Category Archives: Investing

Writing an Investment Statement Policy (ISP)

If you are familiar with this blog, you know that I like to have written plans.  The purpose of a plan is to have a guide.  I am not into hardcore manifestos that are rigid and do not allow room to make changes.  I like to have plans that are written in pencil and can be amended when opportunities present themselves.  An Investment Statment Policy is a good example of one such plan.

I believe in being intentional in life.  Before I act, I need to know what my intentions are.  In most situations, the outcomes are out of our hands, but the reasoning behind our actions are not.

By having a written financial plan, it is a map for our financial life.  A financial plan allows us to know where we currently are on the journey to financial independence.  It is also a guide to where we are going and what we should do when we reach different destinations on our financial journey.

As part of every financial plan, there should be an investment statement policy (ISP).  Nobody knows for sure where the economy is heading in the short term.  That is why it is considered wise to have an investment statement policy (ISP) to guide us along the way.

What type of an investor are you

Having an investment statement policy enables you to define who you are as an investor.  Are you a value investor who looks to buy low-priced stocks?  Do you follow a three-fund approach and like to own all the stocks in a market capitalization-weighted portfolio?  Are you comfortable with average market returns or do you try to beat the market by investing in actively managed mutual funds?  Do you invest in hot-trends like Bitcoin or alternative investments like crowdfunding?

By knowing the type of investor that you are will give direction to your decisions.  It will prevent you from chasing the hot investing tips that your coworkers are talking about at the water cooler.  Before you buy or sell an investment, you will look at your investment statement policy and ask yourself if it follows what you have established in your plan.

Know what you own

Without looking, could you list all your investments?  Could you explain why you own them?  What was your reasoning for adding a given ETF or individual security to your portfolio?

If you cannot list all your investments in less than a few minutes, you might have too many different investments.  If you cannot explain why you own an investment, you probably should not own that investment.  The same is true if you cannot give a sound reason as to why you bought an investment in the first place.

An investment statement policy can remove all those ambiguities that are tied to your investment decisions.  By having an ISP, you will know the why behind every investment in your portfolio.  Your investments will have a specific purpose in your portfolio.

Risk and return

Different asset classes come with different levels of risk and expected returns.  Conservative investments like FDIC insured savings accounts normally have low returns because the returns are guaranteed by the government.  Small-cap value stocks or emerging markets have higher than average returns because an investor is taking on more risk when they invest in these asset classes.

Do you know how much risk you are comfortable with?  Would you be able to keep buying more shares of an investment if it lost (30%) of its value in one year?  Do you think that you could hold onto an investment if it produced negative returns for a few years in a row?

By having an investment statement policy, these decisions will be made in advance.  If you have established that you see market volatility as a time to buy low, you will have established bands that will trigger when it is time to buy.  If you are not comfortable with short-term volatility, your investment statement policy will have already established a more conservative asset allocation that has less volatility.

Time Horizon

When will you be spending the money that you have invested?  Are you planning on retiring in 5 years, 15 years, or longer?  Knowing the answer to that question will help to establish how much of your money should be in equities and how much should be in fixed assets.

If you will not be retiring for ten or more years, holding a higher asset allocation of equities might be suitable for your situation.  If you are recently retired and are following the 4% rule, an asset allocation of 100% in stocks would be too aggressive due to market volatility.  When you are young you have time to recover from market corrections, but after you retire a (50%) market decline or prolonged recession could easily force a retiree back to work.

By having an investment statement policy, an investor can review their timeline annually.  An investment statement policy can help an investor with monitoring their path to retirement.  On that journey, the investment statement policy can guide them as to when it might be time to reduce some portfolio risk as retirement nears.

Monitoring Performance

Do you know what the expected return of your asset allocation is?  How is your portfolio performing this year?  Do you know how much your portfolio is up or down over the past 12-months?  Do you know what your average return was for the past 5 or 10 years?

