Again, my soothsaying tells me that this income will be lower than our current income.

How to Choose?

I can’t give Buck a definitive answer without looking at lots of personal information. I can give Buck some analytical ideas to help him decide.

If you really need a tax break now because your income and tax brackets are high, and you think that they will be lower in the future, then the 401K may be the one to max out first. As long as you are happy with the investment choices available in the 401K.

For the newbies out there, a 401K investment removes your contributions from federal taxation now (because you contribute pre tax dollars). The monies continue to grow tax free. But, when you take the funds out at retirement, you pay tax on them plus tax on any earnings as well.

With a Roth, you pay tax on all of your income, and then contribute “after tax” funds to the Roth. These funds grow tax free just like with the 401K. Upon retirement, or at anytime after age 59 1/2 you can withdraw these funds without paying tax on them! It’s a sweet deal.

If your tax bracket is not in the stratosphere now, the Roth IRA has some important advantages.

You choose your preferred investments.

All withdrawals are tax free.

There is never a requirement to withdraw the funds from a Roth IRA.

As with any investing decision, certain assumptions are made. In reality, those assumptions may turn out to be correct or incorrect. So, make the best decision now, with the information you have.

Have any of you dealt with this decision? Did you choose to max out your 401K or Roth IRA?

Caveat; As with all investment decisions, this is not a recommendation to buy or sell any investment product. Before making any investment decisions, please consult your own investment advisor.

Couple Money writes How to Begin Investing for Retirement with $1,000.

Invest it Wisely tells How to Plan the Ultimate Retirement.

Passive Family Income asks How Your Retirement Investments are Coming Along?

Personal Finance By the Book queries, Should a College Student Save for Retirement?

Redeeming Riches wants to make sure you are dealing with these 5 Retirement Risks.

image credit; Photo Knight

Many readers, especially those recipients of my Wealth Tips Newsletter (sign up on right) write in with money questions.

Recently a reader asked, Should I Invest in a Bond Fund Now?

Today, Prasad asks: “What are your thoughts on Closed End Funds and their suitability as income source? I have been reading about them — on the surface they look attractive but trade press does not seem to talk about CEFs at all.”

As many of you know, I’ve been investing for decades and have put my funds in a variety of investment opportunities over the years. That includes closed end funds as well. Truth be told, I have not invested in a closed ended fund in many years as ETFs and Index Funds have filled my portfolio.

INVEST IN A CLOSED END FUND?

WHAT ARE CLOSED END FUNDS (CEF)?

A fun bit of investing history; closed end funds predate open end or mutual funds. So, what exactly are closed end funds? They are similar to mutual funds, but……

The closed end fund invests in any number of different types of securities. For example, the closed end fund might hold all stocks, all stocks of a certain type such as all preferred stocks, or any combination of holdings.

Simply, a company issues a limited number of shares of a fund filled with any variety of financial assets and then the fund trades like a stock on an index. Once the holdings are purchased for the fund, that’s it. The individual holdings within the fund do not trade but are held in the CEF.

The funds actually have two values. The first, is the underlying net asset value (NAV), which is the sum total of the value of the underlying assets on any given day. You can’t buy the fund for the underlying value. The sales price is determined by supply and demand, and is the price the fund trades at in the market. That selling price might be either a premium or discount to the underlying value of the assets.

Closed End Funds, Exchange Traded Funds, and Mutual Funds

Mutual funds issue and redeem shares at the end of the day at the fund’s net asset value.

Closed End Funds do not issue or redeem shares.

The share quantity of CEFs remains constant as does the portfolio of securities and are traded among investors.

ETFs and CEFs both have an underlying portfolio of investments with a NAV and trade on exchanges.

ETFs, and CEFs both trade like stocks on exchanges.

Mutual funds, ETFs, and CEFs have expense ratios, and fee structures. Typically index funds and ETFs have the lowest fee structures.

Mutual funds, ETFs, and CEFs offer distributions of income and capital gains to investors.

According to Morningstar, “ETFs have a redemption/creation feature, which typically ensures the share price doesn’t stray significantly from the net asset value. As a result, an ETF’s capital structure is not closed. CEFs do not have such a feature.”

CEFs can trade at significant premiums or discounts to NAV.

