September 18, 2007
Finance Geeks - Investment Allocation
Hi everyone. Since there seems to be several finance-geeks in the kordix community (and by several, I mean two), and since i think sites like mymoneyblog.com are soo neat, I thought I'd post something that I've been thinking about for a while... and see if anyone seems to care.
When I first got the job I'm at right now over a year ago, it got me access to a 401k. Of course, I really didn't have much of a clue about what that actually WAS at the time, however. Being the kind of guy that likes to learn tons of stuff, with a sort of do-it-yourself spirit, and not one to make decisions without doing a ton of research, I set out to figure out what the heck this investing thing is all about, anyway.
I've begun to accumulate some knowledge in that area, and have started to fill out a mental list of concepts that I've accepted regarding long-term (i.e. retirement) investing... Here's a few of the conclusions i've arrived at so you can get an idea of where I'm coming from.
First off, hot-shot wall-street types most of the time aren't going to help you. What that really means is that actively managed funds seldom beat low-cost indexing over long periods of time when fund fees are factored in. Trying to get into the new hot fund and get out before it starts underperforming is trying to time the market, and I'm not smart enough to do that. This tendency to think that somebody in new york is smarter than you and should be the one in charge of your money is a bit dangerous, I think. They don't have your best interests in mind. That should be enough to make you think twice about it right there. Another problem is the fact that they are moving HUGE amounts of money around when they make a trade, it can throw the market off a bit, and they may not be able to buy a stock at as cheap a price as they'd like. But it really gets down to the fact that these guys are really trying to predict the future. Heck its hard to know what the heck is happening in the present, let alone the future. Some guys appear to be able to do it. To cite the obvious, Warren Buffet has consistently beaten the market (though he's not just buying and selling stocks, to be fair), but they appear few and far between. For a number of other reasons, I just think that most of the time, an active manager doesn't really add value. Google "efficient market hypothesis."
Secondly, weird as it sounds, adding two risky investments together can reduce your overall risk in your portfolio. The trick is that the two kinds of investments need to be noncorrelated. This is the basis for diversification - i.e. owning all kinds of companies, large and small, value and growth (which i won't get into here), US and foreign, stocks and bonds, etc... For more information, Google "Modern Portfolio Theory."
Third, expenses are the one factor that is guaranteed to affect your investment value a predictable amount, year after year - so try not to pay too much here. Remember - no mutual fund will guarantee you a certain rate of return, but they WILL guarantee a certain rate they'll take from your money every year. Lower is better. I can't cite sources, but lots of studies have shown that this has a more profound effect over a lifetime than you might initially think.
That basically sums up my current thinking on the issue. So, if you're still reading (and NOT asleep), take a look at my current asset allocation:
hrm... all that talk about diversification and... 70% in plain old large cap US? That does seem like I'm talking one way and living another. But, we're talking about a 401k here - which doesn't have a TON of great options. The large blend that I'm using happens to be one I like, with a nice .88% expense ratio. Other expense ratios for my funds are 1.2%, 1.15%, 1.26%, and (eek) 1.6%, so I overweighted the fund for that reason. I'm not really sure if its smarter to favor the better fund or to keep the better diversification and eat the expenses. If anyone can register a comment on that issue, I would appreciate it.
And take a look at those bonds. Corporate bonds. Not a big fan of these nowadays... I pretty much chose them because I didn't know much about bonds (bonds are boring), and the expense ratio and trailing rate of return weren't too bad. I had about 10% in this fund at one time... But - they kinda have been taking pretty steady hits lately and I've started to think that a bazillion years from retirement is a bit too early to have a realllllly significant bond allocation... Plus I don't really like any of the bond funds in my 401k... so what is a boy to do? Eh... just throw more money at the stocks, I guess...
About the International vs. US large cap stock funds - I think this is the only international fund available to me, so I'm in it for diversification's sake. Its also my most expensive (1.6%) and I'm starting to wonder if it is really doing its job. Its mostly large European companies, and seems to be pretty well correlated with large US companies. Its different enough for me to keep some money in it, but not different enough for me to want to throw a lot at it. Thoughts, anyone?
Small/Mid and Mid are going quite well so far, but are a bit more expenseive (1.15% and 1.26% respectively) than I would like, so I haven't been throwing a TON of cash their way for that reason. Wise? Stupid? Let me know.
For future contributions, my allocation breaks down like this:
Bonds: 3%
Small/Mid Value: %15
Mid Growth: 13%
Large Blend: 54%
Int'l Large Value: 13%
Am I still weighted too much toward Large US companies? Leave some comments if you have an opinion, and let me know if you care at all about finance-type blogs or if I should just stuck to the music and randomness. Peace.
Posted by pedalboy at September 18, 2007 11:57 PM
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The only thing I'd suggest is that with a long time horizon, presumably 30+ years, you may be better served by focusing on growth funds. You'd have to read the prospectus of the funds to know for sure, but generally value funds focus more on income (dividends) and a stable stock price, than capital gains (increases in price). Dividends, for small companies especially, are rarely more than 2-4% annually (and not all companies pay dividends), whereas their capital gains could be much higher.
