Book review: The Index Card, by Helaine Olen and Harold Pollack

May 5, 2016

The Index Card. Why Personal Finance Doesn’t Have to Be Complicated. Helaine Olen and Harold Pollack. Penguin Random House, New York, 2016.

Genesis

The authors converged their experiences from  journalism (Helaine Olen) and academia (Harold Pollack) into the worthy effort of demystifying the world of personal finance for everyone’s benefit. Author Pollack began the process by devising an index card of rules for recovering from financial hardship and staying solvent. Author Olen’s experience with the Personal Finance Industry validated Pollack’s scheme. Together, they explain the index card to readers of this valuable book.

Rules from the Index Card

  1. Strive to save 10-20% of your income.
  2. Pay your credit card balance in full every month.
  3. Max out your 401(k) and other tax-advantaged savings accounts.
  4. Never buy or sell individual stocks.
  5. Buy inexpensive, well-diversified indexed mutual funds and exchange-traded funds.
  6. Make your financial advisor commit to the fiduciary standard.
  7. Buy a home when you are financially ready.
  8. Insurance- make sure you’re protected.
  9. Do what you can to support the social safety net.
  10. Remember the Index Card

Highlights

Rule #1. The household budget is essential for living comfortably. Be sure to save 10-20% of your income for future needs. The most important savings account is an emergency fund; every household should save 3 months of income in an accessible savings account to use for emergency expenses. —An emergency expense is both immediate and necessary; something bad has happened.—

Rule #2. Unpaid debt has top priority in your budget. Credit card debt is a preventable financial illness that must be corrected. Other forms of debt must also be managed within the framework of a budget.  Unfortunately, there may be unpreventable causes of overwhelming debt such as health care bills and other catestrophic events. Overwhelming debt may require seeking legal advice to file for bankruptcy; don’t feel ashamed.

Rule #3. The second most important savings account is your retirement fund and/or educational savings account. Start while you’re young to take advantage of the compound interest (a.k.a. compounding returns) from investments in either account. DON’T REJECT employer-sponsored retirement savings plans and DO participate in them to the full extent. You can also open personal retirement savings accounts. Facilitate your savings plan by making direct deposits into the retirement and educational savings accounts.

Rule #4. The media’s ‘toxic’ message is that playing stocks is easy and fun. But no matter how much research you do, buying stocks is still a matter of speculation. Stocks are a pay-to-play business where only the broker can always win. Forego the dream of a big win by investing in a small selection of index funds.

Rule #5. Index funds are designed to automatically match the performance of a selected stock- or bond market index. Index funds are true buy-and-hold investments. Most exchange-traded funds (ETFs) and a few mutual funds are index funds. They charge lower management fees than the actively managed mutual funds. Actively managed funds charge higher fees in order to pay for the research needed to outperform the stock or bond market. Few actively managed funds succeed in their effort to beat the market on a sustained basis. Annual management fees for index funds (~0.12%) are lower that for actively managed funds (~0.89%). The average household loses $155,000 in potential investment gains due to the unnecessary fees of actively managed mutual funds.

Rule #6. Most financial advisors are salespeople who chase a profit at your expense. They are not your friend. However, you still have to pay for good advice from a fiduciary advisor. A fiduciary advisor is responible for acting in your best interest, hopefully providing the best advice at lowest cost. The fiduciary advisor is usually a certified financial planner (CFP), registered investment advisor (RIA), fee-only advisor, or robo-advisor who is a proven fiduciary. It’s important to seek a fee-only advisor who is paid by you and only you. The advisor may charge a percentage of your assets under management, a flat fee, or an hourly fee.

Rule #7. Spend no more than 30% of your budget on housing. There are risks and advantages to either renting or buying a home. The authors discuss both.

