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;

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

• Recession
• Mortgage Meltdown 
• Sub Prime Lending Crisis
• European Debt Crisis
• 911
• Wars in the middle east
• Growth of China as a major world competitor

There are always outside forces that play on our economy and investment returns. These forces are called systematic or market risk. This risk is unavoidable and plagues all market participants. No matter how diverisifed your portfolio is, you cannot avoid systematic risk.

What is an investor to do?

In reviewing the stock market returns from 1928 to 2011 one could assume that rates went smoothly upward at 9.28% per year. Actually, that average hides a bumpy road. Returns on stocks over that time period ranged from annual double digit losses to annual double digit gains. Growth in investing is fraught with ups and downs. Not unlike life itself.

Is There a Pattern to Economic Growth and What Does it Mean for You?

Economic growth typically follows a path that looks a bit like a roller coaster, with gradual increases, leading to a high point of strong economic growth, followed by slowing GDP and usually a recession. This type of growth is certain, where the mystery comes in is the “when”. Cyclical growth is a given; but when the trend changes is unknown. 

 ECONOMIC GROWTH CYCLE

 This pattern means several things to investors. Investing is a long term endeavor. Don’t even think about investing any money you will need within the next 5 years in the stock markets. Stock market returns are way too volatile for short term investing. Knowledge of market behavior will help you stay the course during market fluctuations. Once you understand that the ups and downs in economic and investment returns are normal occurrences, you can learn not to be  surprised when the market tanks for a year or so. In fact expect that every few years, there will be a year with negative stock and/or bond returns.

Accept Ups and Downs in the Market as a Reality and Profit

As an investor here is a simple plan to stay the course.

1. Choose an asset allocation you can live with.

2. Select diversified low cost index funds from a range of asset classes for your investment portfolio.

3. Contribute regularly to your investment account during market ups and downs. In fact, contributing assets in a declining market yields the greatest rewards.

4. Look at how much money you can amass over a few decades of regular investing. Invest $4,000 per year from ages 25 to 65 in a diversified stock index fund with an average annual return of 7.5% and retire with close to $1,000,000.00. Regular investing over time yields great rewards. 

5. You must download my free eBook; 20 MINUTE GUIDE TO INVESTING to learn investing basics and receive a bonus subscription to the Wealth Tips Newsletter.

Following are some of my recent investing articles across the blogosphere;

• The Digerati Life, Buying Bond? The Effect of Interest Rates on Bond Value versus Yield
• Free Money Finance. Dividend Investing is Not the Perfect Solution for Yield
• Consumerism Commentary, I’m consulted about Buying a House with Cash

Women’s Money Week

I’m participating in Women’s Money Week next week. Women have historically been laggards when it comes to finances. This week is about encouraging women to speak up about money, take control of our finances, and reshape our financial future. Women’s Money Week will run from March 5th-11th, 2012 on WomensMoneyWeek.com — coinciding with International Women’s Day.

Following are a few of the participating blogs in Women’s Money Week (I’ll include a few more each day)

Moneylicious
Monroe on a Budget
Moola Saving Mom
Mortgage Free By 30
Mother Miser
Mrs. Nespy’s World
Ms. Money Savvy
Mummy Deals
Musing of an Abstract Aucklander
Musings of a Midlife Mom
My 1/2 Dozen Daily
My Broken Coin
My Dollar Plan
My Journey to Eliminate Debt
My Money and My Life
My Open Wallet
My Pretty Pennies
My Year Without Wasting Money
ND Chic’s Cents
Newlyweds on a Budget
Next Stage, The: Women and Retirement
No More Sheeple
No More Spending
Northern Cheapskate
Northern Living Allowance
Not a Coupon Queen
Not Made of Money
November Sunflower

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?

How Do You Analyze Invesment Performance?

In investing, you feel great when your statement shows a nice fat annual return like 12% or even 13%. Conversely, when you have a “bad” year with a negative return, you’re disappointed.

What is a benchmark? “A standard used for comparison. For example, the NASDAQ may be used as a benchmark against which a technology stock is compared.” Investorwords.com

What are the Correct Benchmarks to Use For My Investments?

What Does Index Mean? “A statistical measure of change in an economy or a securities market. … An index is an imaginary portfolio of securities representing a particular market or a portion of it. Each index has its own calculation methodology and is usually expressed in terms of a change from a base value. Thus, the percentage change is more important than the actual numeric value. Stock and bond market indexes are used to construct index mutual funds and exchange-traded funds (ETFs) whose portfolios mirror the components of the index.” Investopedia.com

How Did My Stock Fund Perform; year-to-date?

