Objective information about financial planning, investments, and retirement plans

Investment Diversification – A Look at the Basics

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Investment Diversification is one of the basic tools  of building a sound investment portfolio. Diversification is the fancy name for  the advice your mother might have given you:  Don’t put all of your eggs in one basket.  This is the basic tenant behind asset allocation, a key diversification tool.

My fellow finance blogger Ken Faulkenberry defines investment diversification as follows:

“Investment portfolio diversification is a portfolio strategy combining a variety of assets to reduce the overall risk of an investment portfolio. “  

A basic look at diversification 

Based on Ken’s definition you could use stocks, bonds, mutual funds, ETFs, private equity and a whole host of assets and asset types in building a diversified portfolio.  In the examples that will follow I am going to limit this to mutual funds investing in stocks and bonds.  Please note that nothing that follows should be construed as advice or a recommendation of any kind.  The mutual funds and allocation percentages used are for example only. 

Let’s start with an investor with $100,000 to invest.  Let’s go back in time to January 1, 2000.  One thought would be to pick a fund that invests in a variety of stocks.  Perhaps the Vanguard 500 Index Fund (VFINX) is a good choice.  How much would an investment of $100,000 have grown to by December 31, 2009, the end of the press has deemed the lost decade?  The answer is that your $100,000 investment would have shrunk to $90,165 for an average annual loss of 1.03%.  Truly a lost decade for this investor.

Let’s say this investor added the following funds to his portfolio:

  • Vanguard Small Cap Index (NAESX)
  • Vanguard Mid Cap Index (VIMSX)
  • Vanguard Total International Stock Index (VGTSX)

How much would an investment of $100,000 invested equally in each of these four funds have grown to by December 31, 2009?  (We are assuming no taxes or rebalancing in this and all examples in this article)  The answer is $137,511.  This is $47,346 or about 52% more than an investment of our investor’s cash only in the Vanguard 500 Index.  Let’s look at the average annual investment returns for each of these funds for the period 1/1/2000 – 12/31/2009:

Vanguard 500 Index -1.03%
Vanguard Small Cap Index  4.36%
Vanguard Mid Cap Index  6.13%
Vanguard Total International Stock Index 2.29%

 

While the average annualized return of 3.23% over the course of the decade is nothing to write home about, it does illustrate the potential benefits of diversification.

Let’s add some bonds 

Some say building a portfolio is much like cooking, which is one of my favorite pastimes.  My motto in the kitchen is “… when in doubt add more wine…”  Sadly wine and investing are not a good mix.

What if we added some bond funds to the mix?  In this case let’s add the following funds:

  • PIMco Total Return (PTTRX)
  • T. Rowe Price Short-Term Bond (PRWBX)
  • American Century Inflation Adjusted Bond (ACITX)
  • Templeton Global Bond (TPINX)

If we now divide the investor’s $100,000 investment equally among the four equity funds from the prior example and among these four bond funds, by 12/31/2009 the $100,000 investment has grown to $174,506 or almost double what an investment of $100,000 in the Vanguard 500 Index Fund alone would have yielded.  The portfolio’s average annual return was 5.72% for the decade.

Looking at the average annual investment returns for each of the bond funds for the period 1/1/2000 – 12/31/2009:

PIMco Total Return 7.65%
T. Rowe Price Short-Term Bond 4.89%
American Century Inflation Adjusted Bond  7.20%
Templeton Global Bond 10.66

 

The impact of diversification

Again this example was based on eight funds weighted equally with no rebalancing and the reinvestment of all distributions.  This was an unusual decade in that bonds largely held their own or outperformed equities.  It is likely that if we performed this same analysis for the ten years ended December 31, 2019 the results would look different.  None the less there are a few things we can take away from this analysis:

  • The decade 2000-2009 was a poor one for large cap stocks as illustrated by the use of the S&P 500 index fund.
  • Small, mid cap, and international equities outperformed domestic large cap stocks.
  • Diversifying the equity holdings in this example boosted overall portfolio return.
  • Bonds were aided by generally declining interest rates and lower volatility than equities.  Both of these factors helped their overall return for the decade and really boosted our hypothetical portfolio.  Bonds in general have a relatively low correlation to equities which assisted in mitigating the volatility of our portfolio and enhanced returns.
  • Even in this “lost decade” asset allocation helped enhance return.

What does this mean for the future? 