Should I Invest in Closed End Funds as an Income Source?

According to Mike Taggart, CFA at Morningstar, in CEFs are Superior Income Generators, “ While we believe CEFs are, in general, the superior income generators, they are not–as a group–necessarily superior investment vehicles.”

The gist of this article indicates that recently CEFs have beaten their mutual fund counterparts in income generation. But, as I’ve repeatedly stated, you can receive a great income stream, but if the asset value declines, your total return will not reflect out performance. Actually, I discussed just this issue over at Free Money Finance.

My advice to Prasad, in addtion to subscribing to my Wealth Tips Newsletter which includes a free eBook, 20 Minute Guide to Investing is to avoid chasing yield. Today’s interests are at historical lows, and they will rise. The average historical bond yields in aggregate, from Treasuries to Corporates is in the 5-6% range. Invest with an asset allocation that fits your risk tolerance and investment horizon.

Personally, I prefer low cost mutual funds and ETFs. Understand that if you are invested in any type of bond fund right now, when interest rates rise, the value of that bond fund will decline. Interest rates are cyclical and are certain to rise and offer higher yields in the not too distant future.

Keep your investing simple and understand that every investment vehicle has risk and volatility. Look at your portfolio in aggregate and over time. Avoid focusing on the short term ups and downs.

What are you investing in for yield?

image credit; Buzzbotsuccess

And Barb Recommends Links

Sign up on right to get free WEALTH TIP’s Newsletter, and FREE bonus eBook; 20 Minute Guide to Investing!

For whatever reason, I find talking about Roth IRA’s boring. Nevertheless, they are an unbelievable way to amass great wealth. To minimze the disomfort of talking about the subject, I’m going to give you the Cliff Notes Version.

INVEST IN A ROTH IRA

Background; I’m one of those finance nerds who started investing in my 20′s and have not stopped. I was decades younger than the other attendees at my first retirement investing seminar. When a way to invest and save taxes came up, I dove in! Thus, as soon as self directed IRAs became accessible, I started contributing the max. When I met El Carino in my mid-20′s, after just a few months of dating, I got him to contribute to an IRA as well.

This article will tell you why you must contribute to a Roth IRA and how to do it.

WHAT IS A ROTH IRA?

According to Money Chimp a Roth IRA is a tax advantaged investment vehicle which allows your money to grow over the long term and only get taxed one time! You put money in an investment account after taxes, invest it in your preferred investments, and pay zero taxes as the money grows and zero taxes when you take the funds out!

That’s correct, you pay no taxes at retirement when you withdraw the funds.

HOW MUCH COULD YOU EARN?

Assumptions:

Put $5,000.00 in an investment account once every year from ages 25 to 65.

Invest in 3 funds:

40% in Vanguard Total Stock Market Index Fund (VTWMX)

40% in Vanguard FTSE All World ex-US Index Fund (VFWIX)

20% in Vanguard Total Bond Market Index (VBMFX)

Earn an average return of 7% over 40 years.

At age 65 your investment account will be worth $998,175.56

When you withdraw the funds, you pay zero taxes.

HOW TO SET UP A ROTH IRA?

Contact a discount broker such as Vanguard, Fidelity, Charles Schwab, Etrade, or other.

Either on line or by phone, follow the required steps to set up the account.

Transfer money into the account either directly from your bank account, paycheck, or mail a check (very old school).

Choose the funds and indicate your preferred percentage for each one. Instruct the brokerage to transfer this money and future contributions into your funds.

WHAT IF I DON’T HAVE $5,000.00 PER YEAR TO INVEST?

No worries. Invest any amount you can. Start now, and set up an automatic transfer every month. Increase the amount as your income grows. Check out an online calculator to find out how quickly even small amounts can grow into large sums over time.

Barb Recommends

Holding Cash is Not a Sin at Morningstar.com by Liana Madura.Even big time fund managers hold cash in their portfolios. It may be your best move on occasion.

How Much Money is Actually Enough in More Magazine is one of those articles that really inspired me. It changed my perspective and allowed me to loosen some of my negative money thoughts. Read it to be uplifted.

Wealth Informatics asks, Is Gift Giving a Waste of Money? My charity contributions are automated quarterly through Charity Navigator. No muss, no fuss. What do you think of Wealth Informatics approach?