The Takeaway

Forget about absolute performance, if you seriously want to evaluate how your investments are performing. Find the benchmarks for your mutual funds, they are listed in the prospectus or on the web-site. Then look at how your investments did in comparison with their unmanaged index benchmarks. If you are besting the indexes over time, great. If not, consider switching your money into a low cost unmanaged index fund. You’ll be certain not to underperform the market!

I’ll let you in on a secret, many years ago, someone told my dad to buy gold. And he did. But after decades of no upward movement he sold. I know he is sorry now. The lesson is that in investing you have some hits and some misses.

ACTION PLAN:

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.

• Choose a mutual fund or etf that you own or are thinking about buying. Go to the web-site of the holding.
• Look at it’s recent recent and long term performance.
• Compare the performance with it’s benchmark.
• If you fund is underperforming it’s benchmark, think about whether to keep it or switch into a related unmanaged index fund.
• Be sure to consider tax consequences.

(Remember, do not take this article as investment advice, but as educational information)

Top Investing Yakezie Blogs

• Buy Like Buffett
• OilandGasETFs
• Darwins Finance
• Financial Success for Young Adults
• Investor Junkie
• Money Mamba
• PTMoney
• The College Investor

Top Investing Websites

• Seeking Alpha
• Morningstar
• Investopedia
• Yahoo Finance
• CNN/Money

How are your investments performing?

image credit; ryanpyle.com

For a quick overview of Investing Strategies, pick up my FREE eBook; 20 Minute Guide to Investing (top right of the page). If you like what you’re reading, sign up for my RSS feed or email subscription and follow me on twitter so you get the word immediately.  

Welcome to encore month at Barbara Friedberg Personal Finance. We are caravanning across the country to our new home in a new land. During this major transition, please enjoy guest articles and some of my best previously published posts.  

This first week of July, check out my MBA series and get some of the same material I taught my Portfolio and Investing students.

a version or this post originally published; May 25, 2010

Risk versus Reward

“When the weather changes, nobody believes the laws of physics have changed. Similarly, I don’t believe that when the stock market goes into terrible gyrations its rules have changed.” Benoit Mandelbrot

This brilliant mathematician speaks to the fact that the price of common stocks goes up and down. Plain and simple, that is where  the risk comes from.

As I have mentioned in a previous article, please follow these steps before beginning an investment program.

Main Topic: What is the relationship between investing return and risk?

Understand the relationship between risk and reward and become a smarter investor. There is an unavoidable trade off between risk and reward. If you desire a higher return on your investment, you must take greater risk.

How it works; a risky investment compensates you with a higher return than a safer investment. If the returns were the same, you would always choose the one with less volatility!

Reward=More money back from your initial investment

Risk=Possibility that your payback won’t be what you expected, but less than you expected.

 NO ONE IS UNHAPPY IF THEY MAKE MORE MONEY ON AN INVESTMENT THAN PLANNED!

So the risk is really that your investment will be worth less in the future than when you started.

How to get a reward from investing?

1.  Buy a financial asset such as a mutual fund which holds common stocks. One of my favorites is Vanguard Total World Stock Index Fund Investor Shares (VTWSX).
2. Receive periodic dividends (cash payments) along the way.
3. Watch your investment increase in value.

How much might I earn?

1. Over the last 80 years, U.S. stocks returned a bit over 9%/year.
2. There is a strong probability that holding this stock mutual fund for 10 years or more would produce a greater return than keeping your money in a savings account.
3. If you invested $1,000 in year 1- received a 7% (a bit more conservative return) return for 20 years, you would have about $3,900.00 at the end of 20 years.

How can I get this terrific return?

1. Open a brokerage account at Vanguard.com or any discount broker.
2. Arrange to have money transferred to the account from your bank account.
3. Purchase a diversified stock index fund (a fund that holds lots of different stocks from a variety of industries).
4. Reinvest the dividends; instruct Vanguard to buy more shares of the fund with the dividends.
5. Wait 10-20 years. Or continue investing every year multiply your returns. 

What is the risk?

1. Stocks, like those in the mutual fund you bought go up and DOWN in price. The risk is almost certain that during those 10-20 years, some years, the value of your investment will go down.
2. There is a possibility that you might have less money than you started if the historical trend of the stock market shifts and becomes negative.
3. Although there is a risk that some years your investment return will be negative, if history is any guide, over the long term, you will earn more money by investing in stocks than if you kept the money in the bank money market account.

