December 2009

Giving Us What We Want

That’s all CNBC, The Motley Fool, and all the get-rich-quick blogs, newsletters, and books are doing. Nobody wants to be told that successful investing usually requires decades of:

  • living below your means,
  • investing regularly,
  • removing any and all excitement from your portfolio, and
  • sticking it out through scary markets.

We’d rather hear that there’s a way to:

  • become wealthy in a hurry,
  • with minimal effort, little risk, and a small initial investment,
  • while proving that we’re smarter than everyone else.

It’s not terribly surprising that there’s a whole industry built upon selling us the message we want to hear.

December 31, 2009 4 comments

What’s the Purpose of Diversification?

“Owning one total U.S. stock index fund is the most diversified U.S. stock portfolio one can have.” –Allan Roth in How a Second Grade Beats Wall Street

“A total market fund is not inherently bad. It is not, however, a well diversified portfolio in terms of asset class diversification.” –Larry Swedroe in What Wall Street Doesn’t Want You to Know

So who’s right? Is a total stock market fund the most diversified U.S. stock portfolio you can have? Or is it possible to achieve better diversification by adding other types U.S. stock funds?

That depends on why you’re diversifying.

Spread Out Your Investment

Many would argue that the purpose of diversification is to spread your investment over as many companies as possible. If that’s the case, then the U.S. portion of your stock portfolio can’t be more diversified than a Wilshire 5000 fund.

  • Adding a REIT fund would not improve your diversification. A Wilshire 5000 index fund already includes REITs.
  • Adding a value fund would not improve your diversification. A Wilshire 5000 index fund already includes value stocks.
  • Adding a small-cap fund would not improve your diversification. A Wilshire 5000 index fund already includes small-cap stocks.

Minimize Volatility

Others would argue, however, that the purpose of diversification is to reduce the overall volatility of your portfolio. If that’s the case, you can improve your diversification by investing in asset classes that have less than perfect correlation to the rest of your portfolio.

In other words, if you can find funds that:

  • Have a similar long-term expected return to the rest of your portfolio,
  • Have similar volatility to the rest of your portfolio, and
  • Behave differently from the rest of your portfolio…

…then you should do it. It will improve your diversification.

Example: A large-cap value fund has similar expected return and similar volatility to a total stock market fund. Yet it performs differently on a month-to-month and year-to-year basis. So adding it to your portfolio–while it won’t increase the number of companies you’re invested in–should reduce overall volatility.

Why Do You Diversify?

I’m reluctant to say that either definition of diversification is better than the other (though personally, I lean toward the second). I would, however, argue that it’s essential for you to understand what you’re trying to achieve when you construct your portfolio.

If you don’t know why you’re diversifying, you won’t know how best to do it.

December 30, 2009 17 comments

401k to Roth IRA Rollover

Note: This article is about rolling a 401(k) account into a Roth IRA. For information about rolling your 401(k) into a traditional IRA, see this article.

Previously (prior to 2008) to rollover your 401(k) into a Roth IRA you had to use the following process:

  1. Open a traditional IRA
  2. Rollover your 401(k) to the traditional IRA
  3. Open a Roth IRA
  4. Convert the amount in the traditional IRA to the Roth IRA.

Now, however, the process has been simplified. After you’ve left your job, you can directly roll your 401(k), 403(b), or 457 account into a Roth IRA.

The Rollover Process

Step 1: Open a Roth IRA (if you don’t have one open already).

Step 2: Request rollover paperwork from your 401(k) administrator. Fill it out, indicating that you want to roll your account into your Roth IRA. (If your plan administrator does not provide this option, you’ll have to follow the old process of rolling it into a traditional IRA, then converting it to a Roth.)

Step 3: Include the amount of the rollover in your gross income on Form 1040 (lines 16a and 16b) for the year in which the rollover occurred. (Note: If your rollover occurs in 2010, you have the option of deferring the tax on the rollover–paying half of it in 2011, and half of it in 2012.)

Am I Eligible to Roll My 401(k) into a Roth IRA?

For tax years prior to 2010, you could only roll your 401(k) into a Roth IRA if your Adjusted Gross Income was below a certain limit ($100,000 for 2009). Beginning in 2010, however, the income limit disappears.

Should I Rollover My 401(k) to a Roth IRA?

After you leave your job, rolling your 401(k) into an IRA is almost always a good idea. Whether you should roll it into a Roth IRA is more debatable. The decision is basically the same as deciding whether you should convert your traditional IRA to a Roth IRA. Specifically, if you:

  • Expect to be in a lower tax bracket in retirement than you’re in now, or
  • You don’t have the cash on hand to pay the tax on the amount of the rollover,

…then it’s probably better to roll it into a traditional IRA rather than a Roth IRA.

