2009 July

Rent a Home vs. Buy a Home

Not an investment?

Recently, many personal finance authors/bloggers have taken to declaring that a home is not an investment. It’s a purchase.

I know they mean well, but that claim seems like nonsense to me.

What is an investment?

Webster’s defines investment as, “the outlay of money usually for income or profit.”

Using that definition (or any reasonable definition that I can think of) the purchase of a home most definitely is an investment, regardless of whether you ever plan on selling it and regardless of whether or not it ever increases in value.

If purchasing a home was not an investment–that is, if it didn’t have a monetary payoff in the end–it would be the most appallingly awful purchase imaginable. (If it were simply a giant storage bin that cost several hundred thousand dollars, what is the likelihood that it would be the single greatest happiness-inducing purchase you could make with that money?)

Luckily, buying/owning a home does have a financial payoff–even if you never plan on selling your home, and even if it never increases in value.

What am I talking about?

The payoff from buying a home lies in the fact that:

At some point, market rent prices will grow to exceed your total home-ownership-related cash outflows (mortgage payment + property taxes + maintenance costs), and
Eventually, the mortgage payment will disappear entirely, thereby making your cash outflows significantly less than what you’d be paying in rent at that point.

So should everybody buy a home?

No, that’s absolutely not what I’m saying. My point is simply that–even in light of the apparently astonishing fact that home values don’t have to double every five years–a home is still an investment. It has an expected financial payoff down the line, and it’s silly to ignore that fact.

July 23, 2009

Individual TIPS vs. TIPS Funds

TIPS (Treasury Inflation-Protected Securities) are U.S. government bonds that provide a specific after-inflation return (as compared to “nominal” bonds which provide a specific before-inflation return). Here’s the description of how they work, right from the source:

“The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater. TIPS pay interest twice a year, at a fixed rate. The rate is applied to the adjusted principal; so, like the principal, interest payments rise with inflation and fall with deflation.”

With municipal bonds and corporate bonds, the single greatest benefit of bond funds over individual bonds is that they diversify your money across several borrowers to reduce the overall risk of default.

With U.S. Treasury securities, however, that becomes a moot point, as they’re generally considered to have zero credit risk in the first place. (And even if the risk is greater than zero, investing in a fund made up exclusively of securities from the U.S. Treasury wouldn’t reduce that risk.)

So with the primary benefit of a bond fund no longer being relevant, is there still any reason to use a TIPS fund rather than buying individual TIPS?

Why buy a TIPS fund?

For the most part, the primary advantage of a TIPS fund is convenience.

Buying: TIPS funds can be bought at any time. Individual TIPS must be bought at auctions which only occur at specific intervals throughout the year.

Selling: You can sell a TIPS fund at any time (with no commission assuming it’s a no-load fund), whereas selling individual TIPS generally involves paying a commission ($45 if your account is with Treasury Direct).

Reinvesting: If you own individual TIPS, you’ll have to wait until the next auction date rolls around before you can reinvest the interest you’ve received. With a TIPS fund, you can have the interest reinvested automatically in the fund.

Why buy individual TIPS?

Lower expenses: Any TIPS fund will have to charge expenses. Yes, for good funds the expense ratio is quite low, but if you buy TIPS directly there will be no expenses eating into your returns.

Known return: With individual TIPS, you know precisely what real rate of return you’ll get over the duration of the bond. With a TIPS fund, you can’t be as sure because the fund is made up of an always-changing collection of TIPS with varying maturities.

Knowing your precise after-inflation return can be quite convenient when saving for situations where you’ll be making a cash outlay at one specific point in the future (that is, expenditures such as college, as opposed to retirement for which people spend cash on an ongoing basis over an extended period).

Which do you use?

For those of you who invest in TIPS, which do you use? A TIPS fund or individual TIPS? And was your decision based on one of the above factors, or are there some considerations that I’ve left out?

