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

“Cash confiscates capital. Long term, after taxes and inflation, the return on cash is negative.” Catherine Keating

Since my mid-20’s, I made financial net worth goals for our family. I’d calculate our current net worth, add additional savings, and punch in an expected rate of return over the period, usually five to ten years. Occasionally, I go back and review prior goals. No matter what the market, over the long term we have met or surpassed the objectives.

Learn how long it takes to meet or surpass your financial goals.

Assumptions:

• Save monthly.
• Divide Savings among STOCK (60%) and BOND (40%) investments. The historical average annual return of 60% stock funds and 40% bond funds is 7.4%. To be on the conservative side, I’m going to assume an annual return for this portfolio of 7%.
• Investment returns over the next 20-40 years approximate historical averages; STOCKS 9% BONDS 5%

HOW LONG WILL IT TAKE?

At an annual return of 7% per year, how long until you are wealthy?

If you save $100 per month, in 40 years you will have $242,481.00. Increase that to $800.00 per month and you’ve got over 2 million dollars after 40 years investing.

Drop your monthly investment to $500.00 and invest for 30 years. You still wind up with a nest egg of over $600,000.00. Not bad.

Empowerment-It’s in your Hands

There are no guarantees in life-but regular savings and investing will DEFINITELY make you wealthier than SPENDING!

Finding the balance between spending and saving leads to pleasure now and future security.

LEARN ABOUT INVESTING

Download my free eBook from the form on the top right of the site. It’s not hard and will get you started to prosperity.

Barbara Friedberg Personal Financeteaches WEALTH BUILDING SKILLS. Pay attention, be patient, don’t overspend on stuff that doesn’t last; save, invest, and you can become rich. Take action to hit your wealth target.

Why I’m Nervous About the Market

If you like what you’re reading, pick up my RSS feed and follow me on twitter so you get the word immediately.

This is a chart of some holdings in the professional portfolio I manage. I have some concerns about their valuations.

Investigating a few metrics implies conflicting valuation information. 

PE Ratio: As I wrote over at Buy Like Buffet in One Step Stock Analysis, the price earnings ratio (PE ratio) is a simple way to begin a stock stock (or Exchange Traded Fund) analysis. As a recap, lower PE ratios indicate undervalued and higher suggest an investment may be overvalued. The best use of this metric is to compare the raw ratio to its historical average.

52 week high and low prices: These prices show the annual price range of a holding. When the current price is hovering around the 52 week high, there’s cause for further investigation. It is more likely the price will drop rather than rise. 

MY CONCERNS

• The PE ratio’sof these ETF’s are either about average, or a bit low as compared their historical norms. This indicates at worst, fair value for the investments and at best, a bit undervalued.
• Since 1870 the historical PE ratio on USA stocks is about 15.
• Every price of these ETF’s is near their 52 week high. Although the prices could continue to rise, they have already increased over 100% in the case of VTI to 43.34% in VNQ. Compared with long term averages, these are substantial annual year increases.
•  In theory, stock prices should correspond with increases in revenues and earnings. In the short term, this rarely occurs. But, if the prices of these holdings moved in accord with their earnings, we should prepare for a substantial share price drop.
• In the short term, stock prices are extremely volatile.

 INCONSISTENCIES

Price earnings ratios are not seriously overvalued.

Rates of return are off the chart. In other words, the rates of return are enormous when compared to their historical averages.

Another consideration, as we are rebounding from several years of negative and low rates of return during the recession, these exceptionally great price advances are not unusual.

Large and small cap stocks average annual returns are 10.17% and 12.01% respectively. Last year, the Vanguard Total Stock Market index returned over 100%. If the statistical concept of “reversion to the mean” (simply put, returns adjust towards their average return over time) comes into play, we are in for some economic pain.

I’m not the only one unsure of the market valuations.

The Yale academic, Robert Shiller, and creator of the 10 year (trailing) Shiller PE is at odds with the market strategist, David Bianco. In the Wall Street Journal article, Is the Market Overvalued?, by E.S. Browning. Shiller believes the market is overvalued and Bianco disagrees.

MY RECOMMENDATION

Even if the market is overvalued, it may take some time to correct. No one predicts the future with certainty and consistency.

 If you are an investor, you need to accept the reality that financial assets go up and down in price.

Maintain an asset allocation you are comfortable with. If you are jumpy about market volatility, invest a smaller percent of your assets in stocks.

Do not invest any money in the stock market you need in the next 5 to 10 years.

Let me first confess; over my investing lifetime I have invested in a large variety of investment vehicles. During many years I’ve beaten the Standard and Poor’s 500 index by several percentage points. In spite of my long term positive investing record, here’s why I recommend choosing index funds.

INVEST IN INDEX FUNDS

The Securuties and Exchange Website defines an index funds as:

“A type of mutual fund whose investment objective typically is to achieve approximately the same return as a particular market index, such as the S&P 500 Composite Stock Price Index, the Russell 2000 Index or the Wilshire 5000 Total Market Index. An index fund will attempt to achieve its investment objective primarily by investing in the securities (stocks or bonds) of companies that are included in a selected index.”

Have you ever been presented with a list of mutual funds and been struck with total confusion? Maybe it occurred when you started a new job and the human resources representative presented you with the abundant investment choices for the company’s retirement account. Or maybe you visited an investment company website like Vanguard or Charles Schwab determined to start investing and found yourself overwhelmed.

First off, congratulations for beginning to invest, it is an important step in creating a secure financial future.

Of course, I would be remiss if I didn’t remind you to take these steps before beginning an investment program (unless you have a company match at work and then, contribute enough to the retirement account to get the match).

Here’s Why to Invest in Broad Based Index Funds

1. Proven Winners

Years of empirical investment research has proven that most actively managed mutual funds FAIL TO BEAT the returns of passive index funds. 

What does this mean? You can spend lots of time selecting a mutual fund managed by a star. His or her fund might outperform for a year or two. But…. over the long term, the index fund returns will beat those of the actively managed fund. 

The Elements of Investing (my favorite investing book), by Malkiel and Ellis, share well documented research that  ”over 10-year periods, broad stock market index funds have regularly outperformed two-thirds or more of the actively managed mutual funds.”

It is extremely difficult for an actively managed fund to beat the returns of an index fund over the long term.

2. Streamline Investment Decisions

There are literally thousands of mutual funds to choose from. Pare down the choices by sticking with index funds. Make investing decisions faster.

Leave more time in life for living!

3. Lower Costs

Since index funds are passively managed, the investment decisions are straightforward. No need for a cadre of overpriced managers here! And lower fees mean less money going to management and more money in your pocket.

Most actively managed funds charge upwards of one percent management fee per year. Index funds annual fees are much lower. Compound those fees over many years, and you are keeping more of your investment dollars invested!

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 and follow me on twitter so you get the word immediately.  

What are your investing recommendations? Do you index or not?

image credit; suns financial