Drill Down: Investment Definitions

The return on an investment is what you gain. It’s usually expressed as a percentage such as five percent or ten percent or twenty percent. The definition of risk is slightly more complicated. It’s related to your potential loss, but there’s a better way to describe it: the variance of returns. As a general rule, investments with higher expected returns entail higher risk.

Before going too far, we need some basic definitions for the different investments we will be talking about.

• Stocks are shares of companies. Each share represents one tiny slice of the total ownership of the company. If the company has 100 million shares outstanding, and you own one of these shares, you own one one-hundred-millionth of the entire business. Wow! Don’t you feel rich?
• Bonds are debts. A company or government borrows money by selling bonds. Each bond promises to pay interest in addition to repaying the original purchase price.
• Mutual Funds are boxes that can hold stocks or bonds.
• Money Market Mutual Funds are mutual funds that own very short-term debts. The per-share value of the fund hardly ever changes, and all return is from income.
• Your portfolio is what we call all of your investments, across all the different accounts in which you own them.

These are your primary investment options in a 401k. They come in different flavors and with a dizzying array of names.

If you go outside of your 401k, there are lots more choices. A few 401k plans offer access to many different investments through a stockbroker. I recommend you stick to a few basic mutual funds.

Hide Drill Down

Drill Down: Investment Returns

Investment returns include two major components: current income and price appreciation. For a bond or bank account, current income is the interest.

Price appreciation—which can also be price depreciation—is the second element of return. Some assets don’t fluctuate in value. Your savings account at the bank is a good example. Most investments, however, can go up or down. Even risk free government bonds can go up or down in price. (I’ll explain how that happens later.)

Both income returns plus appreciation are calculated as a percentage of the asset’s value. Let’s use an example.

• January 1: you own 100 shares of ABC stock that are worth $20 per share.
• Every three months, you receive a dividend of ten cents per share. At the end of the year, your dividends total $40 (10 cents a share, times four times a year, times 100 shares).
• December 31: your shares are now worth $22 per share.

Your total return has two components:

• Dividends came to 2.0 percent of your starting value. (Starting value was $2,000, equal to 100 shares at $20 per share value. Total dividends paid were $40. Dividing $40 by $2000 yields 2.0 percent.
• Price appreciation was 10.0 percent. (The price increased from $20 to $22, a gain of two dollars.) Two dollars is ten percent of the initial value of $20 per share.
• Total return was 12 percent, comprised of two percent income and ten percent price appreciation.

If you’re into mathematics, we can jazz up the arithmetic. Over longer time periods, we usually assume that when dividends were received, they were immediately reinvested in the stock. At the end of the time period for which you own the stock (called “the holding period”), you simply compare your stock’s end value with its beginning value. Going forward, we don’t know what our investment returns are going to be. Will our stocks go up or down? Will the company that issues bonds be able to pay the principal and interest on time? We’re never really sure, so we have to rely on some rough guides. We learn what usually happens from history, but we confirm these conclusions with logical analysis of what “should” be happening, to make sure that we are not just seeing a weird aberration that won’t be repeated.

As a general rule, stocks get most of their returns from price appreciation. In fact, some stocks don’t even pay any dividends but still manage to have good total returns.

Bonds tend to pay out most, or all, of their returns as current income in the form of interest payments.

Money market mutual funds almost always have no price change, so all return is current income.

Hide Drill Down

Drill Down: Returns of Different Types of Assets

So just how much money can you make investing in different types of assets? It’s easy to throw one’s hands up in the air and say that there’s no telling. If you are going to invest in a stock, it is hard for me to know whether you are going to invest in the stock that goes through the roof or one that’s trying to go through the floor.

I take a somewhat agnostic view about the specific investments and simply say, if your stock investments are about average, how will they do? If your choice of bonds is about average, how will they do? And so forth for the major asset classes.

Here are average returns since 1972. You will see slightly different figures if you measure average returns over a different time period.

Treasury Bills
Treasury bills are your safest possible investment. They are secure enough that professional investors often refer to them as “cash” because they are almost as safe as holding cash.

