An update on the bad investment choices in our Merril Lynch 401k

Our Merril Lynch 401k has improved investment options and now has a s&p 500 index fund with a much more reasonable 0.09% expense ratio.

Although not the cheapest in the industry it's very reasonable - especially compared with 0.6%.

I'm moving all of my plan employer 401k plan assets into the s&p 500 index.

We'll use our non-employer investments to diversify our portfolio and seek our target mixture.

Regards, makingourway

Russian investment options

I recently talked with a gentleman from Russia.
He indicated he used Citicorp as his investment manager.
Oh, I asked him, what are your fees. Fees, they don't charge me anything, he replied.
Oh really, how do they pay your advisor? Hmmm... we both said.
Sounds like they're charging embedded commissions.

I quickly explained conflict of interest, issues regarding commissions and referred him to William Bernstein's works.

Oddly, his investment options are quite limited. There really are few if any domestic mutual funds. He invests in equities in what is essentially a fast growing commodity extraction (oil) economy. Although he may diversify specific equity holdings, he doesn't have any real diversification.

I asked if he had any non-equity assets. He did:

Real estate development bonds - capital is protected and earnings are less aggressive than equities.

It was unclear if he has the equivalent of treasury bonds.

Standard asset allocation models as we construct in the USA would be very difficult.

Domestically, Russians do not hae 401k plans. They have social service pensions that are highly taxed. I imagine they are more comprehensive than the USA's Social Security plan, but would you really trust either to be around in 25 years?

My thoughts and recommendations were for him to open brokerage accounts external to Russia. For stability either in Switzerland or the UK and invest at least half of his assets through such channels. I'm assuming he'd have access to many ETFs, but am unsure what mutual funds - especially Vanguard products, he'd have access to.

This information verified what I had learned from several central european colleagues who have little structured external retirement plans other than official government pensions. Actually, these were very senior executives. It really seems they'll be living off what they could save personally with few if any government endorsed programs (like 401ks, etc...).

Regards, makingourway

Thoughts on porfolio construction & All About Asset Allocation

I've been reading Richard Ferri's All About Asset Allocation. Interesting read. About 1/3 of the way through. I'll summarize some key points:

Ferri discusses the benefits of portfolio diversification
Examines rebalancing
Explains Risk and Volatility
Asset Correlation (lower is better)
Key elements of a diversified portfolio
Exploration of different asset classes for consideration / inclusion into a portfolio

I've written about the importance of bonds to diversify one's portfolio, he has a very good discussion of it. One of the interesting model portfolio's in the recent Lazy Man's portfolio articles had 40% bonds, yet had one of the best track records of the lot. Quit interesting!

The sweet spot in the US markets seems to be small cap value. It represents only 3% of market capitalization and has varyling levels of correlation (as do all asset classes). One chart illustrates a 70% total market portfolio and a 30% small cap value portfolio (over a 30 year period) -- the small cap value assets add a 2.7% increase in return with no increase in portfolio volatility. Very impressive point.

Another interesting discussion is the long term edge that Value stocks (large cap) have over growth. 60% total market and 40% value (composed of 85% large cap value and 15% small cap value) had a 1.2% increase in return without additional portfolio volatility.

Of course you could add more value or more small cap value if you don't mind adding volatility. Unfortunately, my current investments do not include much small cap, small cap value or large cap value - primarily due to the tendency for life cycle target retirement funds to prefer market or growth asset classes - which seems ridiculous - as if the portfolio managers tippy toed into the pool of diversification because it was well defined in the popular press, but never read the rest of the research which indicated that stock selection was a very small component of return (but can be a high expense - look at those high ERs).

Regards, makingourway

consolidating my investments into Fidelity and Vanguard - what to do with that solo 401k

As I've mentioned earlier, I've begun shifting the bulk of my investments to Vanguard in pursuit of low cost index fund options.

Unfortunately, Vanguard doesn't offer a solo 401k (aka individual 401k). Fidelity does, though it's called a Keogh by them.

I successfully rolled over our individual 401ks (my wife's and my own) to Fidelity. It happened much faster than the moves to Vanguard - I think we were delayed by end of year retirement account set-up activities.

I was very unhappy with the $50 fee per rolled account Schwab charged me. I wonder if there's a way to ask them to take it back. Felt like a kick in the pants on the way out!

I still have minor accounts at schwab - non-retirement trading accounts, the amounts are small. I'm delaying transferring them for several reasons:

1. Vanguard is expensive as a brokerage with higher fees than Fidelity and Schwab.
2. I need to age the holdings before selling them or else my capital gainst will count as regular income (taxed at the regular rate).
3. I'm wondering if Shanda (SNDA) will continue it's recovery - up 100% from it's low, but still down 30% from it's purchase by me.