Rule #8. Insurance is complicated but necessary. Don’t be exploited by salespeople. The 6 Golden Rules of Insurance are:

  1. buy term life insurance
  2. buy high-deductible property insurance
  3. buy a health care plan that pays your provider
  4. buy umbrella insurance that is twice your net worth
  5. avoid complicated annuities
  6. keep an emergency fund

Rule #9. We can’t protect ourselves from everything; sometimes we need a little help. The government is our insurance-backer of last resort. 96% of us have used government financial support to improve our financial situation. Isn’t it our fiduciary duty to Society to support the best government insurance programs?

Conclusions

I concur with the authors’ advice. The strength of their advice is supported by pages of references at the end of the book. Read and re-read their book.


Design of the investable ETF portfolio

August 28, 2013

[revised on September 3, 2013 and February 3, 2014.  The latest revision is an updated ETFportfolioDESIGNER2 that includes Vanguard’s Total World Stock ETF (VT).  It was necessary to reset the DESIGNER’s time period to 2009 through 2013.  Appropriate changes were made in the following discussion.]

Summary

I ‘like’ a portfolio of exchange traded funds (ETFs) that are listed in the New York Stock Exchange by trading symbols AGG, GLD, VNQ, and VWO [VT is an alternative to VWO]. Equal portions of capital are allocated to each fund. The best way to manage the portfolio is by rebalancing the ETFs. Ordinary investors can be cautiously optimistic about this high risk portfolio after reviewing the following information:

Model

Among previously tested portfolios, a 4-sector model held hypothetical investments in market indices for emerging markets stocks, U.S. bonds, U.S. REITs, and global precious metals.  The model was not an investable portfolio.

Conversion

The 4-sector model was converted to an investable portfolio by substituting index ETFs for the market indices and assigning equal weightings (ref 1) to the ETFs. The big advantage of choosing index ETFs is their ease of trading in the stock market (ref 2).  The objective of the investable portfolio, hereafter called the SmallTradesETFportfolio, is to outperform the U.S. stock market in the long term.

The conversion began by screening funds according to geography and asset class (ref 3).  Selected ETFs were compared to their financial markets, appraised for risk, and tested for optimal portfolio mechanics.

Comparisons.  Chart 1 shows the time course of total returns from ETFs and financial markets. The total returns are charted as monthly percentages of change in market value based on price changes and cash distributions (see endnote) .

ETFpf1

Chart 1. Time course of total returns: All panels show the time course of monthly total returns from a market sector (black dashed line), older ETF (solid blue line), and newer ETF (solid orange line). ETFs are identified by 3-letter trading symbols. Total returns were set to 0% at inception of the newer ETF.

In chart 1, any spread between an ETF and its market sector illustrates the difference in investment performance. Smaller spreads, and therefore closer matches to sector performance, occurred among ETFs aligned to the precious metals and emerging markets stock sectors. Wider spreads appeared when AGG outperformed the U.S. Bond sector by 3-15 percentage points during the 2008 Credit crisis; also when VNQ and REZ consistently underperformed the Equity REIT sector by an average 8 percentage points.

Correlations. Chart 2 shows the correlation of returns between an ETF and its market index.

ETFpf2

Chart 2, Correlation of total returns: ETFs are identified by 3-letter trading symbols. All panels compare the monthly returns of ETFs to their corresponding market sector. Monthly returns were calculated as a percentage change in market value that includes the accumulation of cash distributions from underlying holdings. The identity line shows hypothetically equal returns. “r” values are correlation coefficients for the relationship between ETF and sector returns. “r” values were not calculated for newest funds, CORP and GLTR, due to the scarcity of monthly returns.

In chart 2, the correlation coefficient (“r”) signifies the degree of alignment between concurrent monthly returns. If r were 1.0, the data would lie on an identity line where fund returns match the market returns. All r values in chart 2 were exceptionally high, which supports the visual impression from chart 1 that ETFs traced the time course of their market sectors. All of chart 2’s data except those for AGG were closely aligned to an identity line. About 12 of AGG’s monthly returns outperformed the U.S. Bond market during the 2008 Credit crisis and appear as outliers to their line of identity. The few outliers exerted no practical effect on AGG’s correlation coefficient.