You may have picked up on it, but there are actually 3 different fees that funds can charge though it's rarely all three. A front-end load is a percentage of the money that you put in being siphoned off. Back-end load or redemption fees are a fee to take money out. These are sometimes time-contingent so that you only pay if you take money out before a certain date. Maintenance or 12b-1 fees are annual fees for managing the money. Be sure to check which of these fees is(are) charged because it could change the actual cost of the fund. Again, check the prospectus which, by law, must be publicly available.
Matt, sounds like you've got a good handle on things, especially with the annual expenses. Index funds often outperform managed funds and at the same time, you aren't helping to contribute to someone's 90 bazillion dollar bonus.
I'm no expert, but I'd agree with Neil on risk exposure. Since you won't touch this money for many moons to come, hop on some growth funds. I personally don't have anything in bonds right now. I think it is too risk adverse. Over 30yrs, the market will average 8-9% return while a bond will get you 4-5%.
Get some small cap and emerging market exposure maybe. If you're curious, my allocation looks like this:
Large U.S. Equity 11% .36% expense ratio
International 38% .45% expense ratio
Small U.S. Equity 37% .59% expense ratio
Emerging Markets 14% .91% expense ratio
I like reading others opinions and thoughts on money and investing. It helps to rationalize things and understand viewpoints.
Warren Buffet is an amazing investor, but remember, he invests for the long term. He is no day-trading market whore. Look where that has got him! The hardest part for me is to not react to the markets ups and downs. If something is out of favor one year, it will be in favor the next. Case in point, when I was starting out investing, I didn't understand that a contrarian funds won't break the bank when the market is going gang busters (like during the dot-com boom), but it will do well during a bear spell. Staying cool and realizing the long-term perspective helps me keep my sanity.
Growth over value? I had heard the opposite... One of the resources that I’ve been looking at is the articles on fundadvice.com, which is a service of Meriman Berkman Next… Who seem to know what they are talking about. In particular, I’m looking at an article called "The ultimate buy and hold strategy." ( http://www.fundadvice.com/articles/buy-hold/the-ultimate-buy-and-hold-strategy.html ) The article says…
"Although the most popular stocks are growth stocks, much research shows that historically, unpopular (value) stocks outperform popular (growth) stocks. This is true of large-cap stocks and small-cap stocks, and it’s true of international stocks as well. From 1927 through 2006, an index of large U.S. growth stocks produced an annualized return of 9.3 percent; large U.S. value stocks, by contrast, had a comparable return of 11.5 percent. Among small-cap stocks over the same period, growth stocks returned 9.3 percent, and value stocks returned 14.5 percent."
Is that to be trusted? Now I’ve got to go do a buuuunch more research.
Good call on the fees. I hadn’t mentioned any of the others because (as far as I can tell) they are being waived by my 401k plan. But that brings up something that I’m really very confused about. I can’t find that anywhere in writing, but I keep adding up the money I put into the plan and the money that comes out of my paycheck and they look to be the same. I’ve heard of other plans waiving the front end loads (which mine usually have) and so I am assuming that that’s what’s going on. Perhaps something I should confirm with my benefits people…
The other thing I’m a little foggy on, expense-wise, is when the 12b-1 fees are actually taken out… I’m coming up on the year anniversary of when I made my first contribution. Are they just gonna debit the sucker all at once like that? I suppose so.
Ahhh, yes… market swings. They don’t really bother me yet. That’s actually one reason I was keeping a small amount in bonds. When the market ticks down a bit, I’ll transfer some of the money from bonds to stocks and try to catch it on the upside. Not really something that a pure indexer would really do, cuz it pretty much boils down to market timing, but I haven’t gotten burned yet, and it’s a little fun. Of course, so far when the market has ticked down a bit, I only lose a couple hundred. I would imagine that as the account grows and it becomes possible to lose several thousands in a day, I might have to start being a lot more disciplined in these sorts of things. Course, that’s why there are bonds. But still….
Speaking of fun, do any of you invest outside of a retirement account, and why? I have been considering investing in something like a DRIP, but I haven’t because I figure any extra money I got should go into the tax-advantaged account… But that’s way less fun, sometimes. Any thoughts?
P.S. Dave, I’m jealous of your low-expense funds. Unfortunately, my 401k choices are less than ideal (aside from the large blend, that one’s pretty good). I’m just waiting till I switch jobs and then I’ll roll all this over into an IRA, probably with vanguard. You’ve really got a lot in international… over half. Any particular reason, or just trying to stay diversified?
The distinction between value and growth is more subtle than I made it seem. Value investors look to buy stocks that are "undervalued." This could be in comparison to the industry, historical performance, or some target price that the stock "should cost." The idea is that they are getting a bargain on the stock being priced below where it should be, and then they can sell it when the market correctly prices the stock.
