Book review: How to Make your Money Last. The Indispensable Retirement Guide. by Jane Bryant Quinn.

March 22, 2016

Jane Bryant Quinn, 2016, Simon & Shuster, New York. 366 pages.

Synopsis

This book should be read by everyone who needs to plan for retirement from the workforce.  Author Jane Bryant Quinn is an acclaimed financial journalist with excellent credentials. In this book, she draws from credible research to describe principles and checklists for retiring with a practical financial plan. She speaks from firsthand experience about reinventing life after leaving the workforce: “once again the future is a blank slate” that needs to be filled with activities for a meaningful life (chapter 1). Those activities need the support of a dependable income managed by a practical financial plan.

In her opinion, your default plan is to maximize social security benefits and gradually increase the market value of your retirement portfolio (a.k.a. retirement savings) while maintaining a monthly paycheck for the duration of retirement. The financial core of a good retirement plan is based on 3 principles (chapter 12):

  1. Estimating your budget gap in advance of retirement (chapter 2)
  2. Maintaining a cash reserve throughout retirement (chapter 9)
  3. Making safe withdrawals from your retirement portfolio (chapters 8, 9)

Quinn provides practical checklists for transforming various sources of retirement income to a homemade paycheck.  In addition to building a retirement portfolio by ‘bucket’ investing (chapter 9) are the supplemental sources of income from Social Security benefits (chapter 3), traditional pensions (chapter 5), simple annuities (chapter 6), and home equity payments (chapter 10).  She also provides practical checklists for securing retirement income with the help of spending rules (chapter 8). Quinn’s valuable checklists help manage the financial risks of inflation (chapters 2-4, 8), taxes (chapter 7), costs of healthcare (chapter 4), and spousal protection (chapters 3, 4, 6, 7, 10, 11).

Janet Quinn’s Core principles

BUDGET GAP (chapter 2). The 3 important numbers in your retirement plan are its budget gap (chapter 2), cash reserve (chapter 9), and safe withdrawal (chapter 9). Calculate your budget gap before retirement. It is the difference between future income and expenses. The future gap can be minimized by staying in the workforce (to build a larger retirement portfolio) and spending less money.  Significant adjustments to financial assets and regular income may be necessary to support your desired level of spending later on. Estimate the future annual amount of money you can safely spend by using the following formula (chapter 2):

safe spending = (0.04*financial assets) + regular annual income – estimated taxes

CASH RESERVE (chapter 9). Create a cash reserve at the start of retirement. It will be an important source of money to pay for any budget gap that develops during 2 years of decline in the financial markets.

SAFE WITHDRAWAL (chapter 9). The “safemax” is a percentage of your retirement portfolio that you can safely withdraw in the first year of retirement (chapter 8;“safe’ means “as far as we can tell”). The amount withdrawn, plus an adjustment for inflation, practically dictates how much you can withdraw every year to ensure the 30-year longevity of your retirement portfolio.

Here’s the 4% rule (chapter 8): Withdraw 4% of your retirement portfolio at the start of the first year and safely store the money to pay bills throughout the year. At the start of the second year, withdraw the previous year’s amount adjusted for inflation. For example, assume your retirement portfolio holds a $50,000 investment in stocks and $50,000 investment in bonds for a total of $100,000. Even if you make no more contributions to the porfolio, the following annual withdrawals could be sustained for 30 years when adjusting the previous year’s withdrawal for a 3% rate of inflation and rebalancing the portfolio to maintain a mixture of 50% stocks and 50% bonds:

year 1- $100,000 * 0.04 = $4,000 withdrawal
year 2- $4,000 * 1.03 = $4,120 withdrawal
year 3- $4,120 * 1.03 = $4,244 withdrawal
legend- $100,000 is the portfolio’s initial value, 0.04 is the safemax, $4,000 is the first annual withdrawal, 1.03 is the inflation factor, and $4,120 is the second annual withdrawal.  there is no adjustment for taxes in this calculation.

NOTE: The amount withdrawn by the 4% rule is directly related to the initial market value of the retirement portfolio. For example in year 1, the amount safely withdrawn from a $200,000 portfolio would be $8,000, etc.

Protect yourself from the hidden risks of greedy salespeople as you get older and less interested in managing your accounts. Appoint a trustworthy person as your durable power of attorney and use a written investment plan.

Life-time income

Life-time incomes offset the risk of outliving your retirement portfolio. The reliable life-time incomes of retirement are Social Security, Pensions, and Annuities.

SOCIAL SECURITY (chapter 3). Social security benefits include a guaranteed income for life, protection against inflation, tax benefits, and protection of your spouse without the risk of market fluctuations and without paying investment fees. Beneficiaries can maximize their income by delaying the onset of benefits to age 70 instead of starting at age 62 (be sure to enroll in Medicare at age 65). A survivor’s benefit is based on the earnings-record of the deceased. The spousal benefit is automatically upgraded to a higher survivor benefit.

PENSIONS (chapter 5). Traditional pensions offer either a monthly lifetime payment or a lump sum payment that can be rolled over to an Individual Retirement Account (IRA). The rollover incurs an investment risk (investment risk is the possibility of incurring a loss from your choice of investment or the investment’s fluctuation in market value).  Government pensions (except municipal pensions) are reliable.  Most private pensions are protected by the Pension Benefit Guaranty Corporation (PBGC.gov). If you are ineligible for a pension, consider buying a lifetime annuity.

ANNUITIES (chapter 6). Annuities aren’t a do-it-yourself investment; they are a tool for managing the risk of outliving your portfolio. Find a good advisor who isn’t a salesperson and avoid buying variable annuities with living benefit guarantees. Simple annuities are purchased with a lump sum in return for monthly lifetime income.

  1. The Single Premium Immediate Annuity (SPIA) pays benefits until death unless purchased with payments “Certain”. The SPIA is not designed to create a legacy fund. Its advantage is the payment of benefits that exceed the interest of bonds and dividends of stocks. The insurance company’s rating should be at least AA- (Fitch, S&P), A (AM Best), or Aa3 (Moody’s). [The tax deferred variable annuity can be converted to an SPIA. Find the best available benefit-payments in ImmediateAnnuities.com and switch companies.]
  2. The Immediate Pay Variable Annuity pays monthly benefits that change with the market. The benefit is a percentage of the investment portfolio value. The assumed interest rate (air) is your selected rate of withdrawal from the investment portfolio. The investment risks are volatility and choice of investment portfolio.
  3. The Inflation Adjusted Immediate Annuity pays monthly benefits adjusted to last year’s inflation. There is no inflation or investment risk. The monthly benefits are lower at the beginning than later on. This annuity is more appropriate for younger people with a longer life expectancy.
  4. Fixed Increase Annuities pay monthly benefits that rise at a fixed rate of 1-5%.
  5. With a Deferred-income Annuity (“longevity insurance”) there is a time delay to the initial benefit followed by monthly payments for life. The reasons for owning this annuity are 1) protection from outliving retirement portfolio, and 2) providing your spouse with guaranteed income after death.
  6. Fixed-term Annuities start paying benefits immediately. This is desirable for people with illiquid investments such as delayed social security.
  7. The Charitable Gift Annuity gives a lump sum to charity that guarantees a fixed monthly income for life.