Monitoring the daily performance of your investments is not helpful.  Listening to the daily market reports is an emotional roller coaster. In can do more harm than good and cause you to panic when there is short-term volatility.

By having an investment statement policy, you get to establish when you monitor your investment returns.  You can monitor your investments quarterly, twice per year, or annually.  If you are a passive investor, it could even be every other year.  It is your plan and up to you to establish how it will be monitored.  Personal Capital is a useful tool for monitoring the performance of your investments and it is free.

Skill Level

Are you a personal finance nerd?  Do you read investing forums, listen to podcasts, or attend local chapter meet-ups?  Do you write your own blog or are active in the financial independence community?  As a member of the financial independence community, you are most likely comfortable writing and updating your investment statement policy.

If you are not comfortable managing your own portfolio, there are many good financial advisors out there.  Even if you hire a professional to manage your money, work with them to help you to establish your investment statement policy.  You want to be sure that their decisions align with your needs and long-term goals.

Conclusion

Be intentional about your investment decisions and know the why behind every move.  Having an investment statement policy will help you to stay true to your long-term goals.  It is an invaluable part of a written financial plan.  An investment statement policy is useful to keep you focused on long-term goals when internal or external forces might be tempting you to stray.

After you write your investment statement policy, review it at least once per year.  Update it when needed.  Our financial situations are not static.  The investment statement policy will be different for everyone.  Your ISP will also change with time.  It is recommended to make amendments when a change is needed.  Just be sure that you can explain and make a sober justification for the change.

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Am I Financially Agnostic?

I am not new to investing.  I have been an individual investor for a couple of decades.  Over that period of time, I have seen it all.  There have been booms, bubbles, and busts.  As the result of my experience, I wonder if I have become financially agnostic.

Over that same period of time, I have not sold low as the markets bottomed out or experienced irrational exuberance when the market soared.  My goal has always been to reach financial independence by way of investing in stocks and bonds.  As the result of studying personal finance, I knew that markets go up and down.  Corrections and recessions occur.  They are an opportunity to buy low and to build long-term wealth.  When I started this journey, my time horizon was long and my risk tolerance was high.

Following 9/11, the markets melted down.  My Mom asked me if I was going to sell my stock holdings and not risk losing all of my savings.  I said nope and kept buying. The markets did not recover for more than three years and I did not deviate from my plan.  With every paycheck, I just kept dollar-cost-averaging into my investment accounts.

My response was similar following the market crash of 2008.  My wife asked if we should sell all of our stock holdings.  I said nope because we had a couple of decades to go until we retired.  I kept our asset allocation the same and kept dollar cost averaging.  2008 was scary and I did not know that the next bull market was only a few months away.

The same can be said for chasing performance.  When I started investing, day-trading and investing in technology stocks with high growth potential was crazy.  My experience as an investor was limited, but my gut told me that making money was truly not that easy.

During the early 2000’s, the real estate market was heating up.  Credit was easy to come by.  People who should not have been given loans were signing for variable rate mortgages without knowing the consequences of what future potential rate hikes would do to their monthly payment.  Investors without any real estate investing experience were flipping houses and condos all over the county.  Again, my gut told me to say away because I knew that making money was not that easy and speculators tend to lose their money when the markets make a turn for the worst.

So, why do I ask if you think I am financially agnostic?  It is not because I have no faith in capitalism or the global economy.  There is proof that investing in a market-weighted portfolio has worked in the past and I believe that it will continue to produce results in the future.  There will be ups and downs, but this type of investing will always provide average returns.

I classify myself as being financially agnostic because I do not believe in anything other than investing in a couple of index funds.  I do not know what the future market returns will be.  Whatever the markets do return, I am positioned to capture these returns.

Based on past performance, there are many financial institutions that I have no faith in.  They have mostly failed investors in the past.  They will continue to mislead in the future.  There is no way to know when to trust them and when not to trust them.