Bonds
Bonds are long-term debts. In the case above, I’m showing the debt of the United States Treasury. The bonds are like Treasury Bills, except for maturity. Treasury Bills have a life of three to 12 months whereas Treasury Bonds have lives of one to 30 years. The risk from Treasury Bonds does not come from the possibility that the United States Treasury will fail to pay its debts; instead, the risk comes from changes in interest rates. When interest rates go up, the price of old bonds, that pay the old, lower interest rate, goes down. So your Treasury Bond may drop in value during the time that you own it, even though the Treasury’s promise to repay the bond in full is good as gold.

Stocks
Stocks can be divided between “small cap” and “large cap” stocks. “Cap” is short for capitalization it refers to the company’s size. Capitalization is determined by the number of shares outstanding multiplied by the price of the shares. Another way to think of it is how much you would have to pay to own the entire company.

Large cap stocks have capitalizations of several billion dollars. Small cap stocks have capitalizations of less than one billion. (Different people divide stocks differently. Some like to create another category called “mid-cap” for companies midway between small and large. The bottom line is that small cap stocks offer higher returns, on average, but with more risk than large cap stocks.)

Stocks can also be divided between growth and value stocks. Growth stocks tend to have prices that are high compared to their earnings, dividends, sales and assets. The high prices reflect optimism about these companies’ prospects. Value stocks, in contrast, tend to be priced fairly low relative to the size of the company, because few investors expect strong growth from them. However, value stocks offer good investment opportunities simply because they can be bought fairly cheaply.

Foreign stocks, which can include both developed countries (such as Germany) and emerging markets (such as China), also tend to offer high returns with high risk.

Real Estate
Real estate as listed above refers to the type that large investors buy, such as office buildings, shopping malls, and large apartment complexes. As the table shows, real estate investments offer the possibility of a high return without quite as much risk as the stock investments.

Hide Drill Down

Drill Down: Taxes, Fees and Investment Returns

Taxes and fees can take a big bite out of your investment returns. It’s important for you to have a feel for just how big these issues are.

There are only a couple of good ways to avoid taxes on your investment returns, and one of them requires that you die. The other requires you to give your money away. The third way to avoid taxes is to buy municipal bonds, but the returns are so low that “munis” are not suitable for your core retirement investments.

I sometimes hear stories about people who make truly stupid investment decisions in an effort to avoid taxes. In the case of your retirement funds, though, avoiding taxes becomes very important over time.

Dee and Tex both started saving for retirement at age 25, when each was earning $20,000 a year. They set aside six percent of their income, even as they got raises through out their careers. They invested in identical mutual funds and had exactly the same investment returns. The only difference was that Dee’s money was tax deferred through her 401k plan, and Tex’s money went into a fully taxable account. (Dee’s story would have been the same if she had invested in an IRA, because her employer does not offer a matching contribution.)

Look at how much they each have at age 65:

Dee: $989,642
Tex: $500,837

Dee did so much better because her early investment returns went back into her account. Much of Tex’s returns were taxed each year.

When they start withdrawing money for retirement, Dee has to pay regular taxes on all of her distributions. If she starts off by taking four percent of her assets in the first year, she has $39,586 of income. After taxes she nets $27,710. (I’ll explain how to figure how much you can safely withdraw each year in Chapter 7.)

If Tex decides, like Dee, to take out four percent of his account balance, his withdrawal will be $20,033 before taxes. Surprisingly, that will be taxable initially. Tex already paid taxes on the money he invested, but at age 65, his account will be earning slightly over $20,000 of taxable interest and capital gains.

Let’s be optimistic and assume that when Tex retires, Congress is still taxing dividends and capital gains at a lower tax rate. Tex will net, after taxes, $14,848. Let’s summarize:

After-tax income first year of retirement:
Dee: $27,710
Tex: $14,848

Tex’s relative position improves over time. Both Dee and Tex will increase their withdrawals every year to match inflation, and soon Tex will be selling some stock in addition to using his interest and dividend income. When he sells the stock, he only pays taxes on his gain, not on the value of the stock when he first purchased it. When he does pay taxes on his stock gains, it will be at the lower capital gains tax rate.

Tex’s benefit in the long run will not make up for his worse starting position. He’ll never catch up with Dee. That’s why tax deferred accounts are so important to financing your retirement.