The money I rolled over from Schwab was placed in Fidelity's Four-in-One (FFNOX) fund. The idea being that the bulk of my holdings would be placed in self-managed retirement or balanced funds until after our relocation, at which time, we would resume the investment planning with our financial advisor.

FFNOX is an interesting fund. Historically it's slightly exceeded the s&p 500 by 0.6% to 2% when examining trailing returns. The fund is a balanced combination of the following low cost index funds:

55% Fidelity Spartan 500 (s&p 500)

16% Fidelity Spartan International Index (EFA)

15% Fidelity Spartan Extended Mkt Index (not s&p 500)

14% Fidelity U.S. Bond Index

The exact percentages are not where my target asset allocation is, but it will keep me in the approximate direction.

I was very tempted to load up on international index, international small cap, and domestic small cap value and a REIT index, but the fidelity family products do not include much of what I was interested in. I'll have to steer as much of the diversification investment into Vanguard to compensate. I've already pushed my 401k investments toward small cap value (not indexed), international and bonds. I may move in a similar direction with my wife's 401k, which is now predominantly invested in Barclay's 2030 life cycle fund.

How easy things would be if we could do in-service transfers into our private IRAs from our corporate 401ks!! As things are, my portfolio is pretty far from the target. The equity to bond allocation isn't that bad, but large to small and market to growth ratios need alot of help. As things are, I just have to bite my lip until we start-up again with the investment advisor in July or so.

The Schwab to Fidelity rollover took about two weeks or so. Much faster than the move to Vanguard.

This week I'll focus on rolling one of my son's retirement account from Schwab to Vanguard (where he has other retirement accounts). That will eliminate all but our trading accounts at Schwab. We also have trading accounts at First Trade, but can't move them until the assets hit the 1 year mark - due to capital gains - we've had significant gains there.

Regards, makingourway

Changes in my 401k investment strategy and thoughts on our interim investment strategy

Rather than go with a target retirement date plan as I've been doing with our other investments, I've decided to buy into specific asset classes to help push our asset allocation closer to our target allocation.

For those new to this blog, I have hired a professional investment advisor. We began the investment planning process and have already established a targetted asset allocation. However, with all the life changes ensuing, we decided to pause the investment planning process until our family moves and we have bought a new house. Our interim strategy has been to invest everything in Vanguard's 2025 target retirement plan (VTTVX) as it's bonds to stock ratio most closely resembles are plans target of about 20%.

Unfortunately, not all of our investments can be liquidated and converted into VTTVX. Why?

1. Most of our business sponsored plans do not provide the mutual fund or any Vanguard mutual fund.
2. Some of our non-retirement investments cannot be sold until they are 1 year old to avoid paying regular income tax (versus capital gains).
3. Some of our investments are in the process of rolling over / being transferred.

Our new model for my 401k, which will house about $23,000 plus match this year is as follows:

• 60% DODGE & COX INTERNATIONAL ST
• 20% HOTCHKIS AND WILEY SML CP VL I
• 20% PIMCO TOTAL RETURN FUND

This is a very odd selection of investments for a strong advocate of passively indexed funds, however, our indexed options are quite poor, with high expense ratios. The International index has the same ER as the Dodge & Cox fund. There is no small cap value index. The bond index seems to have the same ER as PIMCO's. I don't expect the money to sit in these funds forever, as I'm skeptical they can beat or even match their indexes forever, then again I will probably not be at the same employer forever, either, giving me a chance to transfer assets into a better plan.

I am tempted to push more of our other 401k plans into similar investment styles to force our asset allocation in the right direction.

Am I making a mistake? Should I put the money into the international index instead? I really don't like Blackstone products, which is my alternative. Should I put the money in a small cap index versus active small cap value?

Regards, makingourway

Books on basic investment planning & the role of bonds in an investment portfolio

In response to Anne's comment in my previous post discussing the role of bonds in an investment portfolio, I felt I would discuss bonds and investment planning more succinctly.

I've recently read, and re-read Bernstein's Four Pillars of Investing. I strongly recommend it's discussion of the importance of bonds in an asset allocation plan and the book in general for those looking to create a long term portfolio and investment plan. Warning, it clearly leans away from active investing and stock picking.

Another interesting read, in the same vein, but more practical towards portfolio planning and construction is All About Asset Allocation by Rick Ferri. I strongly recommend reading both books.

