Investing 101

This evening I had a lengthy, perhaps unproductive conversation with my best friend about investing.  She wants to have a nest egg for the future.  She also does not want to spend all of the money that she has recently been able to acquire.  Most importantly, she knows she is interested in investing, not just saving.  Unfortunately, she does not know a lot about investing, but I gave her a quick crash course.

STOCKSWe talk about stocks all the time that as often as not the exact definition and even the concept can escape us.  Just to clarify, stock are slices of ownership in a corporation.  The ownership is split among thousands of investors, so the ownership is less than 1% of the company, but the performance of the stock reflects the success of the company, so if the company is turning a beautiful profit, your stock should reflect your proportion of ownership in the form of a dividend.  Stocks pay dividends quarterly (sometimes less often like semi-annually or annually) to their owners.

Unfortunately, if a company is trading at $10/share, then investing only $100 to buy 10 shares is counter-productive (transaction costs alone would eliminate profits), so you would have to invest $1,000 to buy 100 shares and even then, you would only have shares in one company.  At that rate, you would need at least $10,000 to invest in 10 different companies in order to maintain any adequate portfolio, and even then, ten companies is not a lot if you were investing strictly in stocks.

Therefore, I classify stocks as a rich-man's game.  There are exceptions to that classification, and E*trade insists that everyone from smart-ass toddlers to their butlers should participate.  Personally, I disagree.

BONDS
Whereas stocks are ownership in a corporation, bonds are the antithesis.  They are company-issued debt.  If a company needs an influx of cash, they will offer a 10-year bond (for example) and they would pay interest monthly on the bond, then pay the principal of the bond at maturity.  While stocks fluctuate greatly with the success of the company to which it is associated, bonds have no variation.  Therefore, they are a far more stable investment.

However, buying bonds has the same issue as above.  If it is a $10,000 bond, then an investor would put the $10,000 out first, and then it would build.  In the bond market, the price may trade below (or even above) the face value of the bond itself in which case terms like "premium" and "discount" come into play, but to keep it simple, a bond is company debt repaid at a later date and you benefit from monthly (sometimes quarterly) interest.  The interest payments in bonds are similar to dividends in stocks.

MUTUAL FUND
The downside to both investments is that it requires a lot of money to begin investing.  This deterrent would prevent several hundred thousands of people from investing if not for a mutual fund.  A mutual fund was once defined to me as an investment vehicle where a group of people pool their money to invest in the stock market with the benefit of diversification and professional management, neither of which they could achieve individually.

Instead of an individual coming up with $10,000 to buy 10 stocks of 10 corporations trading at $10/share, a group can achieve this same feat and, even better, they can easily surpass those numbers.  Mutual funds allow an individual to achieve genuine market diversification through a relatively small investment.  In terms of which stocks to buy and when to sell them, each fund has a professional money manager to make those decisions to the otherwise uninformed shareholders.

The best benefit of mutual funds is their flexibility in terms of starting costs.  While stocks trade at specific prices per share, and investors can only purchase whole shares, mutual funds can sell fractions of shares.  Therefore, if a mutual fund were trading at $10, an investor could buy 12 and a half shares for $125.  Although most investors undervalue this benefit, the beauty comes in with simplified reinvestment when the fund pays dividends.

INDEX FUND
As you may have guessed, professional management is not cheap.  Mutual funds have many fees, sometimes called loads such as "front-end loads," to pay the professionals for their expertise and effort.  Obviously, this is a sweet deal for the money manager but it adversely affects shareholders, especially since the market is too unpredictable and mutual funds require daily attention to the point that money managers do not add as much value to the fund as investors may suspect.

The idea is to "beat the market," i.e. earn returns in excess of the growth of the economy (or losses less than the market declines), but only half of the money managers succeed, and when they succeed, it is usually not by a substantial amount.  Therefore, John Bogle ascertained that a mutual fund could seek to match the performance of the markets and it would not need professional management.  This theory turned into the first index fund and John Bogle later founded The Vanguard Group, where I was employed for most of the past 10 years.