Investment fees also play a dramatic role in your overall returns, though somewhat smaller than the role taxes play. Individual investors may pay commissions to their stockbrokers, and may also pay advisory fees to a financial planner or investment manager. Investors in mutual funds—including 401k participants—pay a management fee that covers the costs of trading and investing the fund. The very lowest fees I have seen are nine cents per $100 invested. (Investment professionals would say “nine basis points.”) The average mutual fund charges about one dollar per $100, and there are many funds that charge between $1.50 or $2.00. You will not see the fees listed in your account statement, but you can find them buried in the fine print in the mutual fund’s prospectus.

The United States Securities and Exchange Commission says, “For example, a 1% increase in a fund’s annual expenses can reduce an investor’s ending account balance in that fund by 18% after twenty years.”

Let’s walk through a calculation. Rich pays a management fee of $1.25 per $100. His friend Chip pays only 25 cents per $100. Surprisingly, Rich’s mutual funds perform no better before considering fees than do Chip’s funds. That’s exactly what the research on mutual fund performance and fees has found: higher fee funds do not do any better than lower fee funds, on average.

So how do Rich and Chip end up when they retire? Using the same assumptions as I used for Dee and Tex above, here’s what I calculated:

Total account value at age 65 for Rich: $728,557
Total account value at age 65 for Chip: $930,065

Chip’s cheapness has paid off handsomely.

I don’t mind paying high fees when I’m receiving good value. I use a very expensive attorney when I need legal advice, and my accountant is not cheap either. But paying high mutual fund management fees will not leave you better off, just poorer.

Paying a fee to a financial planner to help you with all of your investment needs may be money well spent. However, don’t get locked into a high-fee program if you are not receiving valuable help.

Hide Drill Down

Drill Down: Risk of an Individual Investment

Risk is the amount by which your actual outcome will vary from your expected outcome. (Those of you with a statistics background will recognize this as the definition of “standard deviation.”)

If we toss a coin ten times, we expect that heads will come up five times out of the ten. But we won’t be too surprised if heads actually comes up four or six times, instead of exactly five times. That is standard deviation (or “risk” for our purposes) means—the difference between expected and real outcomes.

In terms of investments, if we put $100 in a savings account at the bank, earning three percent interest, we darn well expect to have $103 in a year’s time. There’s no risk, meaning that we don’t expect a penny more or a penny less.

If, instead, we bought a 10-year bond paying five percent interest, there’s a bit of risk. In a year’s time, we’ll most likely have five dollars in interest payments, unless the company that issued the bond has gone bankrupt. But the value of the bond may not be $100 in a year’s time. Perhaps the market now sees this bond to be risky, and therefore won’t pay $100 for it. Or on the happy side, perhaps interest rates have gone down, in which case this old bond that still pays five percent is even more valuable than when you bought it. As there is a fair chance that the total return on the bond won’t be exactly five percent, the bond has risk.

Risk, in investment terms, is about upside possibilities as well as downside. You can buy a particular bond expecting a five percent return, and if it turns out to return ten percent in a year, you’re happy. That happiness can only result from taking on risk.

When we buy a share of stock, we’re taking on even more risk than we would be with a bond. Most of the total return of the stock is due to a change in the stock’s price, and in one year’s time that price may change dramatically, either higher or lower. You may have gone in with an expectation that the stock will return about ten percent, but the reality is that you have no guarantee as to what your actual return will be. In short, the less sure you are of what your future return will be, the more risk you have.

Hide Drill Down

Drill Down: Risk in Real Life

The risk concept is the likelihood that our returns will be something other than what we expected. With bank accounts, there is essentially no risk. With stocks, there is a lot of risk. Let’s translate that into dollars and sense.

Imagine that you have $10,000 to invest, and you want to put it away in some investment for 20 years. Maybe it was an inheritance from your Aunt Sadie, or maybe you had a lucky lottery ticket, or perhaps a one-time bonus at work.

I’m going to give you two investment options. The first is like the stock market: an average annual return of 10.7 percent and a level of risk equal to the overall stock market.

The second option has the same average annual return, but twice the risk as the stock market.

We cannot be certain of what return you’ll earn because we cannot predict the future; we can, however, simulate the future. I programmed my computer to imagine that you had 1000 lives in which you invested in the stock market. Then as a second exercise, I programmed it to imagine that you had another 1000 lives in which you chose a more risky investment, one that had the same expected return as the stock market but with twice the risk. In some of your lives you were lucky, but in other lives you were unlucky. The computer kept track of all this for a 20 year investment period of each of those 2,000 hypothetical lives. The results are shocking:

• With either investment, your $10,000 grows to over $80,000 on average.
• With the stock market investment, your nest egg was worth less than what you started with three percent of the time.
• With twice the risk of the stock market, your investment was worth less than the $10,000 starting value 43 percent of the time.