Growth funds seek companies that are growing, i.e., building new factories, expanding, etc. The idea here is to identify which companies will be getting bigger and then selling when the company reaches a peak or plateau.
"Value" stocks are generally of large, mature companies who tend to pay nice dividends but the price appreciates more slowly. "Growth" companies tend to be in less mature industries and pay small or zero dividends, reinvesting the profits back into the company to grow.
Value funds are more of the slow and steady type. Over time they will earn more steady returns and are more stable. The flip-side is that the returns likely won't be out of this world. Growth funds, on the other hand, are going to be more risky because they are trying to bet on which companies are going to successfully grow the most. When they get it right, though, and get in on the next Google, then they get a real nice payday.
The reason I prefer growth at this point is that with the number of players in the market growing so fast, there's getting to be more and more competition for the underpriced stocks which I think makes them less productive for an investor. It's still possible I think but it takes a lot of work. Warren Buffett is well-known for poring over financial statements into the wee hours of the morning and studying the company very thoroughly before he invests. Additionally growth offers the potential (key word: potential) for higher returns. If you do get some really nice growth returns early, you get a big jump in the long term from the extra compounding early on.
Forgot some stuff:
At this point I actually like the large-cap American stocks with the weak dollar which will only get weaker as the rate cuts get priced in. Weak dollars mean profits in foreign currencies, which many large American companies have, will be even higher profits when converted to dollars. The growth recently though has been international. Jim Cramer always talks about his BRIC countries: Brazil, Russia, India, and China. These are the largest developing markets in the world and so presumably, this is where a lot of the growth will be.
And yes, actually, I had some insurance money that wasn't doing anything so I put it into a discount brokerage about 6 months ago and I've been working with that. It's not all that much but its taught me quite a bit and is giving me experience with what I'd like to go into which is investing. I don't do anything too exciting and am primarily longer term, though I'm thinking about playing with some options since I've taken my Derivatives class.
I've got a bunch of money in international b/c I'm not so hot on the US economy right now. It also helps protect given a weak dollar and it lends to good diversification. Just a personal feeling. I've tried to do a 50/50 balance but since the foreign outperforms the US funds, it gets unbalanced and needs a little tweaking now and then.
Both the international and emerging markets have outperformed the US picks for the past year and a half, by a good amount too.
Usually in a 401k plan, you don't pay the front-end or back-end fees that you would with things like class a or b mutual funds bought on your own, so don't worry about those. If what you put in is what you see in your balance, then there are none.
Also, you shouldn't see/notice a big hit because expense ration is reflected in the funds NAV. Its "hidden" this way, which isn't a good thing.
I haven't dabbled in investing outside a 401k since I started work, although I did have three mutual funds during junior high through college that I played with. Right now I contribute right up to the max of Northrop's matching and then the rest goes into a high-yielding online savings account to be used in the near future on a house/condo/townhome purchase.
Dang - I didn't realize the expense ratio was hidden like that. Yowza.
Neat idea with just getting the match and then saving for a house/condo/whatever... Perhaps I aught to do a similar thing. Right now our "house fund" is also our "emergency fund" and so its harder to keep that money off-limits when the alternator goes out in one of the cars or something...
Speaking of high-interest savings accounts, what do you think will happen to interest rates on those with the fed rate cut? I think ING dropped their rates already. Neil, perhaps you could write a blog covering how that all works in more detail...
Jesus, my 401k offerings from Jackson-Hewitt seem to be terrible. I have 4 options, small cap, large cap, bonds, and equity. Isn't that lame as hell?
One guy at work sat down and explained MPT to me. At first I was excited as hell, but then I realized it's REALLY DAMN difficult to accurately predict correlation without A LOT of research.
Also, MPT is dead. Check out post modern portfolio theory ;)
HOLY FRICK!
I never expected postmodernism to crop up HERE! except this time, everyone can at least agree on a definition...
Haha it really is quite funny though. A dissatisfaction with the "inhuman" nature of MPT, so they factor in the way humans experience risk. Almost does like up with modernism/postmodernism in some ways.
Anyway.... I digress. Those 401k options are pretty lame-ass. get the match, put the rest in an ira or something with more/better options.
About correlation, I thought places like morningstar would have tools to give you a solid number for that stuff... no? If not, how *are* you supposed to figure that out? I haven't actually focused on the numbers as far as correlation goes... mostly just getting in a few different asset classes, which passes for non-correlated assets if you are stuck working with a limited number of fund choices.
About PMPT... I'm really gonna have to do some more reading on this. Is it just basically a new way of defining risk? Interesting stuff... I may have more to say about it after I understand it.
The blog fairy left a primer on how the Fed affects the economy over at blog.kordix.com/nog. Not a bad read, but I think I'd rather have the quarter under my pillow...
I'd never heard of this Post-Modern Portfolio Theory. From the quick once-over I gave the wikipedia article, it looks like it mainly just makes the distinction between upside and downside risk. MPT uses standard deviation from the mean historical price to measure risk. There is no distinction between upside and downside, its just that it varies from the mean by a certain percentage, be it up or down.