Clearly the period used in the analysis was unique one, a decade that contained market declines (as measured by the S&P 500 Index) of 49% from March of 2000 through October of 2002 and 57% from October of 2007 through early March of 2009.  However it seems that market volatility has become the norm rather than the exception so the current decade will likely be an interesting one as well.  A few lessons we can take forward:

  • Diversification reduces risk.
  • Diversification among assets with low correlations to one another further reduces risk.
  • Diversification is important because we have no way of knowing which investments or asset classes will perform well or poorly or when.

Please feel free to contact me with your investing and asset allocation questions. 

For you do-it-yourselfers, check out Morningstar.com to analyze your investment holdings and to get a free trial for their premium services.  Please check out our Resources page for links to some additional tools and services that might be beneficial to you. 

Note that all data used in this article was generated via Morningstar’s Advisor Workstation.

Photo Credit:  Flickr

 

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ETFs – 4 Considerations Before Buying

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ETFs (Exchange Traded Funds) are the  “hot” investing product. Fund companies are tripping over themselves to bring new ETFs to the market place.  This reminds me a lot of the mid to late 90s and the proliferation of new mutual funds.  While the number of ETFs is lower, the growth in new products is still high.

Traditionally most ETFs have been index products.  The new frontier is actively managed ETFs.  Several providers have filed for approval to offer active ETFs, no doubt buoyed by the success of the ETF version of PIMco’s popular Total Return bond fund (tickers BOND for the ETF and PTTRX for the fund).

I have been a big user of ETFs in the portfolios of my individual clients.  To date I’ve used index ETFs exclusively.  The low cost and style purity are the big selling points in my opinion.

Just as with mutual funds or any other investment vehicle, investors need to do their homework before buying an ETF.  Here are 4 factors to consider:

Understand the ETF’s underlying index

Beware of ETFs with somewhat suspect underlying indexes. According to Chuck Jaffe in a MarketWatch article several months ago, a Vanguard report found that “1,400 U.S. listed ETFs track more than 1,000 different indexes. But more than half of these benchmarks had existed for less than six months before an ETF came along to track it.” 

Many of these new ETFs rely on the hypothetical back-testing of these new indexes. While history is not always a good predictor of future performance, I like to see an ETF with an underlying index that has been “battle tested” in the real world.

Even among ETFs tracking more traditional indexes there can be differences.  For example in the Large Cap Growth style:

  • iShares Russell 1000 Growth ETF (IWF) tracks the Russell 1000 Growth Index, the growth slice of the Russell 1000 Index.
  • Vanguard’s Growth ETF (VUG) is in the process of switching index benchmarks as part of an overall switch of benchmark providers by Vanguard across many of its index mutual funds and ETFs.  The new provider’s index will remain a bit different from the Russell index used by the Barclay’s ishares product.
  • The Schwab U.S. Large Growth Index (SCHG) tracks Dow Jones U.S. Large-Cap Growth Total Stock Market Index, with a smaller market cap than the benchmark index of the other two ETFs. Additionally the Schwab ETF has higher weighting in financial stocks than most other Large Growth indexes.

To most investors these are fairly subtle differences, but none the less each of these Large Growth ETFs will exhibit slightly different performance during different market conditions.

Leverage and inverse indexing

Not all ETFs make sense for all investors.  There are a number of ETFs that move inversely with a given benchmark.  For example there are ETFs that move in the opposite direction of the S&P 500 index.  What many investors fail to understand is that these movements are tied to the markets on a daily basis, over longer periods of time the performance may not be as closely tied to the inverse performance of the index due to the use of derivatives in these products.

Leveraged index ETFs are available both long and inverse.  These ETFs multiply the movement of the index both up and down.  This is great if you’ve “bet” in the right direction.  However if for example you hold a leveraged ETF that goes 3 times inverse of the S&P 500 Index during a  market rally the ETF will drop in value roughly 3 times as much as the gains on the S&P 500.

There is nothing wrong with either inverse or leveraged ETFs as long as you understand how they work, when and when not to use them, and are comfortable with the risks.  In my opinion these products are not appropriate for most individual investors.

Know what you are buying 

With the advent of “funky” index products as mentioned above and with the growth of actively managed ETFs, investors really need to understand where they are investing their money more than ever.

ETF providers are just like mutual fund providers (in fact many firms offer both) in that they are about gathering assets and making a profit.  There is nothing wrong with this, but make sure that you invest based upon your needs and unique situation and that you ignore their hype, especially about “new and better” ETFs. 

Cheap is good 

One of the great features about ETFs has generally been their low expense ratios.  Just as with mutual funds and any other investment vehicle the cost of ownership is critical, cheaper is better.