Bill Says: Try to lower risk whenever possible.

I’ll explain soon that there are both easy, and hard, ways to reduce risk. Obviously, we always want to implement the easy risk reduction methods.

Hide Drill Down

Drill Down: Risk Reduction: The Free Way

Risk reduction is good. There are two ways to reduce risk, and one of them is absolutely free! That’s pretty cool and seems to violate the “no free lunch” principle. Don’t worry, it is completely true.

Suppose you want to own some stocks. (We could just as easily be talking about bonds or real estate properties, but let’s use stocks as an example.) If you pick a stock at random, I can tell you what the average risk of that stock will be. But suppose that I talk you into dividing your investment between two stocks instead of just owning one. You will reduce your risk by almost half. That’s because some of the time that one stock is going down, the other is going up. The portfolio that is divided between two stocks is far less risky than the portfolio that contains only one.

If I can talk you into investing in three stocks, instead of two, your risk will go down again, but not by as much. At the ultimate limit, you’ve divided your money among all the stocks that are out there. You have reduced your risk, but your expected return is simply the average return of the overall stock market. It’s the return you would expect to have from investing in a single stock but with much less risk.

You don’t even have to go to the extreme of investing in every stock. Just owning 30 or more stocks reduces your risk substantially. The following chart shows how much risk you will have in your portfolio based upon the number of different stocks you own.

If you own just a few stocks, you are taking on more risk than is necessary. Once you get to 30 stocks or more, your risk is pretty low. It can still go lower, but not by too much. (The line looks like it is perfectly flat after a while, but that’s not quite true—almost, but not quite.)

This shows one of the great advantages of mutual funds. They are all well diversified, and almost all have far more stocks than needed to lower risk to a reasonable level. You can even invest in an index fund that literally owns some of every stock out there.

The moral of the story is that for any type of asset, you should be well diversified. If you own stocks, own a lot of different stocks. If you own bonds, own lots of different bonds. (However, bonds start with a lot less risk, so diversification isn’t quite as important.) If you own investment real estate, own many different properties. It is better to own one-tenth of ten different properties than all of one property, at least in terms of your risk.

Hide Drill Down

Drill Down: Risk Reduction: The Tradeoff Approach

The first step in lowering risk is having diversification for whatever type of asset you own: stocks, bonds, or real estate. The second step is to have different types of investments. So if you currently are all in stocks, you can lower your risk by adding bonds. Or if you own nothing but bonds, you can reduce risk by adding stocks.

The mathematics of investment return is quite different from the mathematics of investment risk. Here are the key results:

• When you blend investments, your return is simply a weighted average of whatever you’ve invested in.
• Example: If you invest half in stocks and half in bonds, your return is halfway between the return on stocks and the return on bonds.

• When you blend investments, your risk depends on the risk of the different asset classes and how those assets correlate with one another.
• Example: When the Packers are playing a football game against the Steelers, you bet with one friend $10 that the Packers will win. With another friend, you bet $10 that the Steelers will win. You have no risk at all. You will lose one bet, but win the other, ending up even. This is true even though each bet, by itself, is fairly risky.

Bill Says: If you combine risky investments in the right way, you can end up with a low-risk portfolio. And it isn’t even magic.

We can see how different blends of investments are likely to work out based upon past results.

First, here’s a quick picture of how stocks, bonds and Treasury bills compare to one another in terms of return and risk. I use Treasury bills as an indication of the risk and return of money market funds, the safest investment choice you have.

Hide Drill Down

Drill Down: How Much Risk Should You Take?

Telling you how much risk you should take is difficult. It is a lot like being asked if you should settle down with your current boyfriend or wait until someone better comes along. At the extremes, the advice is easy to give. If he’s a loser, dump him. If he’s hard-working, kind, honest and makes you laugh, keep him. But if he’s somewhere in between, then you have to decide for yourself.

So here’s the equivalent investment advice, starting with some guidelines.

