May 2009

Investment Losses and Peer-to-Peer Lending: Weekend Reading

I hope you’re all enjoying your respective weekends. I’ve got a fairly diverse list of noteworthy personal finance articles this week. Enjoy!

Investing

Amateur Asset Allocator provides us with a healthy mindset for thinking about investing losses.

Mr. Cheap from Four Pillars has been engaged in peer-to-peer lending for 3 years. He’s learned some lessons along the way.

Behavior Gap reminds us that investing is, ultimately, an act of faith.

From the Dividend Guy: Dividend Investing’s Big Problem.

MoneyNing warns us not to make the same mistake he did: Forgetting to max out his IRA for last year. Might as well get started now, and get everything automated. :)

Monevator shares how UK investors can create a diversified ETF portfolio.

GenXFinance discusses whether it makes sense to continue contributing to your 401k if your employer discontinues their match program.

FiveCentNickel shares 11 questions to ask a financial planner before using his/her services.

Other personal finance

Bluntmoney discusses which types of insurance we do and don’t need.

Bargaineering gently reminds us that carrying debt to improve your credit score is an absolutely terrible idea.

The Simple Dollar asks whether saving money really is bad for the economy.

Wealth Pilgrim shares a wonderful tip for increasing the likelihood that you’ll meet your goals–financial or otherwise.

The Weakonomist apparently saved 15% on his wedding ring in literally 15 seconds. Not bad!

As always, thanks to everybody for reading. :)

May 30, 2009 2 comments

What stock market return should we expect?

One benefit of Oblivious Investing is that you can take an “I don’t know, and I don’t care” attitude about market swings and short-term market results. It’s quite freeing when compared to investment strategies that put you at the mercy of the month-to-month whims of the investing public.

Long-term market returns, however, are another story. There’s simply no way to create an investment plan without using something as your projected rate of return.

In other words, while, “I really can’t say for sure.” is the most truthful market prediction anybody can give, it’s also entirely unhelpful.

Darn.

My best guess

The three primary determinants of market return are:

  1. Dividend yield
  2. Earnings growth, and
  3. Shifts in market P/E ratios (caused by changes in the demand for stocks).

Historically, over periods of 30 years or more, the first two factors (the more predictable ones) have made up the bulk of the return, while the third factor (the unpredictable one) has performed a much smaller role–generally either increasing or decreasing the annual return by 1% or so.

At the moment, applying this formula indicates that we can expect a 30-year annualized return between 7.5% and 9.5%.

Where things get tricky

The problem, as Carl reminds us, is that you don’t pay your bills with percentages. You pay them with dollars. And while expected annual returns become fairly predictable over long periods, expected total return becomes less predictable.

The reason, of course, is that a slight change in annual return–when compounded over multiple decades–causes a dramatic change in ending value.

For example, if an investor plans on 40 years of 10% returns, and she gets 40 years of 9% returns, she’ll have only 76% as much money as she planned on having–even though her estimated annual return wasn’t too far off.

So what should we plan on?

Naturally, the prudent thing to do is plan on a conservative rate of return. For example, based on the “dividend yield + earnings growth” formula mentioned above (often called the “Gordon equation”), I’d currently plan on a 7.5% annual rate of return over the next few decades.

(And for any period shorter than a few decades, my answer is still a stubborn “I have no idea.”)

Ongoing (infrequent) monitoring

At least as important as what return you should plan on earning is the question of how to monitor the return you’re earning to see if it’s living up to your expectations. In my opinion, an annual checkup–done at the same time as your annual rebalancing–should be quite sufficient.

If, when looking at your portfolio’s 5-year or 10-year returns, it appears that you’re falling short of your estimates, it’s time to either step up your contributions or adjust your goals.

May 27, 2009 4 comments

You’re Below Average. (And so am I.)

There. I said it.

You’ve probably spent your whole life learning that you have above-average intelligence and above-average work ethic. And, when considering the entire population of people around you, that may very well be true.

But if you plan to pick stocks (or do anything else to beat the market), the group that you’re being compared to is no longer same group. The fact that you’ve been above average at everything else in your life doesn’t necessarily mean much here, because the same thing is true about your competitors.

More important, though, is the fact that this isn’t just about intelligence.

It’s about resources.

Time: They have more of it. They do this full-time. You probably don’t.

And if you’re currently thinking “Sure, I do this in my spare time, but I still work on it for roughly 40 hours a week,” you’re kidding yourself. I’d be surprised to hear of very many fund managers who call it quits after putting in a 40 hour week.

Data: They have more of it. There’s nothing that you can find in your Motley Fool newsletter or Morningstar subscription that they don’t have access to as well.