BALANCED FUND
Another type of investment vehicle combines all the aforementioned vehicles.  It is a balanced fund, and they can be issued in a number of ways.  It could be a mutual fund that invests strictly in other mutual funds (e.g. "fund of funds").  If those funds include bond funds (which buy numerous bonds and replace those bonds when other bonds mature), then it would be a balanced fund.  The balanced fund may invest in index funds exclusively.

The benefit of a balanced fund (whether it is indexed or not) is that its focus is on the allocation.  If it's allocation is 70% stock and 30% bonds, then it is going to re-balance daily.  Throughout this blog, I expressed the importance of asset allocation and periodic re-balancing.

MY FAVORITE INVESTMENT
Now that we have all those terms defined, it seems that this new information should be put to some use. Therefore, I figured I could share my single favorite investment and explain why it is my favorite. It is the Vanguard STAR Fund, which is an actively managed balanced fund. The term "actively managed" means it is not an index fund. The mutual fund invests in 11 other mutual funds (all held by Vanguard) so it has exposure to stocks (60%) and bonds (40%) through 20 independently managed sub-portfolios with different yet complementary investment strategies. Also, it has a minimum initial investment of $1,000 (the average at Vanguard is $3,000).

But the real reason this fund is my favorite is that it puts the principles of a solid investment allocation first, and its returns are far less volatile than investments strictly in stocks or strictly in bonds. I never appreciated how useful this discipline was until I saw comparisons of hypothetical investments of $10,000 over the course of 10 years for this fund, compared to the Vanguard Total Stock Market Index Fund and the Vanguard Total Bond Market Index Fund. The difference was astounding because when the markets went up, this fund went up. When the markets went down, this fund went down. Contrasted mostly against the Vanguard Total Stock Market Index Fund, its declines were not nearly as drastic yet its gains seemed to be on par with the index fund. In other words, it had all the upside potential while minimizing the downside risk.

I put two months salary into the STAR Fund a while back because I was curious whether, if at an arbitrary point in the unforeseeable future, my investment balance would be more or less than two months salary at my job. I call it my "Engagement Ring Fund" for obvious reasons, but the investment experiment is virtually worthless to me now since I quit my job, so the comparison is no longer a gauge of time.  Also, I've given up on finding a spouse so my arbitrary point in the unforeseeable future is irrelevant to me (P.S., please never use this blog for advice on love).

Included to the right are four charts showing the comparison of the Vanguard STAR Fund to its Total Bond Market Index Fund (Investor shares), Total Stock Market Index Fund (Investor shares), and the Prime Money Market Fund. The charts are from various 10-year periods, including January 2009, February 2009, May 2009, and November 2011.

As you may remember from personal experience or reading prior entries here, the stock markets took a sharp nosedive in late 2008, which bottomed out in March 2009. Additionally, the Tech Bubble busted in March 2000, and then the markets dropped further after September 11, 2001, reaching a bottom in November 2002 if I recall correctly.

Obviously, the Prime Money Market Fund was not phased by any of the volatility since it is a stable value fund. The Total Bond Market Index Fund went through its share of rewards and challenges over 10 years. But note the similarities in the Total Stock Market Index Fund to the STAR Fund. When things were bad, they were worse for the Total Stock Market Index Fund. When things were good, they seemed to be equally good for both funds. This is why the fund is my single favorite investment.

When I started working at Vanguard, I had a joke about the fund's name. It was STAR but, as far as we knew, it did not stand for anything. However, I suggested that the fund should be a pre-starter fund (a starter fund is the first investment selection for your portfolio) so the letters S-T-A-R represented the beginning of the word "Starter." Looking back now, I think it was a ridiculous yet valid observation.

MSN MONEY: 'Father of 401k' disowns it

Ted Benna, who three decades ago seized on an IRS loophole to transform American retirement savings, says he's proud to be "father of the 401k." He also thinks he created a monster.

The plans, which he intended to be as simple for employees as pensions, now offer too many investing options and too many opportunities to make mistakes, he says. "I would blow up the system and restart with something totally different," he told SmartMoney. "Blowing up the existing structures is the only way we can simplify them."

In 1978, when Congress passed the section of IRS code for which the plans are named, lawmakers aimed to limit the scope of cash-deferred plans being offered by some companies, but had no intent to revolutionize retirement. Benna, then the co-owner of the Johnson Companies, a benefits consultancy in suburban Philadelphia, was developing such a plan for a bank client when he happened on the idea that section 401k could allow an entirely new option.