Financial Media

Even though it has improved to some degree, I have little faith in the financial media.  Yes, they have come around to indexing, but that does not sell advertising.  The financial media is out to make money and sell advertising.  The five hot stocks that they say to buy for summer will be different from the best wealth-building stocks they suggest for winter.  Fear sells magazines and newspapers.  It does not build wealth.  If the authors of these articles or the talking heads on television knew so much, they would be out making their own fortune and not reporting about financial news.

Financial Advisors

I have no faith in financial advisors.  Yes, there are some good fee-based financial advisors.  Most, however, are just salesmen.  They are just out to make a buck and do so by selling complicated investment products that come with high fees and low performance.  Collin Cowherd once said, “I trust Smith Barney when it comes to managing my money, but not Barney Smith”.  I guess Smith Barney has not done much better since they are no longer in business.  There has been some legislation around the financial industry to improve the quality of advice that financial advisors sell, but the financial industry has fought the concept of putting their client’s interests ahead of earning a commision.  There is currently no proof for me to trust these people with managing my money.

Actively Managed Mutual Funds

Professional money managers do not have a track record that garnishes much faith.  You would think that an actively managed mutual fund would outperform the index that they are benchmarked against, but the vast majority don’t.  Some outperform the index they track for a year or two.  Over the long hall, most actually underperform the index and go out of business.  They also are inefficient from a tax standpoint due to turnover as the result of all of the buying and selling of stocks within the fund.

The Financial Journeyman

This might or might not come as a surprise, but I also have no faith in myself when it comes to picking investments.  If both the Barney Smith’s and Smith Barney’s of the financial world cannot do it successfully, who am I to think that I can find alpha over the long term?  Easy answer, I cannot, so I do not even pretend to have any faith in my finite ability and resources to beat the market averages.  That is why I invest in my Sweet Dreams Portfolio and don’t pay too much attention to the markets.

History & Experience

Since I have little to no faith in all of those major financial institutions because they have all failed in the past, why do I have faith in the stock and bond market as a whole? My faith is based on experience.  By investing in index funds, an individual investor will outperform 90% of their peers.  I have captured average market returns for decades.  Those returns have allowed me to reach financial independence long before most people in my age group.  I have faith that my balanced-growth portfolio will produce average market returns.  By combining average market returns with a high savings rate and prudent living, I have faith that I will be able to retire early.  When I do retire, I will follow a similar approach with some scaled back risk during the drawdown period.

Conclusion

In life, I have learned to draw conclusions based on the evidence that is presented to me.  It is impossible to have trust in the financial industry that is not willing to take on a fiduciary responsibility.  Just as their goal is in to maximize ROI for shareholders, my goal is to earn the highest returns at the lowest costs to fund my retirement.  Up until this point, as well as moving forward, my faith is in playing the averages.

Are you financially agnostic?

Do you have any faith in the financial media, intuitions, or your own abilities as an investor?

Or, are you like me and believe in average market returns are both available and good enough to carry an investor too and through retirement?

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Using Beta to Measure Investment Risk

When an investment portfolio is being designed, there are a few basic factors to consider.  What is your age? What are your savings goals?  Do you know the type of returns do you expect to earn from your investments?  The most important factor to consider is much risk can you tolerate?  Using beta to measure investment risk is a great measurement to review.

When the stock market is soaring, investors tend to forget about risk.  Who wants to dampen the performance of their portfolio and miss out on the double-digit bull market returns?  It does not matter if you are an aggressive investor in your prime earning years or a more conservative investor who is nearing retirement when the markets start to get volatile, most investors tend to become more focused on risk management and risk tolerance.

Beta

It is important to know how risky the investments that make up your portfolio are.  One of the best ways to measure volatility is to measure the beta of an investment.  Beta is the second character of the Greek Alphabet.  Beta is used to determine how volatile an investment is in relation to its benchmark.

When measuring beta, the baseline is 1.  If an individual share of a publicly traded company, an EFT, or a mutual fund has a beta of 1, it moves exactly in step with its benchmark.  If an individual equity, ETF, or mutual fund has a beta that is greater than 1, the investment is more volatile than the benchmark that it tracks.  On the other hand, if an investment has a beta of less than 1, it would be less volatile than its benchmark.

