Should You Be In the Stock Market?

Photo by: mvhargan

I often hear people tell me that they’ve stopped contributing to their retirement account because they don’t think the stock market is going to go up.  It seems many of these people assume that a retirement account and the stock market are one and the same.  Most plans have many options, and nearly 64% have actively managed bond funds as an alternative.1

The fact that many people don’t even know what their options are in their retirement accounts suggests to me that they probably shouldn’t have been in the stock market in the first place.  Many people were initially sold on stock market-based retirement account options by claims that the stock market returned 8%, or 11%, or whatever their advisor was telling them. They put their finances on autopilot and never looked back.  At least they never looked back until 2008.

The Risk Premium

The philosophical rationale for why stocks should outperform “safe” investments, like government treasuries, is something called the risk premium.  In theory, if equities did not outperform safe investments, then rational actors would cease to buy the equities. The prices would decrease to a level where there would be an adequate risk premium.

This theory was put to the test during the recent financial crisis when, at the nadir of stock prices, there essentially was no risk premium for the previous thirty years.2  Since then, stocks have rebounded a good deal and the risk premium has returned. However, it points out an important fact: the risk premium is only likely in the long term and is not guaranteed.

Risk Tolerance

Because of the wild variability of the risk premium, the value proposition of equities decreases as you get closer to an expected retirement date.  Once you have a near-term window for beginning withdrawals, the amount of time your returns have to “average out” decreases, and your exposure increases.  As you get closer and closer to retirement, equities should become a smaller and smaller portion of your portfolio. (more…)

1. PSCA.org – 51st Annual Survey of Profit Sharing and 401(k) Plans [↩]
2. Bloomberg.com – Bonds Beat Stocks in ‘Earth-Shattering’ Reversal: Chart of Day [↩]

Some Thoughts on “Dollar Cost Averaging”

Photo by: Rob Lee

The term “Dollar Cost Averaging”, or DCA, can have many different meanings.  Oftentimes when referring to “Dollar Cost Averaging,” people actually mean “Automatic Investing.”  DCA typically refers to investing over a period of time an amount you could have invested initially.  So for example, if you had $10,000 to invest, instead of putting it all in now, you invest it over a period of several months in equal dollar amount increments.  Automatic Investing on the other hand is simply taking a set amount out of your income and investing it every month.  This is what the majority of people think of as Dollar Cost Averaging.

The Theory

Proponents of DCA claim that it reduces risk, because you tend to buy more shares when prices are low and fewer shares when prices are high.  This argument makes some sense in an oscillating market that isn’t moving overall in any particular direction.  One question remains, however: why would you want to be investing in an oscillating market that isn’t trending in one direction?  Typically most people’s faith in investing in stock markets is that over time they go up.  If the market is on average going to move upwards, why am I holding back investing a portion of my investment?  On average this simply means I’m going to get a higher price.

The Worst-Case Scenario

If we think about this matter anecdotally it seems intuitive however that by holding back some money to invest we’re reducing our worst-case scenario.  Suppose for example that we invest all our money today and tomorrow the stock drops precipitously.  We’ve avoided that risk.  At the same time however, what if the stock rises sharply and never returns to our original price.  While we may be reducing our worst-case scenario somewhat, we’re also risking leaving a lot of money on the table.  Still there seems to be some merit to increasing your exposure over time. (more…)

76 ETFs For Foreign Stock Exposure

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Many people are looking for various ways to invest in foreign companies.  Whether they’ve lost faith in American companies, want to hedge or simply want  some diversity, ETFs can be an easy answer to eachieve this.  I’ve listed 76 ETFs that provide you exposure to the stocks of certain countries, groups of countries or the world as a whole.  Some things to remember:

• Many countries are highly dependent on a particular sector. For example if you’re buying a Russian ETF in many ways you are buying a lot of exposure to energy as that country is highly dependent on energy income.
• Many of these funds have run up tremendously in the previous few months.
• Some of these funds are not particularly liquid.
• Many of these funds have high fees associated with them.
• Each of these funds implements their exposure in different ways, be sure to read the prospectus.
• This list is far from exhaustive, although it was exhausting to compile.