How do I decide whether investing in a stock mutual fund is for me?

If you answer YES to these questions, investing in a stock mutual fund may be

right for you:

1. Do you have 6 months of living expenses in cash in a safe savings account?
2. Do you have term life insurance for your dependents?
3. Are you without credit card debt or at least paying it off?
4. Can you leave the money in the stock mutual fund at least 8-10 years?
5. Do you want to earn a greater return than the inflation rate for future goal(s)?
6. Can you sleep at night and not panic if your investment value declines sometimes?

PRACTICAL APPLICATION: Why Take the Risk?

In investing, the greater the potential reward, the greater the risk. Common stocks have the potential to offer high returns in the long term. In the short term their values move up and down so much that it is impossible to predict whether your return will be positive or negative.

If you want a way to finance long term goals such as retirement, home renovations, down payment on a home, and college expenses for your child, then stock mutual funds are an excellent vehicle. However, if you cannot cope with an investment that goes up and DOWN in value, do not invest in common stock mutual funds.

ACTION STEP:

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

 If you are interested in investing, and want to read more, check out these resources:

•  
  • Vanguard investing truths
  • Get Rich While you Sleep with the Magic of Compounding
  •  Little Known Investing Secrets: How to Buy Low (Always)
  • ETF Risk at Monevator

 What are your thoughts on investing risks. Have you ever invested more than you could afford to lose?

image credit; O. G. Kraze

For a quick overview of Investing Strategies, pick up my FREE eBook; 20 Minute Guide to Investing (top right of the page). If you like what you’re reading, sign up for my RSS feed or email subscription and follow me on twitter so you get the word immediately.  

In a recent article, How Long Until I’m Wealthy?, I received such a depthful comment the response cried out for an entire article.

Little House commented:
I like how you broke down the stocks and bonds percentages. Do you really think we can expect an average return of over 7% over the next 30 years? My husband and I were just discussing how savings rates are so low and have been for 10 years. We remember when we were kids in the 80′s that they were up to 12%! We can’t fathom them returning to this rate any time soon. Of course, savings rates aren’t the same as stock returns, but still. Am I being to gloom-and-doom? Will we see these returns again? I hope so!

HOW ARE STOCK MARKET RETURNS CREATED?

Economic growth is propelled by innovation, commerce, and invention. Here’s how it works:

•  A company creates products and services.
• Individuals and other companies buy these items.
• Eventually the goods and services may be sold internationally.
• The company makes more money and gets bigger.
• As the company grows, they purchase more from others just as others are buying from them.
• Then, the company sells shares (ownership in their firm) to the public and the stockholders can participate in the profits (losses) of the company.

This is the stuff that “economic growth” is made of.

These steps create more wealth in the participating economy.

Smaller companies can grow faster than larger ones. And smaller (developing) countries can grow faster than larger ones.

IS 7% RETURN ON A BALANCED PORTFOLIO POSSIBLE IN THE FUTURE?

Assume you have an investment portfolio consisting of stock and bond mutual funds (or ETFs). Further, you include some international index funds as well. Finally, toss in some holdings from developed and emerging markets.

Consider these questions and answers to determine whether a 7% investment portfolio is possible in the future.

Will interest rates on bonds and cash increase in the future? It’s likely that interest rates will rise since they are at a historical low point.

Will China, India, and Brazil continue to grow rapidly in the future? There is little evidence to suggest their rapid growth is slowing. These emerging markets (and others) with quickly growing economies will offer higher stock market returns than the slower growing countries.

Will European and North American markets continue to grow? As long as these developed markets continue to innovate and grow goods and services available for consuming and exporting, they will expand. 

BARB’S TAKE

I AM NOT A SOOTHSAYER, but if I had to predict; the world economies, over the long term will expand. Will they falter at some points? Absolutely, as economic growth is cyclical.

History has rewarded those who invested in stocks and bonds. If you have more than 10 years until you need your investment funds, and world markets continue to grow, a balanced allocation of stocks and bonds representing various size companies from around the world could very likely reward you with a 7% annualized return.

And if you’re looking for higher returns on cash, with upcoming inflation, ballooning interest rates will likely pump up your returns on money market funds and certificates of deposit as well.

Readers, what do you think. Is a future 7% return on a balanced portfolio plausible?

image credit; CreativeApril