The variable annuity is a pure investment that risks poor performance in the market. Its insurance company offers a guaranteed living-benefit rider (LBR) that provides a minimum lifetime income regardless of the investment’s performance. Taxes on the accumulating returns are deferred until withdrawal, then taxed as regular income (unless “qualified” in a Roth). The tax is proportional to the ratio of investment return to invested capital.  The goal of a variable annuity is to allow growth of your investment above the guaranteed minimum. Success depends on a 90% allocation of stocks in the investment, yet most insurance companies limit the stock fund to 65% stocks. Why? The insurance company is protecting itself by using fixed income from the portfolio to pay the LBR instead of the company’s own money. Living benefits are first taken from the investment portfolio while you continue to pay the annual fee! This seems unfair, so try to exercise your right to withdraw from the investment every year up to a fixed percentage amount. Even if you draw down to $0, the company will continue to pay your benefit. Spouses are usually not covered by a variable annuity. Rather, the death benefit is an insurance payout that doesn’t replace the annuity’s investment return a survivor might lose. If you bought a variable annuity, it’s too late to extend to your spouse. But you can switch to a better annuity in a tax-free exchange or buy more insurance. Variable annuities often charge excessive management fees of 3-5%.  For a second opinion, consult the Marco Consulting Group at Annuity Review (AnnuityReview.com). They will analyze 2 variable annuities for a fee of nearly $300.

HOME EQUITY (chapter 10). The equity of your home is a ‘piggy bank’ that can be used for income or passed to your heirs. There are several ways of squeezing income from your home equity:

  1. take a Reverse Mortgage to create a 20-30 year spending plan
  2. borrow to pay a large bill
  3. eliminate a traditional mortgage.
  4. refinance your traditional mortgage
  5. take a boarder after first checking on possible restrictions imposed by homeowners associations, zoning laws, etc.
  6. sell the house and lease it from the new owner (i.e., Sale/Leaseback). Consult a lawyer before selling the house.

The reverse mortgage is a loan against the equity of your home in which the lender makes tax-free payments to you because they are loans. You pay all maintenance costs. Don’t repay the loan while living in the house; proceeds of the sale will repay the loan. You keep the excess proceeds, but otherwise are not responsible for a loss on the sale.

The Home Equity Conversion Mortgage (HCEM) is issued by private lenders and insured by the FHA. The HCEM offers 3 types of payments:

  1. lump sum at the beginning
  2. monthly payments
  3. borrowings from the principal

At your death and before selling the house, your heirs will have the option of buying or selling the house before foreclosure. Seek more information and advice from Jack Guttentag on his website, MtgProfessor.org.

Portfolio management

SPENDING RULES FOR THE HOMEMADE PAYCHECK (chapters 8, 9). The basic rules are to make buy-and-hold investments in your portfolio, withdraw funds using the 4% rule, and rebalance the portfolio after you make an annual withdrawal. Based on Quinn’s research up to the year 2016, the 4% safemax may be modified in one of several ways:

  • 4.5% if your stock allocation is 45-65%
  • 5.5% if you reduce the withdrawal in declining markets
  • 3% to ensure surviving the next 30 years
  • adjustments to the Shiller PE Ratio
    • 4% if P/E10 >20
    • 5% if P/E10 = 12-20
    • 5.5% if P/E10 <12
  • 6% is too high and your portfolio may only last 15 years. Instead, borrow on your house through a reverse mortgage.

The amount of annual income withdrawn from your retirement portfolio is determined by your safemax rate of withdrawal (discussed above in the core principles). Be consistent in withdrawing from your portfolio except when the market is depressed. Then withdraw from your cash reserve to pay bills. When the market starts to recover, tap the investments to restore the cash reserve and resume withdrawing at the safemax.

Skip an annual withdrawal when you don’t need it. If the required minimum withdrawal from tax-deferred accounts exceeds your planned annual withdrawal, reinvest the excess amount. Here are 2 ways to preserve capital:

  1. Withdraw from investments that have increased in value, otherwise from investments with the lowest potential return.
  2. Withdraw from taxable accounts before tax-deferred accounts. Within the taxable accounts, withdraw a blend of gains and losses to minimize taxes.

PORTFOLIO INVESTMENTS (chapters 8, 9). Bucket investing is done by putting money into different funds (‘buckets’), each having a specific purpose. First, create a cash reserve (‘cash bucket’) that will pay bills for 2 years when added to pension checks. 90% of the remaining retirement portfolio is allocated to investments and 10% to a discretionary bucket. Allocate 40-65% of the investments to stocks and the remainder to bonds [the author discussed additional guidelines for adjusting your allocation of stocks and bonds according to age (chapter 8)]. The discretionary bucket is used for big, extra items (e.g., new car).

Your allocation of bonds and stocks depends on your capacity for risk, not your tolerance for risk. The capacity for risk depends on how well you are funded and able to pay bills with pension funds. If your risk capacity is low, don’t risk too much on incurring a loss in the stock market. Do you need to risk a stock investment? Not if all your expenses, including health, are covered for life. People older than 80 tend to fall into this category. Younger people with at least a 10 year horizon have more time to survive market fluctuations. The S&P500 Total Return index has never declined over 15 years. Otherwise, you need to invest in stocks if all expenses are not covered for life. The reasons for investing in stocks are to hedge inflation (low allocation of 20-30%) or create a legacy fund for heirs (high allocation of 40-80%).

There are several important advantages to investing in index funds instead of individual stocks and short-term bonds.

  • index funds are easier to rebalance each year
  • you will earn the return of the whole market
  • you will own a portfolio of diversified investments
  • index funds are easily converted to cash
  • short term bond prices aren’t as volatile as long term bond prices

What if you don’t want to rebalance the retirement portfolio?

  • invest in a target-date fund
  • use a rebalancing program
  • pay a low-cost online advisor (e.g., betterment.com )
  • hire a good fee-only financial advisor and avoid paying high fees. consult FINRA.org for help finding a reputable financial advisor.
  • seek advice from a no-load mutual fund company

Risk management

TAXES (chapter 7). The main categories of tax-deferred retirement savings accounts are employer-sponsored plans and personal IRAs. The typical employer-sponsored plan allows investments in mutual funds. After leaving an employer you can keep the plan, merge it into that of a new employer, or convert it to a rollover IRA. Personal IRA’s expand your investment choices, some of which require a trustee to make the transactions (e.g., precious metal trust, real estate trust). Be aware of the costs of converting a traditional IRA to a Roth IRA. At the time of conversion you must pay regular income tax on the investment returns. You may also incur a higher medicare premium and pay possible tax on unearned income. To minimize taxes when you withdraw funds to pay bills, withdraw from the taxable portion of your portfolio first, the traditional IRA second, and the Roth IRA last.