The younger you are, the more risk you can take. Let’s say that you’re 25 years old. You can put all of your investments into stocks, so long as you can stomach some ups and downs. Even if the stock market has a terrible decade, you’ll have another three decades to make up the loss. And over the very long haul, stocks give you the highest reward.

The sooner you will be spending your money, the less risk you can take. You can’t risk a stock market downturn just before you’re planning on spending your nest egg. So people nearing retirement usually reduce the amount of risk from what they had when younger.

If you have a lot of investment assets, you don’t need to take on much risk to meet your retirement goals. This sounds counterintuitive because, if you’re well off, you can afford to lose some money. But at the same time, lower returns will be adequate to fund your retirement, so you don’t have to take too much risk.

You should not take on more risk than you can sleep with. The point of investing is not to make mathematically perfect decisions. The point of investing is to be comfortable and secure financially. If you cannot sleep at night, something’s wrong.

You will be better off financially if you can learn to live with a moderate amount of risk. I don’t know if you can live with some risk, but if you are very cautious person, you should learn more about long-run returns and see if you can get comfortable taking some risk. There really is a reward for taking risk, and few people can achieve their financial goals without some risk.

Those last two points may sound contradictory, but I do not believe they are. People can learn to accept risk without losing sleep, but it requires a factual basis. Let me give you an idea of how taking on risk can help you achieve your goals.

A Story to Illustrate the Point:

Suppose that you have to get from New York to San Francisco, and you want to get there as quickly as possible. You are presented with two choices. You can drive an old car that is likely to break down every 1000 miles, leaving you stuck for a day while the local garage makes repairs. You’ll probably be stuck two or three times on your trip across the country.

Your other transportation is a magic bicycle. What makes it magic is that it will never break down, never have a flat tire, and never throw a chain off the sprocket. As long as you can keep pedaling, it will keep rolling.

Which will be a better mode of transportation for getting across the country? The bicycle is risk free. You’ll never lose a day waiting for repairs. But… it’s a bicycle. You will average maybe 100 miles a day, so the journey will take about 29 days.

That old car? It will probably get you 500 miles a day, but the occasional breakdown will cost you two or three days, so you’re probably talking nine days. Which sounds better? A risky vehicle for 9 days, or a risk-free vehicle for 29 days?

Let’s put this analogy into concrete form. Let’s say that you want a nest egg of $100,000 20 years from now. How much should you set aside today to reach that goal? If you invest in stocks, you need to set aside $16,351 today.

If you want an absolutely safe investment, you’ll choose Treasury Bills. But then you’ll need to set aside $57,029 today because the safest investment around also has very low return. That should give you the idea that tolerating a little risk will help you to achieve your investment goals.

Hide Drill Down

Drill Down: Asset Allocation: Bringing It All Together

It’s time to get away from theory and history to focus on your decision: how to allocate the assets in your 401k among your various investment options.

Here are the basic principles.

• If you have the option of investing in individual stocks, do NOT choose it.

Stick with mutual funds. You need to be diversified within each asset class, and all mutual funds are diversified within the limits of their investment strategy. (That means that if the mutual fund is investing in large American companies, it has a diversified group of such companies. However, it is not diversified into small company stocks, or foreign stocks.)

If you truly want to invest in individual stocks, here’s how to do it. Use mutual funds as your core holdings. Once it looks like you will meet your investment goals, use any excess money you have to play with individual stocks

• If you have the choice of investing in your company’s stock, do NOT do it.

Even if you think your company is great and its stock will go up, do NOT invest your 401k assets in the company stock. First, investing heavily in any one stock is risky. Second, this isn’t just any old company, it’s your paycheck. If the company falls on hard times, you may be out of a job at the same time that your 401k has lost a great deal of its value.

The Enron Story:

Enron began its life as a natural gas pipeline company, but became a large, highly regarded corporation trading energy in different forms. It was a stock market high-flyer, one of the most respected companies in America. Fortune Magazine named Enron “America’s Most Innovative Company” for six consecutive years. Unfortunately, it turned out that the company’s accounting was misleading, and Enron went bankrupt.

The company’s matching contribution in 401k accounts was Enron stock. Employees were limited in their ability to sell the Enron stock that they received as matching contributions. However, employees were free to choose from a wide selection of mutual funds in which to invest their own contributions. Instead of choosing from among these mutual funds, many employees chose to invest their contributions in Enron stock because it had been doing so well. Those employees ended up losing both their jobs and most of their 401k.