This is a recommend as well as an article where I’m mentioned ; Best Tips for Fixing Your Finances, by Donna Freedman over at MSN Money. This article is jam packed with stellar personal finance recommendations from the best money minds on line. If you are looking to learn more about money, you’re certain to find a resource here.

Priorities by Jason, at Live Real Now got me thinking about my own. This article reminded me that the difference between success and failure is putting limited time towards the most important tasks. While you’re there, don’t forget to enter his 2nd year GIVEAWAY.

The Three Stages of Financial Freedom at Invest it Wisely, also got me thinking. Let this article prompt you to consider what financial freedom means in your life.

The Reasons I Like Money Over Gift Cards at Money Reasons. This article echoes the belief of Clark Howard renowned saving guru. Give money and you can be sure it will not go unused.

20s Money writes about why the Outlook is Not Good for 20 Somethings. As a worrier, I tend to get fraught with concern about future generations. This thoughtful article talks about the perils ahead for the Gen Yers.

The 30K Online Challange at 20s Finances drops down the gauntlet for others to participate in this money making competition. Are you a blogger motivated by competition? If so, why not join in?

 Barb Across the Blogosphere

FindtheBest published,  Should You Buy Investment Products at Your Consumer Bank?

Free Money Finance published Dividend Investing is Not the Perfect Solution for Investing

Benzinga Brain Trust Column, Are IPOs worth the Risk?

Emily from Creditcards.com mentioned my Pro Shopping article

Carnival of Personal Finance, at Afford Anything, promoted my Shopping Video.

Totally Money Blog Carnival at BankNerd, published How to Get Rid of Debt; Start Here.

What type of retirement accounts are you using? What asset allocation do you prefer?

image credit; newsusacontent

And Barb Recommends Links

In Where to Get a Loan; Help I’m Really Struggling last week I wrote about peer to peer lending for those of you who need some extra cash. Many commenters asked about my experiences as a lender. Full disclosure, I started lending to borrowers through Prosper.com in October, 2011 so I don’t have too much history to report. As of January, 2012, my annualized investment return is 7.66%. This return is quite short term and not of too much value yet, but I’ll continue to update my results as time goes on.

Prosper advertises over 10% returns which includes a quantified default rate on some of their loans.

10.69% Returns With Prosper

Why Am I Lending? Like many out there, I’m looking for a higher return for some of my portfolio. In fact, like a banker, there is a possibility of 10.69% Returns With Prosper.

Why Prosper? I read about the concept many years ago, but not until I met one of the key employees and grilled him endlessly, spoke to another large investor, Peter Renton of Social Lending Network, and read through the SEC corporate documents did I decide to invest.

What is the risk of lending in this platform? A borrower might default and you lose your investment in that particular loan. The company might fall on hard times and you lose some of your investment.

How do I compensate for the risk? I only put a small amount of money in each loan. I invest in many loans to diversify the risk. Ultimately, I will invest less than 3% of our overall investment portfolio.

How does it work? You can either automate your investing, or read about each individual case and choose which loans to fund. Want to narrow your choices even more? Set specific parameters for your loans.

Investment returns? It is too soon to analyze my returns as my dollars have been invested slowly over the last 2 months. Check out Prosper’s site to read more about lending money with Prosper. For the thorough investors, there is a link to Prosper’s Securities and Exchange (SEC) legal documents as well!

Caveat, this is not a recommendation but an introduction to an investment product. Please consult your own financial advisor before considering any investment product. As stated in my disclosure, per FTC guidelines, this website may be compensated by companies mentioned through advertising, affiliate programs or otherwise.

Barb Recommends

“I always, always, always have a “Plan B”…and a “Plan C”.  I don’t believe that your income should depend on your job.” Sandy at Yes I am Cheap

After Len Penzo highlighted Sandy’s article, Stepping Out on Faith about her decision to quit a job where she was really happy with her co workers and many aspects of her job, I couldn’t tear myself away. I got very anxious on Sandy’s behalf as she described quitting her job without having another one in place. I read through every comment and finally, the above response reassured me. Sandy had a Plan B!!!