If you inherit an IRA from your spouse, your choices are these:

  • ask the trustee to name you as owner
  • rollover to a new IRA owned by you
  • rollover to an IRA already owned by you
  • create an inherited IRA if you are younger that 59 1/2 years.

If you inherit an IRA from someone else, your choices are these:

  • take your full inheritance now and lose the tax shelter
  • retitle it as an inherited IRA to keep the tax shelter

HEALTH INSURANCE (chapter 4).  The Affordable Care Act guarantees your eligibility for health insurance irrespective of your state of health. There are 3 general healthcare plans: HMO (Health Maintenance Organization), POS (Point of Service), and PPO (Preferred Providers Organization).  In each plan, your cost share is capped by the annual maximum out-of-pocket payment.

The government’s Medicare program is comprised of part A for hospitalization, part B for outpatient services, part C for extra benefits plus prescriptions, and part D for prescriptions. You pay premiums for parts B-D, but not for part A. There are cost-sharing charges for services in parts A-D. Medigap is a private healthcare insurance designed to supplement Medicare and used to replace Part C of Medicare. Don’t miss the enrollment dates or else pay a higher premium!

LONG TERM CARE (chapter 4). If you become incapacitated and require long term healthcare outside the hospital, your costs may exceed $85,000 per year. Consider purchasing long term care insurance, but don’t spend more than 5% of your retirement income on insurance premiums for long term care. Group policies are cheaper. Minimize your premiums by choosing a 3-year benefit period (instead of 5 years), avoid paying for inflation adjustments later in life, insure 50-75% of your expected cost, and extend the waiting period to 6 months. The alternatives to long term care insurance are:

  1. join a continuing care retirement community that offers a nursing home benefit.
  2. self insure by selling your home
  3. use Medicaid as a safety net.

LIFE INSURANCE (chapter 11). Don’t buy any if you are a single retiree without dependents. You’re better off investing the saved-premiums. Consider owning life insurance if you have dependents and want to leave a legacy fund or charitable gift. Chapter 11 describes how to extract more value from a life insurance policy.

SHELTER (chapter 10). Younger retirees like living in an active community and older retirees like their “independent living” in a more secure location. The choices for independent living are to remodel your existing home as needed to compensate for a handicap (e.g., wheelchair) or change homes. For example, move to an active adult community (consult 55Places.com; ensure that you will continue to receive healthcare).

Retirees seek “assisted living’ when they need help with the basic functions of living.  The choices for assisted living are to receive in-home healthcare or move into an assisted living facility (consult ALFA.org for choices).

Downsize to make life easier!


Websites for retirement-planning

February 19, 2016

[updates: 3/4/2016, 3/18/2016]

Resources

http://DOL.GOV/EBSA/PDF/RETIREMENTTOOLKIT.PDF , federal programs and retirement calculators
http://SOCIALSECURITY.GOV , benefits & ‘retirement estimator’
http://MEDICARE.GOV health insurance for retirees
http://WISERWOMEN.ORG Women’s Institute for a Secure Retirement
http://HHS.GOV/AGING , health- and legal information
http://USA.GOV/BENEFITS-GRANTS-LOANS , federal benefits
http://AGING.OHIO.GOV , quality of life
http://economiccheckup.org , to plan retirement, reduce debt, find work, and cut spending.

Money management (‘financial planning’)

http://DOL.GOV , search for “Taking the mystery out of retirement planning” and download this excellent pamphlet of useful advice.
http://MYRA.GOV , A safe, affordable Roth savings account for wage earners.
http://WESTERVILLELIBRARY.ORG , search for “Investments 101”

Portfolio management

http://apps.finra.org/Calcs/1/RMD , find link to “required minimum distribution”
http://BANKRATE.COM , click on “RETIREMENT” tab, then on “Retirement Calculators” subtab, then on “Asset allocation calculator”
http://53.COM, click on “Financial calculators”, then click on the “Retirement Planning” tab, then click on the “Retirement Income Calculator” to estimate your longevity of savings; click on the “Retirement Account Calculator” to compare retirement savings accounts.

Risk management

http://IRS.GOV , search “identity protection”, about Identity theft
http://FINRA.ORG (securities help line for seniors, 844-574-3577), Check the credentials of a broker or financial advisor; about Investor protection; http://apps.finra.org/meters/1/riskmeter.aspx to assess your risk for Financial fraud
http://NELF.ORG , about Elder Law
http://ELDER.FINDLAW.COM  , about Elder Law
http://LONGTERMCARE.GOV , about LTC health insurance
http://PBGC.GOV ,  to assess pensions
http://immediateannuities.com , to shop for simple annuities
http://annuityreview.com , obtain a second opinion about variable annuities

Low income assistance nationwide and in Ohio

http://benefitscheckup.org
http://OHIOHERETOHELP.COM
http://OHIOBENEFITS.ORG


2015

January 17, 2016

The investment goal of the Small Trades Portfolio is to outperform its benchmark index, the Standard & Poor’s 500 Total Return.  Regretfully, this has not happened (chart).

portfolio performance 2015

The chart compares the growth of $1.00 invested in the portfolio to a theoretical investment in its benchmark index and the inflation of U.S. consumer prices.  A decline of the benchmark during the 2008 Recession recovered in 2012 and grew to $1.66 (66% above baseline) by the end of 2015.  But the portfolio declined and never fully recovered.   Revised operations after the Recession managed to stabilize the portfolio by reallocating 80% of the portfolio’s principal to exchange-traded funds (ETFs).  The ETFs are invested in underperforming asset classes that will eventually recover.

There are encouraging signs of investment performance found in the trends of compound annual growth rates (next chart) and stock performance (subsequent chart).

portfolio CAGRs 2015

The compound annual growth rates of the benchmark index are leveling off while those of the portfolio are rising.

stock performance 2015

Revisions in my investment philosophy for stocks also show an encouraging response.  For every $1.00 invested in the portfolio on 12/31/2013,  the portfolio’s stocks outperformed the benchmark index and portfolio ETFs for two successive years.

Discussion

The portfolio is intentionally overweighted by index ETFs.  Among these, the equities ETF (ticker: VT) has 75% of holdings in developed markets and 25% in emerging markets. The returns from emerging markets were disappointing due to economic and political factors in foreign countries. The 2015 decline of gold prices was expected, given the global deflation of prices.