The employees who had diversified their 401k investments by putting all of their own contributions into stock and bond mutual funds ended up all right. The amount that the company matched became worthless, but at least these employees retained their own contributions with good returns.

• Include stock mutual funds in your asset allocation.

You can allocate all of your funds to stocks if you are young and willing to take on a good deal of risk. You can also be in entirely in stocks if you have more than enough money, so that even a stinking decade of stock returns leaves you well enough off to live comfortably.

• Include bonds in your asset allocation unless you are young or rich.

Unless you fit the exceptions above, have some bond funds. Even if you are young and rich, it’s OK to have bonds, but it is not a necessity.

• Among your stock holdings, have some foreign stocks, including both developed and emerging countries.

It may feel risky to invest in foreign countries, but it’s actually riskier not to invest overseas. The stock markets of other countries sometimes (though not always) go up when the United States market goes down, or sometimes go down when the American market goes up. As a result, a blend of U.S. and foreign assets will be more stable than either one individually.

By the same token, emerging markets (the poor countries) and the developed markets (rich countries) sometimes move in separate directions. So even though stocks of countries in emerging markets (like Vietnam, Indonesia, and Malaysia) are risky by themselves, they can reduce your overall portfolio risk.

Emerging markets stocks also have higher average returns, historically, so you can get paid to reduce your risk. That is very cool.

Looking deep into the future, I expect emerging country stock markets to be more integrated with developed countries’ markets. Then their stock returns won’t be much higher than ours, and they won’t often go in different directions from our markets. At that time, diversification into these foreign stock markets will not be of much benefit. Until then, diversify.

Hide Drill Down

Drill Down: Understanding Your Risk Tolerance

Begin by determining your tolerance for risk. This depends partly on your own psychological makeup and partly on how many years you have before you need to use some of your money. Your risk level will determine how you should split your investments between stocks and bonds.

Place yourself into one of three categories:

Aggressive: I’m in the upper third of willingness to take risk. I don’t mind playing poker for money. I’m optimistic about the long run. If I have a bad result, I can shrug it off and keep going.

Moderate: I’m in the middle third of willingness to take risk. I can have fun buying a lottery ticket, but I’d never spend much money gambling. If I lose money in an investment it shakes me up, but I try not to over-react.

Cautious: I’m in the lower third of willingness to take risk. Playing poker or slot machines for money makes me uncomfortable, even for small stakes that I can afford to lose. I worry about a lot of things in my life, including family and work.

Now think about how many years you have until you’ll withdraw money from your 401k plan. Given your risk tolerance and your time horizon (the amount of time until you will take out money), we can create the following table to show how much of your portfolio should be in stocks. Put the rest in bonds.

These are suggested guidelines that you can adjust. For example, if you have a lot of money outside your 401k, you can afford to take less risk. If you think you lean more toward the risk-taking side of moderate, find the asset allocation for a moderate risk-taker and bump it up by five or ten percentage points.

Hide Drill Down

Drill Down: Investing Your Bond Money

Put your bonds into a short or intermediate mutual fund if you have that choice. However, if your only bond option is a long-term bond, then split your bond money half and half between a money market mutual fund and the long-term bond fund.

The risk of a bond is greater the longer the maturity of the bond. A bond that pays you back in 30 years is riskier than a bond that pays you back in one year. Some of that risk is obvious. If the bond is issued by a corporation, you may wonder whether that company will actually be able to pay you back or not. New technology could be developed that would make that company obsolete. A lot can happen in 30 years, but not as much can change in only one year.

The greater source of risk for bonds, though, is changes in interest rates. Think of it this way. Once you buy a bond, it’s an “old” bond. After interest rates change, whether they rise or fall, potential investors will be comparing the interest rate on your old bond with what they can receive on new bonds. If you bought your old bond at an interest rate of six percent, but the new bonds are offering seven percent, investors aren’t going to like your old bond very much. They’ll buy it, but only at a lower price than you originally paid for it. A drop in interest rates, however, makes your old bond more valuable. If you originally purchased a six percent bond and then interest rates dropped down to five percent, investors will look at your bond as a great beauty. They’ll pay you a premium price to own it.