Budgets are Sexy divulges his new mindset, Gigs for Goals – This manner of thinking helps break down what you really want and how to fund it. If you think in terms of working to pay a specific bill or for a specific item, the effort may not be worth it. What do you think?

Farnoosh Torabi talks about HOW ANYONE CAN EARN $100.00 PER HOUR. Fascinating interview, replete with motivation for all you entrepreneurs out there.

My Dollar Plan gives a list of Free or Cheap Holiday Resources. Now who doesn’t want to save money?

How My Grandma’s Lumina Make Me Over 2 Million Dollars over at Soldier of Finance. If you have one piece of advice to take today, this is it!

A Curious Thing Happened to my Credit Score When I Took on Some Debt at Moneycone. Pay attention to your credit score, you don’t know who’s watching.

Are You Ready to be a Landlord? at Krantcents. I gave up personal landlording but still keep my hand in real estate with REITs.

Barb Across the Blogosphere

Expert Blogger, Findthebest.com,  How are Financial Advisors Compensated?

Wealth Creation Series, Interview with Barbara Friedberg at Financial Cactus

Guest article Green Tip, at Sustainable Personal Finance about the merits of Cloth Napkins

Bucksome Boomer included my Penn State Scandal post in her week-end round up

Len Penzo reminded the world of my faux pas in What Not to Wear to a Business Meeting

Carnival of Personal Finance in Personal Finance Journey published my article about True Wealth

Novel Investor featured Investing Rule #1; Know Thyself

What are your thoughts on the peer to peer lending format? Would you consider lending or borrowing?

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

What’s Your Asset Allocation?

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I was fascinated by an article at Oblivious Investor entitled,  Why I Don’t Overweight Small Cap or Value Stocks. Mike cogently laid out the research that over time, value and small cap stocks have ourtperformed a broad based index fund. This is widely accepted information from Modern Portfolio Theory and is considered one of the market anomalies of the efficient market hypothesis. The efficient market theory purports that over time the stock market is generally efficient and that prices reflect all available information and revert to their fair value. This Efficient Market theory is the basis of the indexing approach to investing and states it is very difficult t beat the overall market returns.

Yet, the anomaly rebuffs the efficient market theory and shows that small cap stocks and value stocks, over decades, tend to outperform the overall stock market. Although this is so, there are long periods of underperformane of these asset classes as well. In spite of awareness of this research, Mike decides not to act on the overperformance of value and small cap stocks.

How the Small Cap and Value Stock Outperformance Impacts My Investing

Personally, after studying this research in my MBA program, I added an extra bent towards value and small cap ETF’s to my portfolio. I decided to add those asset classes to our asset allocation and purchased two low cost index ETF’s; one specializing in value stocks and the other in small cap stocks. I was well aware that although small and value stocks outperformed in the long term there were also long periods of underperformance. That doesn’t bother me, as I’m quite disciplined and don’t change my well thought out investing strategy easily.

What About Mike?

In his own words,

“If, however, you’re somebody who would start to doubt your choice–and potentially back out on it at the worst time–during a period of relative underperformance, you should think twice about implementing a tilted portfolio. And that’s the boat I’m in. For whatever reason, I’ve come to have a strong suspicion of anything remotely clever when it comes to investing.”

I was completely taken by his rationale.

In lieu of the possibility of a higher long term rate of return, Mike decided to create a portfolio in line with his self knowledge and investing comfort level. He understands his risk tolerance and is interested in sticking with a simple and clear cut investing strategy in line with his personality.

Very wise.

A Favorite Asset Allocation Site

For more ideas on efficient market influenced index fund investing, take a look at the Lazy Portfolio site. Paul B. Farrell of MarketWatch follows several passive asset allocation approaches and aptly names these portfolios the Lazy Portfolios. From the Margaritaville Portfolio with three holdings to the Aronson Family Portfolio of 11 funds, these all index fund strategies are aptly called lazy because once the money is placed in their respective funds, all you do is rebalance every 6 months or yearly and maintain the allocation.

I highly recommend checking out these portfolios if you are looking for an easy way to manage your investment dollars. This set it and forget it strategy beats most actively traded portfolios!

Finally, I was intrigued by Mike’s disclosure and his discipline to act within his own self knowledge.

How do you decide which investment approach to follow?

image credit; posarma