July 22, 2009

Options Strategies for the Passive Investor

As regular readers will know, I’m a proponent of a very simple buy & hold, passive investing strategy. However, I do believe that there’s a value to discussing and understanding alternative strategies so that you can decide whether they’re appropriate for you. That’s why I recently invited Mark Wolfinger, author of Options for Rookies to write a guest post. He was kind enough to oblige.

Option strategies, specifically the collar strategy, can provide additional safety for your portfolio. That means a guarantee against incurring significant losses (you decide how much loss you are willing to accept–much like the deductible on an insurance policy). No asset allocation program comes with guarantees. They may come with high probability of fulfilling your needs, but that’s not as good as a guarantee.

Many of you have a negative feeling towards options and that’s understandable considering how much bad press options (or any derivative product) have received. The truth is that options were created as hedging (risk reducing) tools, and if more investors used them for that purpose, options would have a better reputation.

My specific objective today is to share why I believe passive investors can benefit by using options. General option education is available elsewhere.

There’s more to investing than choosing between passive and active management. For example, the Prudent Man Rule tells us that asset allocation and diversification are vital to reducing risk. But, the recent (technology bubble and 2008) market meltdowns have convinced many that these methods only work in bull markets.

A recent WSJ article discusses how a bunch of financial advisors have been shaken by a failure of ‘prudent’ measures. Another article tells how some advisors abandoned their traditional ideas and are now making (in my opinion) extraordinary investment decisions–in a desperate attempt to succeed. These advisors have abandoned passive investing. I’d never suggest that you do the same, but there are steps you can take to make your portfolio bulletproof. Of course, that excellent protection comes at a cost, and that cost is accepting limited profit potential and giving up the possibility of earning a substantial sum in a hurry. You still have room for growth, but it is limited.

The difficult part of investing is to find methods that provide relatively good results when markets are falling. That does not mean losing 30% when everyone else is losing 40%. It means not incurring any large losses. Ever. For the majority of investors, preventing occasional large losses is impossible and the question is: Are you confident that owning a properly diversified portfolio with assets appropriately allocated is good enough? Do you believe you are protected and can survive during bear markets, or would you prefer to own the necessary protection, knowing that your portfolio will underperform when markets are marching steadily higher?

If you are uncertain and concerned that years similar to 2008 will occur with more frequency going forward, option strategies can alleviate that concern. My host, Mike, says that good asset allocation worked last year, minimizing losses. I have no idea how well diversified portfolios performed, but the WSJ articles quoted above suggest that asset allocation did not do the job. How well did you do?

Here’s what I suggest: Continue asset allocation and diversification. But take out insurance when possible. As I explained in a recent post, owning collars underperforms significantly in bull markets and outperforms just as significantly during declining markets. (For reference, Mike’s counter-argument can be found here.)

Using collars protects your investments from serious losses. It also limits profits. Collars provide a smoother ride because the portfolio value is less volatile. Again, options are not for everyone, but insuring the value of your equity and commodity holdings by adopting a collar strategy guarantees long-term survival. Failure to use options shows a willingness to be satisfied with the (current) advice given to the Prudent Investor. Which is right for you?

July 21, 2009

Closet Index Funds: What They Are and Why to Avoid Them

Hiding something?

Closet index funds are actively managed funds that claim to attempt to beat the market, but in reality they simply mimic an index fund (at a higher cost).

The problem, of course, is that if a fund manager is investing in the same stocks that make up the index (and in similar proportions), while at the same time charging you higher costs, then there’s roughly zero likelihood that the manager will actually succeed at his job. (His job being to outperform the relevant index/benchmark.)

How to Spot a Closet Index Fund

One way to determine whether an actively managed fund is a closet index fund is to calculate the correlation between the fund’s performance and the performance of its relevant index/benchmark. The higher the correlation, the more likely it is that the fund manager is a closet indexer.