My summary of all this is:  Read the Prospectus, Read the Prospectus, Read the Prospectus.  Make sure you know what you’re actually buying if you buy one of these ETFs.  I’m not recommending or endorsing any of them, I’m just compiling some resources to help you start your research. (more…)

Treasury ETFs

Photo by: Ryan McFarland

U.S. Treasuries surged in popularity during the recent crisis.  In fact at one point people were so anxious to buy up treasuries that the short-term yield dropped to 0%.  At this point Warren Buffet emailed his directors:

This should be bullish for Berkshire. With great foresight, I long ago entered the mattress business in a big way through our furniture operation. Now mattresses have become fully competitive as a place to put your money, and sales will soon take off.1 

People were anxious to find a safe place to put their money, which is one of the strong suits of U.S. Treasuries. 

Treasuries have a very different risk profile than many other investments.  There is a very low risk of default compared to other types of bonds, but you are exposed to risks like inflation.  ETFs can provide a way to introduce this risk profile into our portfolios more easily than actually buying the bonds.  There are several ETFs which allow you to do this and many concepts that can be pivotal to understand before doing so.  

Understanding Yields and Prices

Bond prices and yields can be a bit opaque to those without experience; however they are a fairly simple concept.  When a bond is issued, it pays a certain amount and has a certain cost.  Say for example I buy a $10,000 bond that will pay me $300 per year.  Thus it yields 3%.  Now many would think that since the bond will repay my $10,000 at the end of its life, it would be a risk-free investment.  However suppose that interest rates go down at that 3% becomes more attractive, people will be willing to pay more for that same bond.  As the price goes up, the $300 per year becomes a smaller fraction and the yield of the bond goes down.  Meanwhile if interest rates go up, my bond becomes less attractive and the price will go down.  

This is very important when considering inflation.  Generally if inflation is high, you will see higher interest rates.  As such in an inflationary environment, bond yields tend to increase, meaning the price of any bonds you own may very well go down.  This means that the term of the bond becomes very important.  While over a short period of time, inflation may be predictable; over long periods any number of things can happen to affect interest rates.  Obviously because of this, longer dated bonds tend to pay higher yields.  

Treasury ETFs

There are many treasury ETFs and will likely be many more in the future.  Some of the more popular ones include:

TLT – Long Term Treasuries (more…)

1. Forbes – Buffet Bets On Mattresses [↩]

The Difficulty of Investing in 2009

Photo by: Mel B.

2009 is a dreadful year to try to invest.  While we have seen a massive rebound in stocks, there are a variety of factors that make long term planning very difficult.

Asset Class Difficulties

The first thing that makes the current economic climate so difficult is the correlation between asset classes.  Under normal circumstances declines in one asset class involve money moving to another asset class.  Thus when stocks go down, bonds or gold or another asset class is usually the beneficiary.

What makes the current economy so difficult is that you see capital essentially being “destroyed” by the deflationary spiral.  Forced liquidation on the part of many funds caused by redemptions and margin calls contribute to this problem as well.  While this problem was particularly pronounced in 2008, you continue to see deflationary pressures affecting all asset classes.

Government Intervention

One of the most obvious difficulties of building a long term plan in 2009 is the frequency and fervor of government intervention.  Policy makers are attempting to walk several fine lines and thus are constantly exerting strong forces upon the market.  In their zeal they make it very difficult to draw long range conclusions about what makes sense.

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5 ETFs That Can Help Balance Your Portfolio

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While I generally advocate against investing in individual stocks for amateur investors, I make some exceptions for ETFs.  Exchange Traded Funds are funds that trade on the stock market like a regular stock, but represent underlying assets like a mutual fund.  These ETFs give you an opportunity to hedge your stock market positions and provide some balance to your portfolio fairly easily.  While I would still recommend a lot of research before buying any of these, each of these ETFs gives you some ability to round out your positions.

GLD: Gold

I’ve been known to make fun of “Gold Bugs” now and again in my days, but you have to admit that with the specter of inflation looming over all of the spending and stimulus, gold becomes a bit more appealing.  The mechanism for this ETF is supposed to be fairly straightforward, and it’s done a good job of duplicating the returns of gold recently.  Because most of the currencies out there are from governments who are in straits just as dire as the USA, it can be appealing to find a “currency” that no government has control over.

TIP:  Inflation Protected Treasuries

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