Strategy

I prefer to invest in healthy emerging markets and when that occurs, I will trade the world-market ETF (ticker: VT) to a riskier emerging-market ETF (ticker: VWO). A continued decline of gold prices will likely cause me to rebalance the ETFs to equal portions of 25% among four asset classes of emerging markets equities, U.S. real estate, U.S. bonds, and gold bullion.  25% allocations of emerging markets equities, U.S. real estate, gold bullion, and U.S. bonds collectively impose a higher risk-return quality to the ETF portfolio compared to a 60:40 allocation of U.S. stocks and bonds.

My investment strategy for stocks is evolving from placing conditional trading orders on cyclic stocks to buying good growth stocks for the long term.

Douglas R. Knight

 

 

 


Lead article: Stock Index Funds

January 16, 2016

The only way an individual investor can quickly invest in hundreds of different stocks is to buy shares of a stock index fund. The tremendous advantage is an immediate ownership of a diversified portfolio in one affordable investment. It’s the surest way of earning the stock market’s returns provided the correct investment is held through a series of ‘bull’ and ‘bear’ markets. Selecting the ‘correct’ fund requires only a few hours of easy research based on the following information:

INDEX. Stock index funds are passively-managed investment funds designed to imitate a stock index. The index measures the investment performance of a hypothetical portfolio of stocks. Some indices are riskier than others by virtue of the underlying securities in the hypothetical portfolio. For example, micro-cap stocks are riskier than all stocks combined by virtue of differences in turnover, liquidity, and diversification.

FUND MANAGEMENT. The investment fund is an actual portfolio of stocks that are managed for the benefit of the fund’s shareholders. Passive management is an investment style that imitates the performance of the selected index. Active management intentionally avoids imitating the index and is a more costly endeavor.

The legal structure of an index fund regulates its style of management. A unit investment trust (UIT) is bound by a trust agreement to manage a portfolio of fixed composition. The UIT has an unmanaged portfolio because there is no allowance for adjustment of composition by the manager. The open-end investment company (OEIC) operates a managed portfolio of adjustable composition. The OEIC is bound by its investment strategy to operate either a passively or actively managed fund. OEIC managers of an index fund are bound to passive management but have leeway to supplement the fund’s income by revising, lending, or borrowing a minor portion of the portfolio. These operations may increase the risk and tax burden of investment.

PRICING. The pricing mechanism of an index fund is closely regulated. Mutual funds are OEICs that trade shares at net asset value (NAV); in other words, they are priced at the fund’s net worth-per-share. The mutual fund’s share price is not quoted until the next day because the NAV is determined after trading hours from closing prices of the underlying stocks. Mutual funds are marketed through an authorized broker and guaranteed to be priced at the NAV. Exchange-traded funds (ETFs) are OEICs or UITs that trade the fund’s shares in the stock market, which means that the share price is quoted by public auction during trading hours. ETFs are traded the same way as stocks. The intraday net asset value (iNAV) and share price are continually updated and reported by the stock market. The fund’s share price is linked to the fund’s iNAV by arbitrage. Individual investors can neither participate in arbitrage nor redeem ETFs at NAV.

FEES. Managers of investment funds are compensated by charging an annual expense ratio that diminishes the NAV. Competition has decreased the expense ratio of stock index funds to only a few basis points (1 basis point = 0.01%), but beware that the expense ratios of bond index funds and actively managed mutual funds are typically higher; read the prospectus. Mutual funds are notorious for adding special fees to trades and imposing minimal holding periods; check with the broker and read the prospectus. New, small index funds are at risk for early termination when the NAV fails to grow above an estimated fifty million dollars. The expense ratios of small funds generate insufficient compensation for the fund sponsors, so they close shop.

TAXES. OEICs and UITs are registered Investment companies (RICs) that pass all income taxes to the shareholders. The amount of tax depends on dividends and capital gains earned by the fund. Managed portfolios incur a higher tax burden due to the more frequent turnover of portfolio securities. Consequently, mutual fund shareholders pay taxes on unrealized capital gains that ETF shareholders don’t have to pay. In theory, UITs are more tax efficient than OEICs.

INVESTMENT PERFORMANCE. During the 10 year period of 2006-2015, the compound annual growth rate of Standard and Poor’s 500 Total Return Index was 7.2%. In comparison, the growth rates of an index ETF (ticker: SPY) and an index mutual fund (ticker: VFINX) were 7.1% and 7.0% respectively. The slight differences in performance were due to an expense ratio, tracking error, and pricing error of the investment funds compared to the index.

OTHER INDEX FUNDS. There are indices to measure the investment performance of bonds, commodities, precious metals, and other assets. Likewise, there are mutual funds and ETFs that track the various indices. Bond index funds are managed by OEICs and require frequent turnover of the underlying bonds. The index funds for commodities, precious metals, and other assets are structured as grantor trusts, partnerships, or debt instruments. Stock index funds are generally less expensive, taxed at lower rates, and less risky than other index funds. Leveraged ETFs are exceptionally risky investments designed for same-day trading.

CONCLUSION. A broad-market stock index fund is the correct investment for earning returns from the entire stock market or a sector of the stock market. Simply choose an established, reputable index for the particular market that interests you. Then choose an established, reputable mutual fund or ETF that imitates the index. Use screeners or reputable fund families to select appropriate funds. Verify the fund’s expense ratio, extra fees (if any), NAV, longevity, and passive management by reading the prospectus and/or research reports. XTF.com is a free and excellent rating service for screening and assessing ETFs. Cross check your research with a trusted broker.


What is a good growth stock?

December 22, 2015

Theme

—profitable companies attract investors—

A good growth stock represents the profitable company that sells desirable products. The company’s business earnings should grow nearly 6% annually so as to match the growth rate of the U.S. Economy (about 3.5%) and compensate the rate of U.S.Inflation (about 2%); otherwise, the company might do well to liquidate its business and reinvest in securities.

Growth stock investors seek an annual rate of return that exceeds the U.S. Stock Market’s historical 8-10% annual rate of return. The basic approach is to buy stocks at a low price and sell them at a high price, but that is easier said than done. Investors can help realize high returns by selecting stocks from well managed companies, holding the stocks through an adequate growth period, to offset price volatility, and diversifying their stock portfolio.

Evaluating the company

Does the company earn respectable profits with a sustainable business? The answer is yes if the company has a:

  • growth rate of earnings that surpasses 6% annually.
  • future growth rate of earnings that surpasses 6% annually.
  • durable business with a sustainable growth rate.

Growth rate. The company that recognizes and satisfies the needs of customers will accumulate sales with the demand for its product. Profitability is the combination of sales growth coupled with efficient management of business expenses. In other words, the profitable company has a respectable growth rate of sales with respect to time, respectable rate of earnings with respect to sales, and consequently, a respectable growth rate of earnings with respect to time.