As a random example, I went to Fidelity’s fund overview page, and chose the first domestic stock fund in the “Large Blend” category that has been in existence for 10 years or more: Fidelity Disciplined Equity Fund. (I used a Large Blend fund simply for convenience, as that’s the category for which the S&P 500 is the relevant benchmark.) Then I dropped the fund’s performance figures into a spreadsheet along with those of Vanguard’s S&P 500 index fund:

Next, I used Excel’s “correl” function to calculate the correlation between the two. The answer? 98.7% correlation. Hmm…think we caught one?

Check your own funds.

If you invest in any actively managed funds (or are considering doing so), you might want to try the above exercise on them. It could be an eye opener. Be sure, however, to use the appropriate index. (For example, don’t compare an international stock fund to the S&P 500.)

Of course, I’d still argue in favor of avoiding actively managed funds entirely, if that’s an option.

July 20, 2009

Retirement Accounts and Disability Insurance: Weekend Reading

Happy Friday, everybody. A few recommended reads from this week:

Investing Articles

4 Features Missing from Your Retirement Accounts from Weakonomics
Slumlords (about investing in low-end real estate) from Four Pillars
Lessons Learned from The Kirk Report
Where can I buy California IOUs? from The Finance Buff
Taxes and the Future from The Simple Dollar
Saving for the Short-Term from Get Rich Slowly

Blog Carnivals

Articles from my blog were included in three blog carnivals this week:

My Life ROI was kind enough to include my “Why I Invest with Vanguard” post in this week’s Best of Money Carnival.
Carnival of Pecuniary Delights, hosted by Wisebread

I hope you enjoy your respective weekends, and thanks for reading.

July 17, 2009

Introductory Guide to Asset Location

Asset location is the process of determining which investments to keep in which accounts. That is, after you’ve determined your appropriate asset allocation, how should you divvy that up between your tax-sheltered accounts and your taxable accounts?

Example: Let’s say that you decide that your appropriate asset allocation is a simple 70/30 stock/bond split. You currently have $100,000 in your 401(k), $50,000 in a Roth IRA, and another $100,000 invested in taxable accounts.

So your grand total is $250,000, and you would like $175,000 (70%) invested in stocks and $75,000 (30%) invested in bonds. A few potential asset location options would be as follows:

Split each account up so that it’s allocated 70/30,
Invest $75,000 of your taxable account in bonds and invest everything else in stocks,
Invest $75,000 of your 401(k) in bonds and invest everything else in stocks, or
Invest all $50,000 of your Roth in bonds, $25,000 of one of your other accounts in bonds, and everything else in stocks.

Option 1: Shelter those bonds!

From a tax standpoint, it makes a great deal of sense to put all of your bonds in tax sheltered accounts. Why? Because they pay the most taxable income.

In contrast, stock income comes in the form of either dividends (which, for the moment, are taxed at a lower rate than interest income) or capital gains (which, if the holding period for the stock was greater than one year, are also taxed at a lower rate than interest income). As a result, you stand to benefit more from tax sheltering your bonds than you do from tax sheltering your stocks.

Option 2: Split everything equally.

Rick Ferri in his All About Index Funds argues that, from a psychological point of view, each account should be split up so that it has the same asset allocation as your whole portfolio.

Ferri makes the case that, if one account were to be entirely bonds and another entirely stocks, many investors would have a hard time considering them as part of a broader portfolio, rather than separately. (And, therefore, rather than deriving the psychological comforts that usually come with having a diversified portfolio, the investor would be watching whichever account is comprised entirely of stocks and panicking whenever it goes down.)

Ferri’s viewpoint makes sense to me. I certainly see a potential psychological benefit to having a mix of asset classes in each account. However, I suspect that the value of that benefit depends largely on the individual.

Which approach is best?

Anytime there’s a math vs. psychology debate, I’m reluctant to declare one option as “best.” As for my own portfolio, however, the entire bond portion is located in my Roth IRA.

July 16, 2009