December 29, 2009 1 comment

Tinkering and Chasing Performance

Passive investors aren’t immune to the temptation to chase performance. We just do it by tinkering with our asset allocations rather than hopping between various actively managed funds.

For Example

Imagine two portfolios: Both have a 70/30 stock/bond split. Both have the same total costs. And both have identical holdings in the bond portion of the portfolio. The difference is that:

Theoretically, Portfolio B should earn slightly higher long-term returns than Portfolio A because it carries slightly higher risk. Of course, there’s no guarantee those additional returns will materialize over any particular period.

All we know with certainty is that there will be some years in which Portfolio A does better and some years in which Portfolio B does better. And that can create a temptation to tinker: “Perhaps I should be overweighting small-cap and value stocks after all.” or “Perhaps I went a little overboard with the small-cap/value idea.”

However, picking either A or B and sticking with it is likely to beat the heck out of jumping back and forth between A and B, always moving to the one that’s done well over the last couple years.

Be Wary of Tinkering

The same thing happens with your allocation to REITs. Whether you allocate 5%, 10%, or 20% of your portfolio to REITs, there will always be years in which you wish your allocation was something different from what it is.

And with your U.S. vs. international allocation: Should 20% of your stock portfolio be invested internationally? 40%? Regardless of what you choose, there will always be some other allocation that’s done better.

Be wary of the temptation to tinker with your portfolio. It may be nothing other than chasing performance.

Or to put it differently: How we invest is at least as important as what we invest in.

December 28, 2009 7 comments

Emergency Funds and ETFs: Weekend Reading

Merry Christmas to those who celebrate it. :)

Without a doubt my favorite read this week was an interview done by Charles Kirk of The Kirk Report. He interviewed Bill Schultheis, author of The Coffeehouse Investor. It’s a fascinating interview because Schultheis is quite firmly in the “buy & hold index funds” camp, while Kirk is a full-time investor who:

  1. practices and writes about all of the things Schultheis recommends against, yet
  2. recommends that most investors adopt a passive investment strategy.

You can read the interview here.

My other favorites from this week:

Investing Articles

Other Money-Related Articles

Blog Carnivals

Thanks to everybody for reading. I hope you’re enjoying your holiday season. :)

December 25, 2009 4 comments

What’s the Best Bond Fund or ETF?

If you could select one of the following funds to serve as a diversifier for a stock-oriented portfolio, which would you choose?

I’m currently using Total Bond Market for the bond portion of my portfolio, but I’m considering switching.

The Differences

The difference in expenses between the funds is quite small, so that leaves two factors for deciding: credit rating and maturity.

The Total Bond Market fund is roughly 34% Treasury securities, 38% government-backed mortgage securities, and 28% corporate bonds. The other two funds are obviously 100% Treasury securities.

The Short-Term Treasury Fund has an average maturity of roughly 2 years, while the Intermediate-Term Treasury Fund and Total Bond Market fund have average maturities of roughly 6 years.

Treasury or Total Bond Market?

The primary reason I’m considering switching out of the Total Bond Market Index Fund is that it holds 28% of its portfolio in corporate bonds.

When investors get scared about the prospects of our economy (as they did in late 2008), they tend to sell corporate bonds as well as corporate stock. So it would seem reasonable to expect stock market performance to be more closely correlated to corporate bond performance than to Treasury bond performance. (The return data posted on Vanguard’s site seems to confirm that suspicion, though it only goes back to 1994.)

Their lower correlation to the stock market would mean that either of the Treasury funds would work as a better diversifier than the Total Bond Market fund.

The downside: Due to their lower-risk profiles, the Treasury funds should have lower expected returns than the Total Bond Market fund.

Short-Term or Intermediate?

The shorter a bond’s maturity, the less sensitive it is to inflation risk and interest rate risk. As a result, the short-term fund exhibits less volatility (in terms of annual returns) than the intermediate-term fund. In exchange, it should earn slightly lower returns over extended periods.

The flip side, however, is that precisely because of its greater exposure to interest rate risk, the intermediate-term fund has historically exhibited lower correlation to the U.S. stock market. (That is, during market crashes, if investors panic and flock to Treasury securities, interest rates will go down and bond prices will go up. The longer the maturity of a bond, the greater its price will increase.)

For me, if an asset class has higher long-term returns and lower correlation to the rest of my portfolio, that’s a good thing. And even if its stand-alone volatility is higher, it may lead to a less volatile overall portfolio.

What do you think?

As you can probably tell, I’m leaning toward switching to the Intermediate-Term Treasury Fund, but I’d love to hear your thoughts on the matter.

December 23, 2009 26 comments

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