How much your bond changes in value depends on both the level of interest rates and the maturity of the bond. (Maturity is how many years until the bond is paid back.) There’s a calculation that can be made on a bond, or a mutual fund full of bonds, called “duration.” The longer the duration, the greater the risk the bond holds.

For the bonds you put into your 401k, I’d like to see a duration of about two or three years. That’s what you’ll see in a typical “short-intermediate” bond fund. There’s not much risk in such a short duration.

But a long-term bond fund may have a duration of six years or more. That’s more risk than I’d like you to take on the bond portion of your portfolio. To get a lower level of risk, blend a long-term bond fund with a money market mutual fund to get the duration you want.

Here’s the advice:

• If you have a short or intermediate bond fund as one of your choices, use it for your bond allocation.
• If you do not have a short or intermediate bond fund option, split your bond money between a long-term bond fund and a money market mutual fund.

If you need to blend together a long-term bond fund and a money market fund, here’s how to figure out the proportions. If you want to keep things simple, split your bond investment half and half between the long-term bond fund and a money market mutual fund. If you are willing to do a little arithmetic, here’s my suggestion. Try to find the duration of the fund that you can invest in. It may be buried in a table describing the fund’s investments. (It may be labeled “modified duration.”) You’ll blend this bond fund with a money market mutual fund to get the resulting mix down to a duration of two. To find the correct proportion, divide two by the duration of the bond fund. For example, if the bond fund has a duration of 5.0, then take 2.0 divided by 5.0 to get 0.4. That tells you to put four-tenths of your bond money into the bond mutual fund and the rest into the money market mutual fund. (For those of you mathematically inclined, the money market fund has a duration of approximately zero.)

Hide Drill Down

Drill Down: Investing Your Stock Money

Your stock market investments should be well diversified among different types of stocks, including both United States stocks and foreign stocks. Be certain that your United States holdings include small cap stocks. Your foreign stocks should be split among developed countries and emerging markets, if you have those choices. If you have all of these opportunities, I recommend that you divide up your investments in proportion to the value of different classes of stocks. For example, of all the stock traded around the world, 40 percent of the value is in United States stocks. Therefore I recommend that 40 percent of your stock investments be in American companies. This gets you the maximum diversification possible.

Basic Stock Market Allocation

40% U.S.
34% S&P 500 (or similar large cap index)
6% small cap
60% Foreign
48% developed countries
12% emerging countries

Your particular 401k plan may not give you all of these options. Don’t fret. The minor details are not terribly important.

Two of these four components have historically offered higher long run returns: U.S. small cap stocks, and emerging country stocks. There’s a good argument for overweighting them, if you are comfortable taking a little more risk. You might, for example, allocate 12 percent to small caps and 24 percent to emerging countries at the most aggressive end of the spectrum. Don’t go overboard, however, or you lose the benefit of diversification.

So the process is this:

• Based on your tolerance for risk, pick the split between stocks and bonds.
• Make sure that your stock holdings are well diversified among large stocks and small stocks, and between United States and foreign stocks.

Hide Drill Down

Drill Down: If You Do Not Own a Home

Real estate is a good asset to own, but most people in 401k plans already own a home. If you don’t, then we’ll modify this allocation to add some real estate. If you do own a home, do not add additional real estate investments to your 401k because you already have sufficient exposure with your home.

If your 401k plan offers you a real estate fund, which may be called a REIT fund, use it. (REIT stands for Real Estate Investment Trust; it’s like a mutual fund that owns office buildings, warehouses, shopping malls and apartments.) Put the real estate into your stock market allocation, with a weight of 30 percent. That lowers the percentage that you’ll have in actual stocks.

Stock Market Allocation with Real Estate

36% U.S.
18% S&P 500
18% small cap
36% Foreign
18% developed countries
18% emerging countries.
28% Real Estate

Hide Drill Down

Drill Down: Buy and Hold, or Trade?

The approach we recommend is sometimes called a “buy and hold” strategy. That means you buy the assets you want and just hold them. You’ll do some rebalancing, which I’ll explain later, but not real trading. The opposite of buy and hold is to trade, either daily or less often. Traders are trying to figure out which way the market will move in the short run.

I don’t recommend trading strategies. Sometimes you can make a lot of money trading, but you can also lose a lot of money trading. The research shows that traders do not, in fact, make more money than buy and hold investors. In fact, they usually make less, because buying and selling runs up transaction costs, including commissions.