The bottom line, and one which Moom, did a great job elaborating more eloquently than I is that a diversified portfolio with rebalancing will have a higher return for a given level of volatility - you want to manage volatility as you grow older (reducing risk when you need the money available). However, I still have the impression that for very long investing horizons (30 years or more) a diversified portfolio with rebalancing is likely to exceed any single asset's performance due to the cyclical nature of asset performance.

This means that those in their 30s or 40s should plan on having a diversified portfolio and rebalance regularly unless they expect to die fairly soon.

For Anne's benefit, Bonds are an effective asset to diversify with against stocks as they usually have a low correlation against stocks. This means that when stocks shoot up or down, your bonds are not likely to follow as far or in the same direction. Other assets like REITs, commodities, emerging markets, small cap value and at times foreign large cap are either less correlated or lightly correlated. The multi-asset class portfolio uses the different asset classes and rebalancing to ensure assets are sold high and bought low with a higher return for a given level of risk (or volatility). Ferri has nice charts that demonstrate the benfits of multiple asset classes over dual and single asset class portfolios.

The key approach to make such a plan work is a very long term investment horizon. A diversified asset allocation plan should assume markets will rise and fall and non-correlated assets can be sold to take advantage of buying opportunities when you rebalance.

Anne, I hope this discussion helped, but Bernstein and Ferri do a better job than me.

Regards, makigourway

the role of bonds in an investment portfolio a simplification of modern portfolio theory

A key tenant of modern portfolio theory is that a diversified portfolio of non-correlated asset classes when regularly rebalanced has long term performance that is superior to the compounded returns of any individual asset class in the portfolio.

This means that a mixture of stocks and bonds can beat the long term compounded performance of stocks or bonds individually. Portfolios with even more asset classes perform even better.

How does this work? Rebalancing. At the end of a year, if one asset class performs very well - perhaps exceeding your target allocation percentage by 20%, you sell some of it and buy more of your other asset classes until your target allocation has been met. You have effectively sold one asset class at a high price and bought the under-represented classes at low prices. How do you make money? Sell high and buy low! Rebalancing does just that.

In simple portfolio allocations, bonds are the asset class that usually, but not always, is outstripped by equities performance. Historically, we have been told to subtract our age from 120 to determine the % of bonds our portfolio should have. With young people often having little bonds - after all, at that age, who wants 5-7% average returns?

Unfortunately, the young investor and those that make recommendations to them confuse average returns with cumulative returns. They are simply not the same.

I recommend investors think of bonds as a form of stored investment capability - like a battery. When the market goes down, you have your bonds - often stable in value - as a source of capital to buy into a cheap market.

Bonds and the entire concept of non-correlated asset classes takes advantage of volatility. When markets push one asset class down, another asset class retains enough purchasing power to buy the depressed asset class at a discount. It's the equivalent of buying food or clothing on sale. Think value investing. However, most of the investment media and many brokerages make recommendations based on average annual performance - they ignore or fail to clearly discuss volatility. The result is that average returns are used to project growth -- the benefit from rebalancing is lost. Furthermore, cumulative investment returns fail to match average annual returns - it's a bar that cannot be met. If a fund drops 10% in one year and 20% the next, it's cumulative value will not equal 100% - it will equal 108%. Rebalancing helps bring the return back to 110%.

Without bonds or other non-correlating asset classes, there would have been no reserve money to buy more when the stock was cheap.

Perhaps the formula to determine the percentage of bonds should not be 120-your age, but rather, what is the expected volatility of your non-correlated investments - is there enough of your non-correlated investment (e.g.) bonds, to rebalance the rest of your portfolio if? If stocks drop 25%, will you have enough allocated in bonds to cover the 25% loss in stock?

Incidentally, the average rebalancing benefit is usually 0.5%. In a low expense mutual fund it could make a very big difference.

I'm sure there are modelling tools available to recommend the ideal % of bonds compared to the volatility of the rest of the portfolio.

My gut says that it should be at least 20% but possibly higher. What is your bond allocation?

Regards, makingourway

investment opportunities of global warming

With the new IPCC report discussing global warming issued recently, I began wondering what the impact on investements and the economy would be.