In other words, beta is the risk measurement of investing in the stock market.  The stock market has a systematic risk.  If an investor wants to reduce the volatility of a market portfolio, they might want to consider adding some investments with a beta that is less than 1.

Investors who invest in a portfolio constructed of passive investments would generally be considered beta investors.  That is especially true for those who invest in broad market portfolios.  Investments such as large-cap index funds would have a beta of 1.  For example, an S&P 500 index would have a beta of 1 because it tracks the S&P 500 index. Investors who invest in a portfolio that incorporates bonds into their mix would have less volatility than a portfolio made up of only stocks because the beta would be less than 1. 

Below are a few mutual funds to consider if you are looking for a low beta option:

Fidelity Growth Strategies Fund FDEGX

Beta: 0.82

Fidelity Low-Priced Stock Fund FLPSX       

Beta: 0.54

Fidelity Small Cap Growth Fund FCPGX

Beta: 0.79

Vanguard Wellington Fund Investor Shares VWELX

Beta: 0.68

What are some investments that have a beta that is greater than 1?  It is not uncommon for actively managed mutual funds to have a beta higher than 1.  That is because fund managers are trying to beat the market.  There are index funds as well as ETFs that also have a beta higher than 1.  Micro-Cap funds and emerging markets tend to have a beta higher than 1. 

Some examples of funds with a high beta are:

ALPS Medical Breakthroughs EFT SBIO

Beta: 1.86

Consumer Discretionary Select Sector SPDS Fund XLY

Beta: 1.73

Fidelity Nasdaq Composite Index Tracking Stock ONEQ

Beta: 1.37

First Trust Dow Jones Select Micro-Cap Index Fund FDM

Beta: 1.33

Alpha

While the beta is used to measure risk, alpha is the benchmark that measures market-beating performance.  Alpha is the goal of active managers.  Alpha is the Holy Grail of active management.  Those who consistently produce alpha become legends.  Those who don’t ultimately receive a pink slip.

Many investors would like a portfolio that has both a low beta score and a high alpha.  Building a portfolio that has the combination of low-volatility and market-beating returns is very hard to accomplish.  That is why most active fund managers do not succeed. 

Formula

Alpha is based on PR – [RF + Beta * (MR – RF)]

PR is the return produced by the investment portfolio

RF is the risk-free rate of return (Treasury Bonds)

MR is the market return

It is very difficult for active fund managers to consistently produce market-beating returns.  It is possible in the short-term, but the vast majority of managers do not beat their benchmark over long periods of time.  Most produce a negative alpha beyond 5 years.

It is almost impossible for individual investors to produce market-beating returns year after year.  Individual investors have a more difficult time than professional investors because they do not possess the resources or information that professional fund managers possess.  It would be easier for an individual investor to use beta to help in designing a portfolio than trying to produce long-term alpha.  

Conclusion

There are many factors to consider when building an investment portfolio.  Beta is one of many measurements to use as a guide.  It is not the sole measurement that should be the determining factor when trying to decide if an investment fits in with the rest of your portfolio.

Focus on learning how much real-world risk you can tolerate.  Could you tolerate a (50%) drop in the value of your portfolio?  If not, a portfolio of 100% invested in stocks might not be for you. How about a (20%) drop?  If that sounds more bearable, you should consider a more balanced portfolio. To help track your portfolio, consider using Personal Capital to monitor your asset allocation and performance.

Before you ever make an investment decision, be sure to check with an investment professional. 

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The Roth IRA is 20 Years Old

The Roth IRA is 20 years old.  Where does the time go?  Time sure does seem to fly when you are having fun.  It seems to go faster when you are dollar-cost-averaging and building wealth.

That is exactly what the Roth IRA has done over the past 20 years.  It has been a great wealth building tool for many individual investors.  Since it was created, I have been depositing money into my Roth IRA in the form of dollar-cost-averaging with almost every paycheck for the past 20 years.