Earnings are the net income from sales after payment of expenses. The growth rate of earnings matches the growth rate of sales when the company runs its business in a consistent manner. Both sales and earnings should grow annually by at least 6% to outperform the national economy and compensate for the effect of inflation. Growth investors typically monitor the company’s earnings per share (EPS) on a quarterly basis. The EPS should grow at a compound annual growth rate of 6%, or more, as determined from at least 5 years of historical data. When evaluating a company’s earnings, consider the possibility that management is manipulating the EPS to earn higher compensation.

Future growth rate. The earnings estimate is an analyst’s quarterly or annual forecast of the EPS. The estimate is more uncertain when the forecast extends to 3-5 years. Investors use the earnings estimate to track a company’s performance and to derive a future range of share prices. The growth investor should seek companies with earnings estimates above the 6% compound annual growth rate.

Durable business. Any company can be driven out of business by an economic disaster in the entire industry, strong competition, and a declining market for the company’s product. The durable company has sufficient financial strength to survive hard times coupled with the competitive advantages needed to maintain its market position. The sustainable growth rate is a measure of the company’s capacity for earnings growth, assuming there’s room for growth of sales in the product’s market. An analysis of market opportunity is used to estimate the future demand for the company’s product.

Evaluating the stock

If a profitable company attracts investors, its stock price will rise with investors’ demand for shares. The attractive stock may be detected by a:

  • favorable valuation
  • price momentum
  • projected annual return above 10%

Favorable valuation. Growth investors place a high value on the company’s EPS for the simple reason that EPS represents the net income that generates an investment return. The 2 sources of investment return are dividends and capital gains. If the company choses to pay dividends, they are derived from the net income. Capital gains are the amount of profit from an increase in share price generated by investor-demand.

The price of a growth-stock tends to increase with the rise in EPS. This relationship is measured by the price-to-earnings ratio (P/E or PE). The current P/E is today’s price divided by the EPS of the past 12 months. The current P/E reveals what investors are willing to pay for each dollar of company earnings. The relative P/E is a ratio of the current P/E to past P/Es or to some benchmark P/E such as the average P/E of the stock market. At parity, the relative P/E is 1.0. Stocks below parity are undervalued by market participants and may be trading at prices that favor buyers. Conversely, stocks above parity are overvalued and may be trading at prices that favor sellers. There are other ways of assessing the value of a stock such as the calculation of fair value performed by stock analysts.

Price momentum. Another characteristic of the growth stock is that its share price is likely to continue in the direction of an upward trend as long as there’s a demand for shares. A review of historical prices will reveal the direction of price momentum.

Projected annual return. The reason that growth investors should seek returns above the 8%-10% total return of the stock market is that an alternative investment in index funds will capture the market’s return. One way of projecting the stock’s annual return is to multiply the future EPS by a P/E ratio to obtain the future share price. The difference from today’s price represents the future capital gain. Factoring in the stock’s dividend yield will give the projected annual return.

Risk management

The primary hazards of incurring a loss are,

  • company risk
  • market risk
  • portfolio risk

Company risk. Poor management can weaken the company and reduce its profitability. A fundamental analysis of the company, which includes a review of the financial statements, can help reduce the possibility of investing in a poorly managed company. Periodic reviews of financial statements and company news are needed to reassess the company’s management efficiency and help prevent a serious capital loss from investment.

Market risk. Volatility is the moment-to-moment fluctuation in share price that results from trading activity in the stock market. Greater volatility produces greater upside and downside risks. Upside risk is the potential gain from an investment. It represents a reasoned guess of the future peak share price. Downside risk is the potential loss. Volatility, upside risk, and downside risk are calculated in several ways. Generally speaking, riskier investments should be held for longer time periods to improve the chance of earning an estimated return.

Portfolio risk. A concentrated portfolio has a large investment in one stock compared to others. Any capital loss from the largest holding could seriously degrade the investment return of the whole portfolio. The potential impact of capital loss from a large investment can be reduced by re-allocating the principal among stocks that are diversified with respect to industry and company size.

Conclusions

A good growth stock outperforms the stock market because the company’s earnings grow faster than the Economy. One way detecting a good growth stock is to find the company that has a good sales record, bright future for earnings, and durability. Then determine what value other investors place on the stock in today’s market and future years. A potential capital gain of 10% or higher is a good growth investment.

Copyright © 2015 Douglas R. Knight


Rates of return

March 20, 2015

Preview

The simple rate-of-return ( R ) is a measure of your investment’s profitability for any chosen time interval.  By comparison, the CAGR and IRR are rates of return that measure your investment’s profitability as if it were an orderly process with respect to time.  CAGR is the acronym for “compound annual growth rate”.  It is the constant rate at which an investment’s market value grows every year in a cumulative fashion.  IRR is the acronym for “internal rate of return”, which describes the performance of all cash flows in a financial project such as the individual investor’s program of dollar-cost-averaging or an investment club’s program of portfolio management.  IRR is an annualized rate-of-return when all time intervals are measured in years.

Return

Any profit from your investment is called a return.  There are 2 types of return: realized and unrealized.  Realized returns are cash payments from dividends, interest, and sales.  Unrealized returns are the market values of reinvested dividends and unsold holdings.

return = market value – cost  [equation 1]

Example 1: Suppose you invested $100 and held the stock for 5 years until its market value grew to $201.  From equation 1, you determine that your return is $101.  If you sell it, it’s a realized return; otherwise, it’s an unrealized return.

Simple rate-of-return

The simple rate-of-return ( R ) is a measure of your investment’s profitability for any chosen time interval, but time is not an essential factor in the calculation (equation 2).

 R = return/cost [equation 2]

R is reported as a decimal number or a percentage.

Example 2: The cost of an investment was $100 and 5 years later the return was $101.  From equation 2, R = $101/$100 = 1.01.  Multiply the answer by 100 to find the percentage.  R = 100×1.01 = 101%.

CAGR

The CAGR is a rate-of-return that measures your investment’s profitability as a growth rate.  Time is a factor in the calculation of CAGR (equation 3).

rate = (final/initial)(1/N) -1  [equation 3]

N is the number of events or time periods between

the initial and final values.

Example 3, simple R versus CAGR: The cost of an investment was $100 and 5 years later its final value was $201.  We know from example 2 that the simple R is 101%.  Using the growth rate formula from equation 3, we find that the CAGR is 15%.

Significance: CAGR is the acronym for “compound annual growth rate”.  It is the constant rate at which an investment’s market value grows every year in a cumulative fashion.

MATH: CAGR is a growth rate that describes the ‘future’ (or final) value of a single cash payment.  In contrast, the discount rate devalues a cash flow.  Both rates represent a common ratio that generates a geometric series of points aligned to a smooth curveref 1. Chart 1 illustrates the geometric series of an inflated and devalued investment.