ETF appraisals. The SmallTradesETFportfolio contains healthy, wealthy ETFs with proven ease of trading. Every ETF is eligible for holding in a tax-deferred brokerage account and otherwise offers a low tax burden when held in a taxable account (exception: returns from the precious metal held by GLD are taxed at the higher rate for ordinary income rather than lower rate for long-term capital gains). Here are the investment strategies and risks of the funds, with a link to their scorecards (ref 4):

  • AGG (iShares Core Total U.S. Bond Market ETF) invests 95% of its capital in a basket of U.S. investment grade bonds that reflect the Barclays Capital U.S. Aggregate Bond Index. AGG receives fixed income and capital gains from the bonds. The fixed income is derived from payments of interest and returns of principal. Investment grade bonds are less likely to default on payments of fixed income than non-investment grade (‘junk’) bonds. Investment grade bonds generally pay lower interest than junk bonds and are low-risk investments (ref 5).
  • VWO (Vanguard FTSE Emerging Markets ETF) invests 95% of its capital in a representative sample of stocks listed in the FTSE Emerging Markets Index. Emerging markets stocks are more volatile and less liquid than U.S. stocks. Stocks are generally high-risk investments that reward investors with payments of dividends and capital gains. VWO invests in emerging market stocks which have characteristically higher risk and higher returns than developed market stocks (ref 5).
  • VT (Vanguard Total World Stock ETF) invests in stocks issued in the emerging and developed markets.  VT is an alternative to VWO.
  • VNQ (Vanguard REIT ETF) invests in real estate properties by purchasing shares of real estate investment trusts (REITs). Equity REITs are companies who invest pooled money into the ownership of real estate and distribute at least 90% of their taxable income to shareholders. Equity REITs are considered low-risk, high-return investments (ref 5). Because VNQ concentrates on real estate, its primary risk is a decline in the real estate market.
  • GLD (SPDR Gold Trust) is a physical commodity fund that invests all capital in gold bullion. Gold only provides income when sold in the market for a profit. Investors typically buy gold bullion as an insurance policy against the devaluation of currency (ref 5). GLD shareholders risk losses from declining prices and damage or theft of the bullion.

Portfolio mechanics

Market forces continually change the value of a portfolio either to the benefit or detriment of the investor. The investor’s choices are to make no adjustments (“buy-and-hold”), sell rising assets to buy declining assets (“rebalance”), sell declining assets to buy rising assets (“reallocation”), or revise the investment strategy (ref 6).

The choices to buy-and-hold or rebalance the SmallTradesETFportfolio were examined by using a computer-assisted program to test a set of 5-year historical returns from the ETFs [the computer-assisted program is outdated and therefore replaced by ETFportfolioDESIGNER2.  The discussions of Tables 1 and 2 are outdated, but they remain instructive]. The buy-and-hold strategy was to purchase each ETF with 25% of the total invested money and automatically reinvest the cash distributions. The rebalance strategy was divided into 2 plans for correcting the buy-and-hold portfolio.  The scheduled plan made regular corrections during the life of the portfolio. The signaled plan made irregular corrections depending on when the holdings drifted from the allocation plan by an assigned error signal (ref 7).

The data in table 1 show that all choices outperformed the benchmark investment in U.S. stocks.  Both rebalancing plans enhanced the portfolio CAGR of the buy-and-hold strategy, namely by 1.3 percentage points when rebalanced yearly and by 2 percentage points when rebalancing a 32% allocation error.

ETFpf3

COLUMN HEADINGS: The investment strategies for the ETF Portfolio are “Buy-and-hold”, “Rebalance #1”, and “Rebalance #2”. The “Benchmark” portfolio is an index of the U.S. Stock Market.
ROW HEADINGS: “Rebalancing plan” shows the best schedule for “Rebalance #1” and best error signal for “Rebalance #2”. “Rebalance episodes” are the total number of rebalances. “Final market value” is computed from the weighted market returns. “Portfolio CAGR” is the compound annual growth rate; higher CAGRs reflect higher returns. “Sharpe ratio” is an adjusted annual rate of return; higher ratios reflect higher returns.
ASSUMPTIONS: Every portfolio is funded with $10,000 and 25% of the $10,000 is allocated to each holding. There are no fees for financial services, all cash distributions are automatically reinvested, and the portfolio holdings are never withdrawn.