The Roth IRA has come a long way in 20 years.  The Roth IRA is named after William Roth a Senator from the state of Delaware and was part of the Taxpayer Relief Act of 1997.  What makes the Roth IRA different from a Traditional IRA is that unlike the Traditional IRA, there are not any immediate tax deductions.  The Roth IRA is funded with after-tax earnings and when the money is withdrawn at retirement, it is tax-free.

When I first started investing, the Roth IRA was not available.  It did not become available until I was investing for about 1-year.  As soon as I learned about the Roth IRA, it sounded like a great wealth building tool.

When the Roth IRA was first introduced, the annual contribution limits were only $2,000 per year for an individual who qualified. From 1998 until 2001, the contribution limits were $2,000. The contributions limits have slowly been increasing over the past 20 years.  In 2002, people over 50 have been allowed to contribute more in the form of a catch-up contribution as they got closer to retirement age.  In 2018, individual under the age of 50 can contribute $5,500 per year and people who are over age 50 can contribute $6,500 per year.

There are income limits on who can take advantage of the Roth IRA.  Single filers who earn less than $120,000 qualify for a full contribution.  Single filers who earn between $120,000 and $135,000 are eligible for a partial contribution.  Joint filers who earn up to $189,000 can take advantage of the full contribution.  Joint filers who earn between $189,000 and $199,000 are eligible for a partial contribution.

Since my wife and I earn less than $189,000 we are able to better diversify out retirement tax strategy.  We contribute to our Traditional 403B accounts to reduce our annual taxable income. We also contribute to our Roth IRA accounts to have money that can be withdrawn tax-free later on in retirement.

What if you want to contribute to a Roth IRA account, but do not qualify.  For those folks, there is a Backdoor Roth IRA method that could be used to convert a traditional IRA into a Roth.  That approach is more complicated based on taxation.  It might be wise to check with a CPA before trying to implement this strategy.

Unlike a Traditional IRA or 401K, there are not any Required Minimum Distributions (RMDs) with a Roth IRA.  In a Traditional IRA account, the money has to start to be withdrawn at age 70 ½. That is not the case with a Roth IRA.  The money never has to be withdrawn.  It can remain in the Roth IRA and the money can keep growing.

Since the money never has to be withdrawn, it is recommended by many financial professionals to drawdown Roth IRA accounts last.  We have added that strategy to our retirement drawdown plan.  Based on our age and different types of investment accounts, we will be following a Buckets Approach to funding our retirement.

We will first drawdown our taxable accounts.  The second source of retirement income will come from our Traditional IRAs based on the RMD schedule.  If we live long enough, the last source that we plan on drawing down is our Roth IRA accounts.

There are many benefits with passing on a Roth IRA to a surviving spouse.  They are not forced to take RMDs. They can roll the inherited Roth IRA over into their own Roth IRA.  They can also continue to contribute to the Roth IRA with new earnings.  These benefits do not apply to someone who inherits a Roth IRA who is not the spouse.

Another benefit of a Roth IRA is that you can withdraw money from the account prior to being age 59 ½.  With a Traditional IRA, there is a penalty for early withdrawals.  The money that a person withdraws early is taxed as ordinary income.  There is also a 10% penalty unless it is considered a special circumstance.  With a Roth IRA, there are not any penalties if the money that is taken out is limited to contributions.

Over the past 20 years, the Roth IRA has become a very popular type of retirement account.  According to the Employee Benefit Research Institute, more than 29% of all individuals have a Roth IRA account.  That is an amazing statistic since so many Americans struggle with saving money for retirement.

There are few things in life that most people agree on.  In the world of personal finance, I cannot think of anyone in the financial independence community who does not like the benefits of investing in a Roth IRA account.  It is hard to not see and embrace the ability to build wealth in an account that allows people to have tax-free income at retirement.

Do you invest in a Roth IRA account?