The original 401k plans "could be explained to employees in just a minute," Benna, now 69 and semiretired himself, says. "There were two options, a guaranteed fund and an equity fund," he says. "With the guaranteed investment fund, we'd tell them this is what you will have when you retire. With the equity fund -- which was usually something like the Fidelity Magellan fund -- we'd say, you might have more, but you might have less. Most people would split their contributions 50-50 between the two."

Plans became too complicated
As the plans were embraced by employers and financial institutions, Benna says 401k's were made so complex one needed to be an investing pro to make sense of them. "Now this monster is out of control. We went to three options, then to six, then to seven, then to 15 -- it is far beyond what most participants were able to deal with," Benna says. "And I am not convinced we have added value by getting more complicated."

Better education was supposed to be the solution to intricacies of the plans, Benna says. If employees understood the options, the power of compound interest and dollar-cost averaging, and the advantages of making pretax contributions, it was believed they would do the right thing. "We're throwing tons of money away trying to teach participants how to become skilled investors -- we said, we are going to make people smart and savvy enough to make the right investment decisions, but it just hasn't worked."

Benna blames the newfound complexity on what he says was the small percentage of employees who wanted it. "What triggered this whole mess is that some of the more sophisticated participants were a pain in the butt," he says. "You'd have these troublemaker loudmouths push human resources, and say, 'Why don't we have this "flavor of the month" fund?'" These sophisticated employees are also the ones taking advantage of the education and advice being offered, he says.

Overwhelmed, employees made mistakes
The consequence of all the complexity is twofold, he says. First, employees felt they could be more active investors. "There is too strong a potential for employees to do the worst thing ever, which is moving in the wrong direction, panicking when things are bad and cashing out after they have been battered." Secondly, the current plans induce "a kind of gridlock -- employees get so overwhelmed they do not participate -- they do nothing," he says.

Education didn't work to stop employees from sabotaging their own futures, he contends, but legislation might. "We need a legislative mandate that when you change jobs, the money needs to be retained in a retirement account -- there cannot be an option of 'here's a check, you decide,'" Benna says. He also advocates mandating all employees be auto-enrolled in the plans, and that their contributions be automatically increased one percentage point per year to a maximum of 10% to 15%.

Despite these misgivings, Benna insists the plans are benefiting millions of employees. He gets rankled whenever someone suggests the workforce would be better off had the 401k never been born, noting that the pension system was more fraught that many remember. "I am not anti-defined-benefit​ plan -- in fact I sold them for decades -- they are great, but only for those who stay with the same company for 20 or 30 years."





By Jeremy Olshan vai SmartMoney.com
http://money.msn.com/retirement-plan/article.aspx?post=eb9632ff-1d35-44ad-bf77-349f8492a081

Failure Is Unlimited

I feel as though I would be remiss if I did not discuss Occupy Wall Street somewhere in this blog, so tag this entry with #OWS.

Too bad no one argued that banks were "Too big to bail."

For the past several years, the phrase "too big to fail" has been a buzzword in these shaky markets. Certain corporations, especially in the banking and insurance industries, have been granted various benefits to keep the company afloat under the guise that they are too important to our economy to risk failing. It mostly started in the fall-out of the Lehman Brothers bankruptcy, and it was deemed a necessary measure to prevent the country from falling into an extensive recession or another "Great Depression."

It has been a controversial phrase in the finance industry since the beginning, mostly because it is a blatant oxymoron. While it has arguably been a success in keeping the economy going, the inherent flaw in the concept is destructive to long-term growth. The dissenting opinion of this tactic is that if large companies are endangered, then their structure is flawed and their collapse will see several new companies emerge from the ashes. Former Federal Reserve Chairman Alan Greenspan simplified it when he said, "if they're too big to fail, they're too big."

The Occupy Wall Street movement has pushed this issue and similar issues to the forefront recently. The(se) protest(s) is (are) mostly against this tactic and other methods to protect the country's wealth, which unfortunately has translated into protecting the country's wealthiest.