 Chart 1.  Geometric series.

geometric series

In chart 1, the black circle represents a single investment.  The blue curve is a series of theoretical values related to the investment by a common ratio called the discount rate or the growth rate depending on the particular application.  The discount rate devalues the investment to lower values as a function of the time-period N.  The growth rate inflates the investment to higher values.  Both rates are calculated by the formula in equation 3.

IRR

Equation 3 is also used to calculate the IRR, an acronym for the “internal rate of return”.  The IRR is used to measure the profitability of investments with multiple cash flows.  It is a discount rate that balances all devalued cash flows in a financial project.

MATH: In the field of Finance, a devalued cash flow is called the present value.  The present value is found by revising equation 3 to calculate the initial value for time period N at a given discount rate.  The net present value of the project is the sum of all present values.  The IRR is the discount rate that sets the net present value to zeroref 2.  It is the best-fit discount rate found by an iterative process of trial and error.  The significance of the IRR will be discussed after working through example 4.

Example 4, IRR:  An investor paid $100 each year for 4 years to purchase and accumulate shares of a particular stock.  After 5 years the market value of all shares was $735.  Since the purchases were multi year cash flows, the IRR is a good choice for analyzing this investment.  In this example, the trial discount rate is 13.1%.  Table 1 (below) illustrates the analysis:

Table 1.  IRR analysis of the investment in example 4.

IRRanalysis

Row 1, N displays the time period in years for factor N of equation 3.  Row 2, ACTUAL is the series of investments that began with a $100 payment at time 0.  Additional $100 payments were made at the end of years 1 through 4 for a total cash outflow of $500.   The total market value of the investment was $735 at the end of the 5th year.  To determine the IRR, the present value ref 2 of every cash flow was calculated with the trial discount rate of 13.1% after rearranging equation 3 to solve for the initial value.  Row 3, DISCOUNTED is the series of present values for each cash flow in row 2.  Notice that the total present value of all cash outflows equals the discounted cash inflow of $396.65.  Therefore, the net present value is $0 and the 13.1% discount rate is the investment’s IRRRow 4, PROJECTED is the final value for each present value in row 3.  The final value is predicted by rearranging the terms of equation 3 and using the IRR’s 13.1% as a growth rate for the remaining time.  It’s no accident that the sum of final values in row 4 equals the $735 cash inflow in row 2.  Chart 2 (below) illustrates the growth curves for projected values.

Chart 2. Projected values for every cash outflow in example 4.

IRRinterpretation

In chart 2, N is the time period in years.  Each black square depicts an investment of $100.  Each blue curve shows the predicted growth of the investment.  Every point on a curve is a future value and the endpoint at year 5 is the final value.  The final values are listed in row 4 of table 1.  They decreased as the years progressed because there was less time remaining for growth.

Significance:  The IRR is a rate-of-return that describes the performance of all cash flows in an investment.  The IRR is an annualized rate-of-return when all time intervals are measured in years.

Time distortion

A positive CAGR or IRR always shows a profit.  Conversely, a negative CAGR or IRR always shows a loss.  Higher CAGRs and IRRs imply more profitable investments, but beware that those with short holding periods may grossly misrepresent the long term performance of an investment.

Example 5, time distortion:  Suppose that four different $100 investments grew to $200 apiece.  From equation 1, we know that the return was $100 for every investment.  If the holding periods were 10, 5, 1, and 1/5th years, what were the annualized rates of return?

Table 2.  Annualized- and Simple Rates of return

for different holding periods

TimeDistortionOfCAGR,IRR

Legend.  Equation 3 is used to calculate the annualized rate-of-return when the unit of time is in years.  For this equation, the “Holding period” is the value of N and “Final/Initial” is the quotient of $200 divided by $100.  The 4th column is the annualized rate-of-return calculated by equation 3.  The 5th column is the simple rate of return calculated by equation 2.

High annualized rates are desirable, but don’t feel exuberant about an exceptionally high annualized rate-of-return.  As shown in table 2, the annualized rate-of-return might temporarily be inflated by a brief holding period.  It’s unlikely that a short term investment could sustain the 3,100%, or even 100%, annualized rate-of-return in the long run.

Significance:  The passage of time decreases an annualized rate-of-return when cash flows are static.  ANY increase in the CAGR or IRR over time indicates a profitable increase of cash inflow relative to cash outflow.  It’s always wise to verify this impression by checking the payout of the project.

Conclusions

In the investment world, rates of return are measurements of profitability.  Positive rates indicate profits and negative rates indicate losses.  All rates of return are sensitive to the volatility of market prices; they rise and fall with the market.  The annualized rates of CAGR and IRR are exquisitely sensitive to short time periods; don’t get exuberant about high annualized rates before checking the time period and potential payout.  In the long term, annualized rates tend to decline unless supported by dividend payments and capital gains.  An IRR that is holding steady during the passage of time is revealing an underlying growth in market value.

Copyright © 2015 Douglas R. Knight

References

  1. Donna Roberts, Geometric sequences and series. Copyright 1998-2012.  http://www.regentsprep.org/regents/math/algtrig/atp2/geoseq.htm
  2. A. Groppelli and Ehsan Nikbakht. Barron’s FinanceFifth Edition.  2006, Barron’s Educational Series, New York.

2014

February 4, 2015

The SmallTrades Portfolio holds investments in five financial markets.  Tax expenses are reduced by trading the Portfolio’s underlying holdings in a tax protected brokerage account.  For tax reasons, any stock or exchange-traded index fund (ETF) issued by a partnership is excluded from investment.

The Portfolio has two subgroups:

  1. Established ETFs that are traded infrequently in the markets for global stocks, global gold, U.S. real estate, and U.S. bonds.
  2. Common stocks that are traded frequently in the U.S. market.

Both subgroups contain high risk investments which are expected to outperform a benchmark index called the Standard and Poors 500 Total Return Index.

The investment performances of the Portfolio and its benchmark index are measured graphically by plotting changes in the market value of an invested dollar (chart).

performance2014

For every dollar invested on the inception date of 12/31/2007, the market values of the Portfolio and benchmark index dropped by nearly half during the Recession year of 2008.  Recovery from the Recession left the performance of the Portfolio lagging behind the benchmark due to the underperformance of a large subgroup of stocks.  Starting in 2013, the Portfolio’s investment capital was gradually shifted from stocks to ETFs and the result was a gradual rise in market value.   Starting in 2014, the ETF for emerging-market stocks (VWO) was replaced by one for global stocks (VT).  At the end of 2014, the market values of the holdings were distributed into a 79.4% portion from ETFs and 19.7% portion from stocks (table).

 portfolio2014

The Portfolio’s performance is measured statistically by its compound annual growth rate (“CAGR”) of market value since inception.  The performance improved during 2014 (CAGR -3.3%) compared to 2013 (CAGR -5%), but still lagged the benchmark index (CAGR 7.3%) and U.S. inflation of prices (CAGR 1.8%) by considerable margins.