Here's a quick summary:

• Fossil fuels were accused as the primary protagonist with a 90% confidence
• Temperature increases of 2.7 to 8.1 degrees, north central and Mountain West see up to 7 degree increase
• More heatwaves in S and W of US
• Less frost in N of US
• Sea levels may increase up to 20"
• N states see more rain and snow, drier regions become drier still

What is the commercial impact:

1. Catastrophe claims increase in coastal areas - sub-sea level areas become uninsurable - residential properties decline in value or become unusable - insurance companies see increased costs, wind and flood premiums rise. Opportunity: construction technologies designed to withstand significant flooding and wind damage.
2. Significant increase in electrical costs for air conditioning and refrigeration - nuclear energy and alternate energy products - much of what GE produces.
3. Dramatic change in farm lands will create opportunities to grow tropical and other food crops domestically. Traditional grain belt may shift N into Canada. Free trade agreement between US and Canada becomes more important. Geographic impact of shift in agriculture as well as labour and transportation dislocation risk social instability and increased social welfare costs (i.e. taxes).
4. Relocation of population further inland to avoid the worst of weather and water related catastrophes as well as those who have lost homes.
5. Florida will be one of the worst hit locations. Somehow I expect increasingly significant catastrophe damage will drive relocation faster than rising waters, which will be more gradual.

This is certainly not an apocolyptic message, but certainly one full of change and discomfort.

The report further discusses the unlikeliness of reversing these effects - in fact cessation of any greehouse gas emissions would still leave a 100 year legacy.

Scientific research, of periods long past, also indicate previous greenhouse epochs, so we know our planet will survive. The most critical decision is how we plan to adapt and how we can preserve our invstments in the process.

One thought, without inexpensive energy sources, we will not be able to compete economically against the many third world countries creating export based economies who do not abide by greenhouse gas reduction treaties.

We are most likely to see reactive tarrifs placed upon their products. Actually, this plays well into the current positioning by democrats in regard to their demands for globalization offset terms as part of their renew of President Bush's fast track trade negotiation rights. Congress would further like to further hobble the President's trade agreement freedoms with various special interest requirements that will certainly nueter future trade negotiations. It's odd how President Clinton, a Democrat, also desired and lead free trade negotations free of special interest influence.

We are at an unusal time where the cheap US dollar makes our exports more competitive. Will we destroy the opportunity for economic growth, increased employment, etc...? I'm sure congress would like to do so.

Regards, makingourway

Kudos to the lazy portfolio (aka Modern Portfolio Theory)

Paul Farrell has written a wonderful article discussing the immense success many published Lazy Man's portfolio's have had compared to their market indeces. You can find the article here at Market Watch.

Farrell compares quite a few of the simple passive investment portfolios recommended by some of the most well known advocates of MPT. In virtually all cases the portfolios have beaten the S&P 500 over the prior 5 year period. Virtually all also beat the s&p 500 index for the three year period and half beat the one year index.

I strongly recommend the article. It's a great glimpse into the power and benefit of a passive indexing strategy using MPT.

A few quick comments on the article:

1. The S&P 500, although well known is an inappropriate comparitor - most of the portfolios are diversfied outside of the s&p 500 - it's comparing apples and oranges.
2. Some of the portfolios selected from different writers are hardly their high performing portfolios (Bernstein is a good example).
3. One year returns, although interesting, are especially meaningless when analyzing index investing strategies. 30 year regressions would be much more interesting and include more varied markets.

Anyway, try the articles, it's a great way to examine the actual undertakings of low cost index based strategies using MPT (modern portfolio theory).

Regards, makingourway

Asset Allocation: How diversification improves portfolio performance

I'm reading Rick Ferri's All About Asset Allocation. Great book. More how to and less academic than Bernstein's book. I recommend reading the Four Pillars first. It has a stronger theoretical foundation.

In chapter 2 Ferri discusses risk and return. One of the interesting points he raises - something I hadn't read before, is the relationship between volatility, simple average return and compound return.

Volatility represents the amount of up and down an asset class experiences; e.g. historically, in one year, 86% of the time (i.e. usually) the asset class goes up to 20% or down to 7%.

The simple average return is the average of returns for each year; e.g. over 5 years the average return for each year was 10%.

The compound return is different. It factors the impact of the prior year's return into the results of the current year. So a highly volative stock might drop 20% in year one from 10 down to 8. The following year it goes up 10%. The new value is 8 times 10% or $8.80. Whereas the simple average would have calculated the value as $9.00. Over time, the numbers can drift apart quite a bit.

An effective asset allocation plan which invests in low correlating assets helps insure that only some assets go down, while others go up. The end result of an effective allocation strategy is reduced volatility while maintaining a high average rate of return.

As I read on, I'll share some of the thoughts I learned. I for one, am interested in the question "how do you allocate to reduce volatility while maintaining a high rate of return."

Regards,
makingourway