Efficient investment. The total returns in table 1 were earned under the best of circumstances because there was no payment of fees for financial services and plenty of money was used for making the initial investment. Without fees, all levels of initial investment are equally efficient in yielding a return. But additional fees create a penalty margin that reduces returns by as much as 25 percentage points with $1,000 investments and 2 percentage points with $10,000 investments (ref 8).

So, how might trading fees and initial investment affect the SmallTradesETFportfolio? Table 2 demonstrates the efficiency of earning returns based on the initial investment and a $10 trading fee.

ETFpf4

The data are total returns as measured by CAGR; higher CAGRs reflect higher returns. All trading fees are $10/trade.
ROW HEADINGS: “Initial investment” is the total amount of money spent on creating the portfolio, including trading fees. “Buy-and-hold” means that no trading occurred during the 5-year holding period, 2008-2012. “Rebalance #1” is a plan to rebalance the holdings on an annual basis. “Rebalance #2” is a plan to rebalance the portfolio when a holding drifts from the allocation plan by a 32% difference.

In table 2, the maximal returns of the buy-and-hold and rebalanced portfolios were achieved when the initial investment reached $15,000. There was no advantage to rebalancing the portfolio with only $2,000 of invested capital.

Financial services fees. ETF managers charge an annual expense ratio to specialists in the primary market, not to ordinary investors in the secondary market.  The expense ratio reduces the net asset value of ETF shares in the primary market and the net asset value determines ETF share prices in the stock market (ref 2). Ordinary investors may pay an advisor’s fee when they are clients of a financial institution (do-it-yourself investors take pride in avoiding this fee). The typical advisory fee, about 1% of the annual portfolio value, reduces the total return of the portfolio by an amount that can be estimated in the computer-assisted program.

Recommendation

The SmallTradesETF Portfolio is designed for risk-tolerant investors who seek to outperform the U.S. Stock Market over a time period of many years. Each ETF tracks a unique sector of the financial markets with proven transparency, durability, and liquidity of fund operations. In terms of risk management, rebalancing the holdings helps protect from losses incurred during market declines. An initial investment of $4,000 is needed to gain the advantage of rebalancing the portfolio. Better results are obtained by investing at least $10,000.   I prefer using a 30% 28% rebalancing signal (rather than a schedule) to rebalance the SmallTradesETFportfolio. The signaled rebalancing method is easy to obtain and use by clicking on this link, Rebalancing an Investment Portfolio.

Cautious optimism

Similar portfolios are advocated in newspapers (ref 9) and books (refs 10-12). The unique features of the SmallTradesETF portfolio are its simple allocation plan and tested rebalancing strategy. A major disadvantage is the uncertainty about future market returns. Fifteen years of historical data for a model portfolio and 5 years of historical data for an ETF portfolio are unreliably predictive of future returns (ref 10). Consider that ¼th of the Portfolio is invested in emerging markets stocks and that today’s emerging markets are in decline after attaining a historical peak (refs 13,14). How long will these markets decline? The optimist could argue that over 75% of the world’s population lives in the emerging economies where there’s tremendous capacity for growth. Today’s emerging economies have nearly half of the world’s GDP and their share of the global GDP seems to be growing despite blips in the trajectory  (ref 14).

Endnote:  Cash distributions are made by fund managers to fund shareholders. The typical sources of cash distributions are dividends and capital gains earned from the fund’s underlying assets.