News: They get it sooner. Many of your competitors are literally on the floor of the NYSE. When something starts to happen, they can react far more quickly than you can.

Don’t worry. I’ve got some good news too.

The good news is that you don’t have to beat the market to be a successful investor. (This concept doesn’t get nearly enough media coverage.)

It seems to be a pretty safe bet that the businesses in our global economy will continue to earn a net profit for the foreseeable future. Capture your share of that profit, and you can build a great deal of wealth.

For the most part, all you have to do is invest regularly, select an appropriate asset allocation, diversify within asset classes, minimize costs….and then not screw up by bailing out on your plan.

Added bonus: It’s actually less work to match the market than it is to underperform it. :)

May 25, 2009 7 comments

TIPS and Portfolio Checkups: Weekend Reading

Quick admin update: Starting next week, I’m going to be cutting back by 1 post per week. (Instead of the “Monday-Thursday posts with a roundup on Friday” routine that I’ve had since October, the new routine will be “Monday, Wednesday, Friday, with roundup on Saturday.”)

Not that I’m getting bored of this blog. Precisely the opposite, actually. Writing about/discussing investing is sufficiently fun that it’s been keeping me from getting through my annual update to all my tax books (which has proven to be a particularly large task this year due to all the new tax law changes).

With that out of the way, let’s move on to the links. :)

Investing

Larry Swedroe advises us how to protect against inflation by including TIPS in our portfolios.

The Dividend Guy provides a list of steps to take when doing your regular portfolio checkup.

Monevator continues his series on rebalancing–this time tackling how often to do it.

Amateur Asset Allocator takes a look at immediate annuities.

Behavior Gap shares some insights on predicting the market.

The Weakonomist’s love for financial calculators rivals my own. (Though admittedly, my favorite financial calculator is an excel spreadsheet.) I mention this post because it reminded me yesterday of the importance of the concept of time value of money. If you’re a personal finance writer or financial advisor, please take the time to learn about it if you don’t already understand it. :)

Taxes

GenXFinance and FiveCentNickel both had correspondence audits with the IRS recently. Good times. :)

TaxGirl discusses California’s consideration of enacting an “Amazon tax” similar to New York’s.

Other Personal Finance

MoneyNing walks us through the process for disputing erroneous charges on our bills.

Wealth Pilgrim shares 6 mistakes he made when he started his business.

Four Pillars reminds us not to underestimate the power of small savings opportunities. Bad Money Advice warns us not to overestimate it.

BluntMoney shares some thoughts on the benefits of stretching ourselves.

That’s it for this week. Thanks to everybody for reading. :)

May 22, 2009 1 comment

The downside to passive investing.

In the last few weeks, a handful of people have asked to see a greater discussion of the drawbacks to passive investing. I’ve been thinking about it a lot. So here we go…

  1. It’s boring.
  2. There’s precisely zero chance that you’ll get rich overnight.
  3. It’s difficult. (Not the mechanics of it–those are quite simple. The hard part is sticking it out through a down market.)

From my perspective, that about covers it. :) Anybody have anything they want to add?

May 20, 2009 18 comments

Ways to Improve Investment Return

Nobody wants to be–or thinks they are–average.

When it comes down to it, I think that’s the only reason that low-cost passive investing isn’t enthusiastically used by every investor out there. People have a tendency to believe that they–or somebody acting on their behalf–will be able to outperform the market, whether by earning a greater return or by matching the market’s return while incurring less volatility.

However, with every transaction that occurs in the stock market, two things are true:

  1. One of the two parties is buying an investment that will underperform (or selling an investment that will outperform) and is thereby decreasing his total return relative to the market, and
  2. The total return by the group (that is, both investors considered together) is decreased by an amount equal to the transaction costs incurred.

Most books/articles about investing tend to focus on point #1 above and how to make sure you’re not the one getting the short end of the stick, so to speak.

Truth be told, I have yet to see anything that convinces me that an individual investor has any advantage whatsoever over the institutional investors who are likely to be on the other end of most transactions.

As a result, I find myself more interested in point #2 and what we can do to improve the total return earned by investors as a group. It seems to me that it would be beneficial for our society as a whole to spend more time discussing this topic and a great deal less time discussing the first.

How we can improve our total performance:

Cut costs! Common sense would indicate that, as a group, the best return we can possibly hope for is the return earned by the assets in which we’re invested. So we might as well seek to minimize costs and come as close as possible to earning a return equal to that of the market, right?

A few ways we can do that:

As far as I can tell, that’s it. Anyone have any other ideas?

May 19, 2009 4 comments

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