Calendar year 2014 was the inaugural year for graphing the performance of the ETFs and Stock subgroups.  The following chart shows that stocks outperformed ETFs during the first year of assessing subgroups.

subgroups2014

ETFs subgroup

The ETFs subgroup is designed to match the performance of financial market indices for global stocks, U.S. investment-grade bonds, U.S. real estate, and global gold bullion when equal amounts of cash are invested in each market.  The market indices for global stocks and U.S. real estate are expected to outperform the U.S. bond index.  The gold index is expected to fluctuate according to changes in investor sentiment for stocks, bonds, currencies, and commodities.  The gold index typically moves moves up when investors seek the gold market and down when investors seek other markets.

The main risk of losing money from established ETFs is derived from a large decline in market prices.   Consequently, the risk management strategy is to rebalance every asset class to 25% of total market value when any asset class drifts below 18% or above 32% of the total market value.  Drifts did not trigger a rebalance of asset classes during 2014 (chart).

ETFassets2014

Stocks subgroup

The investment strategy is to buy stocks at a discount price and sell them at a premium price.  Discount prices are selected from undervalued companies in several ways:

  • Use of a stock screen
  • IPO’s of potentially successful companies after the first day of public trading
  • Media disclosure of good companies
  • Previously owned stocks

Premium prices are discovered by setting alerts for rising prices and placing conditional sell orders in the broker’s trading platform.

The typical holding is selected by a stock screen, held less than one year, and sold with a conditional sell order.  Small-cap stocks characteristically offer better growth potential and higher returns – but at a higher risk – compared to large-cap stocks.  Consistent with the Portfolio’s high-risk investment goal, the total market value of the Stocks subgroup is divided into portions of 22% for large-cap stocks and 88% for lower capitalizations (chart).

MktCaps2014

Conclusions

The SmallTrades Portfolio is an unleveraged, diversified collection of high-risk securities that are traded in the U.S. stock market.  The Portfolio continues its gradual improvement in performance following the 2008 Recession, but its performance still lags that of the benchmark index.  Acceleration of the Portfolio’s performance will depend on the future resurgence of stocks in the emerging markets coupled with high performance of the U.S. real estate market.  Rebalancing the Portfolio’s holdings is expected to partially offset the potential loss from a future declining market.

Copyright © 2015 Douglas R. Knight


The internal rate of return (IRR) of a portfolio

December 18, 2014

Summary

Since investment portfolios have multiple cash flows, their performance is typically measured by the internal rate of return (“IRR”)refs 1-3.  IRRs are widely used to plan and analyze financial projects.  The planning process called capital budgeting won’t be discussed in this article.  The purpose of this article is to describe the analytical use of IRRs in evaluating profitability.  Generally speaking, the positive IRR reflects a profit and the negative IRR reflects a loss.  Higher IRRs infer more profitable investments, but the analyst is cautioned to examine the investment’s return as well as its IRR refs 1-2!!  There are three steps to computing an IRR.

  1. calculate the present value of every cash flow
  2. find the net present value
  3. find the IRR (the IRR is a specific discount rate that sets the net present value to 0).

[Click on this link –calculate_IRR– to download an IRR calculator.]

Present value

Analysts evaluate the history of multiple cash flows by finding the time value for each cash flow.  Time value is measured by converting the future value of each cash flow to its present value.  In hindsight, the present value is the initial cash payment and all future values are subsequent cash flows.  Equation 1 shows how one present value is estimated from one future value over the time span labeled N.  The present value depends on its discount rate, R.

present value = future value/(1+R)N                    Eq. 1

Discount rate

The process of discounting an item means to reduce its price or market value.  In equation 1, the discount rate (R) is the rate at which the known future value reverts to its theoretical present value.  The practical significance of the discount rate depends on its intended use.  In financial planning it reflects the risk of an investment as influenced by interest rates, inflation, and the uncertainty of time ref 2.  In the hindsight analysis of a portfolio, the discount rate represents the rate of return for a given cash flow.

Net present value (NPV)

The sum of all present values in a portfolio is the theoretical cash balance called net present value (NPV)refs 2-3.  The positive NPV reveals a profit and the negative NPV reveals a loss.

Internal rate of return (IRR)

The IRR is a specific discount rate that sets the net present value to 0.  As such, it represents the time value of all cash flows in a portfolio.  It also reflects the rate of return of the portfolio.  The IRR is calculated by a trial-and-error process of computing net present values for different discount rates.  In the appropriate set of trial discount rates, net present values will vary from negative to zero to positive or positive to zero to negative depending on the cash flows.

Example

Suppose $1,000 was invested every 6 months and the stockbroker charged a $7 trading fee each time.  After 21 months, the total market value grew to $4,436.46.  Was the IRR 10%?

Time span in years (N) Item  Cash flow
0 Investment + trading fee -1,007
0.5 Investment + trading fee -1,007
1 Investment + trading fee -1,007
1.5 Investment + trading fee -1,007
1.75 Market value 4,436.46

 

NPV = sum of present values

= (PV at N=0) + (PV at N=0.5) + (PV at N=1) + (PV at N=1.5) + (PV at N=1.75)

= (-1,007/(1+.10)0) – (1,007/(1+.10)0.5) – (1,007/(1+.10)1) –( 1,007/(1+.10)1.5) + (4,436.46/(1+.10)1.75)

= -1,007 -960.79 -915.75 -873.51 +3,757.05

= 0

Yes, the IRR was 10%.  The NPV was $35.13 at 9% IRR, $0 at 9.985% IRR, and -$35.18 at 11% IRR.

Applications

Periodic reports.  The IRR increases when cash inflow increases, cash outflow decreases, and time is compressed ref 1.   The passage of time will decrease the IRR when all cash flows are static.  Consequently, any increase in IRR over time indicates a profitable increase of cash inflow relative to cash outflow.  It’s always wise to verify this impression by checking the payout of the project.

Comparisons.   Be cautious about using the IRR to compare different investments ref 1.   For one reason, higher IRRs don’t always identify higher returns.  Two projects with different cash flows may have the same IRR, yet one project yields a higher return at the time of comparison.  For another reason, the compression of time tends to raise the IRR and promote a false sense of security.  Project A’s exceptionally high IRR for a brief time period may not be sustainable in the long run.  Project B’s lower IRR over a longer time period may be sustainable.  Be sure to examine the payouts as well as the IRRs when comparing investments ref 1!!

U.S. Tax Code

The calculation of IRR is indifferent to tax rules for reporting an investment’s cost basis.  The LIFO and FIFO rules have no effect on calculations of IRR.

Miscellaneous

IRR vs CAGR.  Both the IRR and CAGR measure an investment’s rate of return.  The CAGR measures an initial and final cash flow over one time period.  The IRR is a more flexible measure due to its capability of analyzing multiple cash flows over time ref 4.