The Dow Jones Industrial Average (DJIA) or "The Dow" is comprised of 30 components. By components, we mean corporations or stocks. There are more than 2300 companies actively traded on the New York Stock Exchange. The reason the Dow is cited most often is that its history dates back to May 1896, so it compares today's markets to 100 years of history in a single measure. However, the reality is that while the DJIA is the most cited index, most index funds have far more than 30 stocks in them. Case in point, the Vanguard 500 Index Fund has 500 companies, mirroring the S&P 500. When one of those companies falls from the S&P 500, it is sold from the fund and the new company entering the S&P 500 is purchased. There is a constant "out with the old, in with the new" methodology built into the index fund itself. Likewise, the Vanguard Total Stock Market Index Fund has over 3,000 companies, so the Dow is quite literally 1% of the total stock market.

Unfortunately, the exact demands of OWS have been conceptual and the protests are unclear. Personally, I had a vague idea of the issues central to the movement, but I had to research OWS at length before I could discuss it. Most recently on "Market Watch with Mo Ansari" (an often-cited radio program), there was a guest who opposed "too big to fail" methods and proposed that what our country is facing would be the "lost decades," as opposed to the singular "lost decade" (2000-2010). At the center of his discussion, though, was a pitch for a plan to balance the country's budget in 10 years. He said several other groups tackled the proverbial Rubik's Cube known as the nation's deficit, and his proposal was the only one to wipe it out in 10 years (conversely, the average of most other proposals was 40 years).

Social Security would continue, he promised, but it would be limited to the population who needed assistance, and the population who did not need the financial assistance would stop receiving the benefits. At that point, I had to wonder: where is the incentive to be a productive member of society? I stopped listening to the guest and started pondering the question for myself. I remembered when my ex-girlfriend told me that she had to pay income tax, and I was genuinely excited for her! She moved out of state and started paying all her bills herself for the first time in her life. On top of that, she was earning enough that she owed taxes at the end of the year. Every single part of that filled me with vicarious joy. She, on the other hand, was not excited.

It seems most conversations about Occupy Wall Street begin and end at this troubling concept.

What exactly was the one demand?

Since the guest on the program mentioned lost decades, it is only appropriate to debunk that misconception as well. If a mutual fund (or individual stock) were trading at $10 today and you invested $1,000, then you would obviously have 100 shares. If the fund (or stock) rose to $17 in five years and then fell to $9 two years later, but then rallied back to $10 three years after that, then it seems as though you would have the same $1,000 again from ten years ago.

Except each year, sometimes each month or each quarter, the fund (or stock) will pay a dividend. For bonds, this is the interest earned on the debt. For stocks, it is a portion of the profit paid out to the owners of the company (stockholders). If you are investing in a tax shelter, such as a 401(k) or IRA, then you are most likely reinvesting dividends. This may not apply to complex portfolios, but the assumption of reinvesting dividends is usually a safe bet.

Therefore, you spent 10 years going between $9 and $17 per share, but your $1,000 investment is substantially higher because, periodically, the fund paid dividends and put money back into itself in the form of more shares. Ten years ago, you had 100 shares trading at $10. Ten years later, you could have 125 shares trading at $10. The investment's earnings would be 0%, but your actual return would be 25%.

However, these "cumulative returns" are often overlooked. While the media is viewing the markets at a 0% return and naming it a lost decade, your wealth has grown 25% in this single investment. The first investment in my Roth IRA was on March 11, 2003, and it went into the Vanguard 500 Index Fund. Lucky for me, that day was the lowest point in the market of the year. I did not invest any more money into that particular fund (future Roth IRA contributions went into other funds) but this investment has given me a bird's eye view of cumulative returns, so trust me when I say it was not lost time for me. The only real "losers" of the Lost Decade were the people sitting on the bench and not getting into the game.

Catchphrases and hooks grab attention. Personally, where my money is and what it is doing is enough to get my attention. And I don't have to outsource that attention to the financial media. "Too big to fail" and "lost decades" are worth discussing, but they should never drive personal investment decisions. Like Mo Ansari often reminds his listeners, you have to invest based on what the markets do, not what they should do. Which is to say, the markets rarely listen to the what financial media says. Follow the market, not the media.