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The Rule of 72

Do you want to know how long it will take to double your money?  Most investors do.  Are you interested in the expediential growth of your money?  Have you ever tried to calculate the rule of 72?

When I first started to read personal finance and investing books, I learned about the math behind what makes investing work.  The big driver behind what causes your money to grow is compound interest. While I was studying, the one theory that I kept coming across was the rule of 72.

The rule of 72 is just a basic mathematical formula.  It is used as a tool to help investors determine when they should expect to double the money they currently have invested.  The rule of 72 allows an investor to know when they should expect to double their money based on a forecasted rate of return.

Start by taking the projected rate that you expect your investment to return every year.  Divide that interest rate by 72. That will give you the number of years that it will take for you to double your money.

Example:

72 / 6% expected rate of return = 12 years to double your principal

72 / 8% expected rate of return = 9 years to double your principal

72 / 10% expected rate of return = 7.2 years to double your principal

The rule of 72 is what makes stocks a more attractive option than bonds or other fixed-income investments.  For example, the Vanguard 500 (VFINX) has returned 10.97% per year between the years 1976 and 2016.  Currently, the average interest rate on an FDIC insured savings account is slightly higher than1.15%. What is the difference between these two investments based on the rule of 72:

Vanguard 500 – 72 / 10.97 = 6.56 years to double your principal

Saving account (national average) – 72 / 1.15 = 62 years to double your principal

Over the coming decade, stocks are not expected to return 10% per year.  Currently, stocks are expensive investments and there is not much value to be found.  Jack Bogle who founded Vanguard and the first S&P 500 index fund that was available to individual investors predicts a more modest return of 6 or 7 percent for the coming decade.  Based on that forecast and the rule of 72, how long would it take to double an investment of $3K in the Vanguard S&P 500 fund:

Vanguard 500 – 72 / 6.5% = 11 years to double your principal

Time is on Your Side

When I started investing, I received a brochure from the investment company that provided me with a few charts on compound interest.  The chart showed how the rule of 72 worked with different interest rates. The brochure explained the wealth-building power of stocks vs more conservative investments based on the difference in long-term performance.  It also showed how it benefited an investor who had a few decades to take advantage of this powerful wealth building formula.

For example, a one-time investment of $10K to grow in value to $40K based on different interest rates:

  • If an investor received a return of 3%, it would take 48 years for that $10K to grow to $40K
  • If an investor received a return of 6%, the time would be reduced to 24 years to grow to $40K
  • If an investor received 12%, however, it would only take 12 years to grow $10K to $40K

What to do Now

What can investors do now to follow the rule of 72?  What are some alternatives since the S&P 500 is projected to underperform its historical average?  Is it possible to try to reduce the time it takes to double your money without taking on too much risk?  Here are some options that might help in doubling your money quicker:

Save more money.  By increasing your savings, you will double your money at a faster pace.  Try to increase your savings by 2-3% per year.

Go beyond the S&P 500.  Add a small-cap blend or extended market index fund that includes mid-cap stocks to your asset allocation.  Small-cap stocks have historically outperformed large-cap stocks. If you go with a 4:1 Ratio, you will emulate the total stock market.

Go beyond the United States for investing opportunities.  Add some international stocks to your portfolio. Add both developed nations and emerging markets for their growth potential.

Remember to keep some bonds in your portfolio.  Many experts are telling investors to stay away from bonds because of their current low yield and the raising interest rates.  Bonds have an opposite correlation than stocks. When stocks go down in value, bonds go up. By owning some bonds, you can buy stocks at a lower price when there is a stock market correction.

Conclusion  

As an investor, you should keep the rule of 72 in the front of your mind.  You do not need to know the exact date as to when you will double your money.  From time-to-time, look at how your portfolio performed over the past 5 or 10 years to identify what your average rate of return is.  Apply the rule of 72 to know where you stand. If you are not satisfied with how long it is taking, look for ways to increase your returns that are within your risk tolerance.   

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