Along these same lines there is an ETF price war going on.  The major players are Vanguard, Barclay’s (via their ishares), and Schwab who is trying to make inroads into the ETF business. It is key to make sure that the ETF product fits your needs and your portfolio, don’t just opt for the lowest expense product.

It is also important to note the transaction fees involved in buying ETFs.  Remember ETFs trade like stocks during the trading day as opposed to mutual funds which trade daily after the market close.  A number of custodians offer no transaction fee trades for certain ETFs.  Look at how you will be investing. Will you make larger lump-sum purchases? If so, paying a transaction fee for an ETF really won’t make much of an impact. However, if you will be making smaller purchases, say via dollar-cost averaging, it pays to look around.

Do you use ETFs?  Please leave a comment about your experiences with ETFs both good or bad.

Please feel free to contact me with your financial planning and investing questions. 

For you do-it-yourselfers, check out Morningstar.com to analyze your ETFs and all of your investments and to get a free trial for their premium services.  Please check out our Resources page for links to some additional tools and services that might be beneficial to you.

Photo credit:  Wikipedia

 

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Are My Investments Safe?

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This is a question that I hear and am asked often.  Concerns over the issue of investment safety have increased markedly

MILWAUKEE, WI - JUNE 9: Justin Turner #2 of th...

over the past few years in the wake of high-profile investment scams, such as with Bernard Madoff, as well as a result of the severe market decline of 2008-09.  This is a question that should be addressed from several points of view.

Which investment was the safer choice? 

A major concern of investors in or approaching retirement is the risk of losing money from their investments.  Any way you look at it, a 37% loss in the S&P 500 Index (as occurred in 2008) is devastating, especially to an investor on cusp of retirement.  Many investors sold out of their equity positions in late 2008 or early 2009 just as the stock market was nearing bottom (the S&P 500 hit its low point of that cycle on March 9, 2009).

Let’s look at an investor who had $10,000 in an S&P 500 fund at the beginning of 2008.  The index lost 37% for the year so his fund was worth roughly $6,300 (we will ignore fund expenses for this example).  If this investor sold his holding and moved it all to a money market fund his money would have “grown” to maybe $6,500 by September 20, 2012.  As anyone who invests in a money market fund knows the interest rates are abysmal.

By contrast if the investor had held onto his fund, it would have been worth about $10,899 as of September 30, 2012.  While the market fund would not have lost any money during a couple of down periods over this time span, the investor certainly lost purchasing power.  Which investment was the safer choice?

When investing client money risk of loss is certainly top of mind, hence the reason client dollars are invested in a diversified portfolio that combines their need for investment growth with their aversion to losses.  I would tell any retiree or pre-retiree that their biggest risk in retirement is loss of purchasing power (aka running out of money) vs. the risk of investment losses.

Safety from fraud 

Whether its Madoff, Alan Stanford, or any number of lesser know fraudsters investment scams are in the news a lot.  I’d like to tell you that using a fee-only NAPFA member like me is an iron clad guarantee, but alas we’ve had several former members accused of defrauding clients, including two former organization chairmen.  Part of protecting yourself is using you own good common sense.  Ask these two questions (among others):

  • Are the returns touted by the money manager too good to be true?  In the case of Madoff he sold false consistency.  The returns were very steady, but unspectacular.  They were also not possible given how he claimed to have invested the money during the years of his fraud given what actually occurred in the financial markets.
  • Will your money be housed at reputable third-party custodian (Schwab, Fidelity, your bank, etc.)?  If not, this is huge red flag, end the relationship immediately.  This was again a key element in Madoff’s fraud.

Over and above this, check up on what your advisor is doing.  Get online access to your accounts and review each statement carefully with an eye towards verifying and understanding each and every transaction that occurred. 

Safety from fear mongers 

This isn’t one that makes many lists of investor concerns.  I won’t call these folks fraudsters as such, but when the markets aren’t doing well folks telling you to shun more traditional investments and put your money in gold or index annuity products come out of the woodwork.  Both of these can be viable alternatives for a portion of your investment allocation, as can many other non-traditional vehicles.  Again, understand what you are buying, the fees involved, any restrictions on accessing your money, and who is selling the investment product to you.  Invest from a position of knowledge, not fear.

As a brokerage commercial stated many years ago “… money doesn’t come with instructions…”  You don’t need to be a financial expert but you do need to be diligent about who you invest with and where your money is invested.

Please feel free to contact me with your financial planning and investment questions.

Photo credit:  Source: daylife.com

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