Copyright © 2014 Douglas R. Knight

References

1. Beginners’ Guide to Asset Allocation, Diversification, and Rebalancing, U.S. Securities and Exchange Commission, SEC.gov/investor/pubs/assetallocation, Modified: 08/28/2009.
2. ETF structure, Small Trades Journal, a blog at WordPress.com.
3. XTF, ETF experts. XTF.com/Research/.
4. #ETF-scorecard, Small Trades Journal, a blog at WordPress.com.
5. Asset classes, Small Trades Journal, a blog at WordPress.com.
6. Jason Van Bergen, 6 Asset Allocation Strategies That Work. ©2013, Investopedia US, A Division of ValueClick, Inc., October 16, 2009.
7. #SmallTradesPortfolioREBALANCER, Small Trades Journal, a blog at WordPress.com.
8. Beware of trading fees, Small Trades Journal, a blog at WordPress.com.
9. Anna Prior. A Portfolio That’s as 2-sector as One, Two, Three. The Wall Street Journal, July 7, 2013.
10. William Bernstein. The Four Pillars of Investing: Lessons for Building a Winning Portfolio, McGraw-Hill, 2002.
11. Mebane T. Faber and Eric W. Richardson. Top of the Class: A review of The Ivy Portfolio. 4/6/2009, Advisor Perspectives, DShort.com.
12. John C. Bogle, The Little Book of Common Sense Investing. John Wiley & Sons, Inc. Hoboken, 2007.
13. Emerging economies: When giants slow down. Jul 27th 2013. The Economist.
14. Emerging vs developed economies: Power shift. Aug 4th 2011, 17:34 by The Economist online.


Book review: The Little Book of Common Sense Investing, by John C. Bogle

February 6, 2013

Subtitle: The only way to guarantee your fair share of stock market returns.

Introduction

Today’s households are held hostage to making investment choices by the threat of facing bankruptcy after retirement.  Consequently, there are well-meaning and predatory money managers who offer investment services for a substantial fee.  John Bogle offers the best advice for an insignificant fee, the small cost of buying and reading this book.  The scope of this book is concerned with investing wisely and cheaply in the U.S. Stock Market. 

Core concepts of the book

Winning strategy.  A winning strategy is to buy all of the nation’s publicly held businesses at very low cost with the idea of capturing the total return of dividends and earnings growth from business operations.  The author recommends buying shares of a mutual fund that holds the stock market’s portfolio and keeping the shares “forever”.  Here are the key elements of his strategy:

  • Invest at very low cost– buy shares infrequently and never pay unnecessary fees.
  • Reinvest the returns– participate in investment plans that provide no-cost, automatic reinvestment of capital gains and dividends.  Automatic reinvestment of returns creates the exponential growth of your investment known as the ‘miracle of compounding’.
  • Seek business returns, not speculative returns, from the stock market– the profits earned by businesses are translated into dividends and earnings growth in the stock market.  During the 20th century, the average annual market return was 4.5% from dividends and 5% from earnings growth.  By comparison, speculation generated an average annual 0.1% return.
  • Buy index funds– The value of a market is measured by its index.  Buy shares of mutual funds that mimic the portfolio of an index.
  • Forever– a long, undefined period of time that effectively captures the earnings growth of businesses in the stock market.

Losing strategy.  Trying to outsmart the winner’s game by picking and trading stocks is frequently a loser’s game.  Playing the loser’s game incurs several penalties:

  • Advisors (middle men; money managers) charge fees for picking stocks
  • Making frequent trades in the stock market will compound the cost of paying the middle man and reduce the investor’s returns (the ‘tyranny of compounding costs’).  The average investor never outperforms the stock market’s index due to the tyranny of compounding costs.
  • Selling stocks incurs taxes on the capital gains

Conclusion

Bogle recommends the 100% indexing strategy using a mixture of stock- and bond index mutual funds.  After all, the future is uncertain and bumpy.  Indexing is a good strategy for managing the risk of uncertainty.

His allocation rule is a percentage of bond funds equal to the investor’s age in years.  For example, 20% bonds and 70% stocks at age 20.  If you, the investor, crave “excitement” invest 95% of your cash in index funds (“serious money”) and 5% in excitement (“funny money”).


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