ERR.  The IRR is sometimes called the economic rate of return (ERR)ref 3.

IRR computation.  The trial-and-error determination of IRR is applicable in all situations, but it can be simplified to a single step when all cash flows are constant ref 2.

Two IRRs.  For mathematical reasons, an investment project with delayed cash outflows may have two IRR’s of widely different values ref 1.   The practical significance of the higher IRR is uncertain.

References

  1. Baker, Samuel L. Perils of the internal rate of return.  Economics interactive tutorials, University of South Carolina.  12/5/2009.  ©2000.
  2. A.A. Groppelli and Ehsan Nikbakht. Barron’s FinanceFifth Edition.  2006, Barron’s Educational Series, New York.
  3. Grayson, Linda.  Internal Rate Of Return: An Inside Look.  © 2014, Investopedia, LLC.
  4. Fuhrmann, Ryan C.   What are the main differences between  compound annual growth rate (CAGR) and internal rate of return (IRR)?  © 2014, Investopedia, LLC.

Time value of money

December 6, 2014

[updated on 12/20/2014]

The changing value of money affects everyone.  Unfortunately, the prices of most things eventually increase by a process called inflation.  Because of inflation –and other economic risks– investors should assume that money has a greater purchasing power ‘today’ than ‘tomorrow’.  That change in purchasing power is called the time value of money.  In other words, the difference between the future value and present value of money is its time value, or total discount Ref 1.

Financial planners use the following nomenclature to describe the time value of money:

timevalue

Future value

Today’s money can be used to buy things now, save for an emergency, or invest in the future value of money.  The future value is predictable with assumptions about the expected rate of return (R) and time (NEq.1, Ref 1.

future value = present value * (1+R)N ,     Eq. 1

Eq. 1 is useful for predicting an investment’s return.  The expected rate of return,  R,  is either published for the type of project, estimated from historical changes in market value, or arbitrarily chosen for an assumed level of risk.  N is the number of time periods reserved for growth.

Present value

The present value is today’s cash value of an investment’s future return Ref 1.  Eq. 2 is used to discount (i.e., reduce) the future value.

present value = future value / (1+R)N ,     Eq. 2

The discount rate, R, adjusts the future value for the risk of investment and the uncertainty of time (e.g., high R for high risk and high N for more uncertainty).

Applications: The present value enables the comparison of profitability among different projects of a give time period.  Other applications include the design of an annuity contract and analysis of variable cash flows Ref 1.

Discount rate

The discount rate is a factor that discounts the future value of an investment.  It often serves as an interest rate applied to a series of future payments to adjust for risk and the uncertainty of time Ref 1.  In other applications, it is the required rate of return that a firm must achieve to justify an investment.

Reference

  1. A.A. Groppelli and Ehsan Nikbakht. Barron’s FinanceFifth Edition.  2006, Barron’s Educational Series, New York.

Investment strategy of the SmallTrades ETF Portfolio

February 14, 2014

An index ETF is designed to capture the investment returns from a financial market.  The SmallTrades ETF Portfolio (“Portfolio”) uses index ETFs to invest in several financial markets.  The goal of the Portfolio is to earn returns at a faster rate than possible by investing in risk-free bonds or the broad market of U.S. stocks, thereby ensuring that the accumulation of returns outpaces the inflation of prices in the American economy.  Success is measured by the following benchmark indices:

Investment strategy

The Portfolio is a high-risk, high-return investment in ETFs that duplicate well-established market indices for global stocks, U.S. bonds, U.S. real estate investment trusts, and gold bullion.  Twenty five percent of the portfolio’s market value is allocated to each index.  The ETFs generate at least 99% of the portfolio’s value and any remaining value is stored in a money market fund.  The ETFs will be held indefinitely except when faced with the advantage of replacing one with a more suitable ETF for the same index.

Table of holdings

ETF trading symbol Market Allocation
 AGG   U.S. bonds 25%
 GLD   Gold bullion 12.5%
 SGOL     Gold bullion 12.5%
 VNQ     U.S. real estate investment trusts 25%
 VT  Global stocks 25%

Expected return

Unfortunately there is no 50-100 year history of ETF performance that enables the forecast of an expected return.  To compensate for this limitation, two models were used to test the allocation plan shown in the table of holdings.  In one model of the 15-year recovery from the 1997 Asian Financial Crisis, the allocation plan outperformed the U.S. stock market.  In the other model of the 5-year recovery from the 2008 Global Financial Crisis, the allocation plan underperformed the U.S. stock market.  Among both time periods, the lowest return of the model portfolio was 8.5%.

  • MARKETS portfolio of financial-market returns from 1997 to 2011: The global-stocks market was simulated by a mixture of 75% U.S. large capitalization stocks and 25% emerging markets stocks.  Trading and management fees were excluded from the model.  The annualized return of the portfolio was 8.5% in comparison to the 5.7% annualized return of U.S. large capitalization stocks.
  • ETF portfolio of historical prices from 2008-2013: Trading fees, but not management fees, were included in the calculations (– management fees are charged in the primary market before ETFs are listed in the stock market).  The annualized return of the portfolio was 10.9% in comparison to the 17.8% annualized return of SPY, an ETF that tracks the Standard & Poor’s 500 Total Return.

Risk management

The holding period will be at least 5 years.  Fluctuation in market prices is the main risk of investing in index ETFs.  The likelihood of incurring a loss from a declining market decreases as the length of the holding period increases (– e.g., the risk of loss from stocks and bonds declines by 50% as the length of the holding period increases from 1 to 5 years; and, the risk declines by 80% when the holding period is extended to 10 years (1)).

The Portfolio will be rebalanced as needed to maintain the allocation plan within an acceptable limit of 28% error.  The Portfolio is concentrated in 4 markets and losses may occur when one or several markets decline.  The 25% allocation plan assigns equal weightings to each financial market in order to smooth the effect of market declines.  After accounting for trading fees, the strategy of rebalancing a large allocation error is more cost-effective than using a rebalancing schedule.

The Portfolio holdings are investable, have established reputations, charge low management fees, and are safely structured.  Although there’s no guarantee that the index ETFs will sustain their historical performance, the stock market, bond market, and real estate market ETFs provide diversified investments in underlying assets.  The risk of investing in these ETFs is lower than the risk of investing in an underlying asset.  Gold bullion ETFs are non-diversified investments in the volatile gold market.  Gold bullion is theoretically susceptible to physical damage by theft or fire.  This risk is diminished by investing in two funds, GLD and SGOL, that store the bullion in separate vaults located in London and Lucerne.

The investor’s tax burden can be reduced by holding these index ETFs in a tax-deferred retirement account.

Copyright © 2013 Douglas R. Knight

References

1.           James B. Cloonan, A lifetime strategy for investing.  American Association of Individual Investors, Chicago, 201


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