The problem with this recommendation is that you likely just heard a radio commercial about a trading strategy that makes big bucks with low risk. Maybe my recommendation would be different if I had heard the same commercial, or if I knew your golfing buddy who has made big money trading on the Dogs of the Dow theory, or if I were intrigued by some other trading system.

I’ve heard the commercials, so let’s talk about that first. Suppose that you, yourself, discovered a method that would guarantee high returns. How would you use that information? Here’s what I would do: I’d put my own money into the investment. I’d talk to family and friends about the investment, offering to use my system with their money, for a share of their profits. I’d put all of my effort into raising money to invest this way.

Here’s what I would not do: Hold public seminars explaining my system. I would not make a business based on radio advertising to sell seminars. That’s what a marketing genius does to make a living, not what an investment genius does. In fact, as an investment genius, I’d be afraid that other people would figure out my idea because if everyone tries to buy the investment that I want to buy, I’ll have to pay a higher price because of those other investors. And if I have to pay a higher price, then I’m not going to make 43 percent per year.

As for your friend with a system, many systems have been studied by the academics without a single one of those systems making enough money, over a sustained period of time, to cover trading costs and to earn a return higher than a “buy and hold” strategy.

Your friend is probably not keeping records that allow him to compare his results to a buy and hold strategy on an apples-to-apples basis. That takes a good bit of detailed effort. All of us who are human tend to remember the things that reinforce our beliefs and to forget the things that refute our beliefs. Your friend wants to believe that he’s got a great system. He remembers his wins. He forgets his losses.

Stick with a buy and hold strategy.

Hide Drill Down

Drill Down: The Ultimate Buy and Hold Strategy

This allocation comes from my friend Paul Merriman, an investment advisor who runs the FundAdvice.com website. He calls this “The Ultimate Buy and Hold Strategy.”

He begins with a basic diversification upon which we all agree. Next, he deliberately overweights the asset classes that have a long-run track record of providing higher returns. For example, he overweights small cap stocks in the United States.

Value stocks are also overweighted. One way to look at stocks is to divide them into two categories: value and growth. Value stocks tend to be cheap because investors doubt their long run prospects are very strong. Growth stocks tend to be expensive because everyone sees their ultimate potential. A good deal of research suggests that in the long run, value stocks perform a little better than growth stocks. There’s no doubt that the growth stocks have great prospects, but you have to pay so much to buy a share, that you may not have a very high return when it comes time to sell. So Merriman overweights value stocks.

Merriman also overweights stocks in emerging countries. The small, fast growing countries tend to have stocks that grow at a faster rate than the global stock averages.

Why not just put all of our money into small caps, value stocks and emerging markets? They are very risky. Each, by itself, is riskier than the overall stock market. However, diversification reduces risk, so it’s not bad to have these stocks in your portfolio. Overweighting them does add risk, but that extra risk is probably justified by their higher average returns.

Finally, Merriman includes real estate through mutual funds that invest in Real Estate Investment Trusts (REITs). This is a diversification move. This is the only place where I disagree with Merriman. I concur fully that real estate is a good asset to own. However, if you own your own home (even with a mortgage on it), you probably have enough exposure to real estate. Unless your stock and bond investments are more than five times greater than the market value of your house, don’t add the REITs. (In looking at this test, use the market value of the house, not your equity in the house. When real estate goes up in value, your gain is proportional to your house’s total value, not your equity.)

So here is Paul Merriman’s Ultimate Buy and Hold Strategy, with my adjustment to delete REITs:

40% Short-intermediate bond funds

6.7% S&P 500 Index Fund
6.7% Micro cap index fund
6.7% Large cap value index fund
6.7% Small cap value index fund
6.7% Foreign large cap index fund
6.7% Foreign small cap index fund
6.7% Foreign large cap value index fund
6.7% Foreign small cap value index fund
6.7% Emerging market index fund.

You don’t have to follow these percentages exactly. Just get in the ballpark and don’t worry too much about the decimal points.

Hide Drill Down

Drill Down: What about Balanced Funds?

A balanced fund may be one of your 401k options. A balanced fund is a mutual fund that holds both stocks and bonds. Since I recommend holding stocks and probably some bonds, this may sound like a good idea. But frankly, I don’t like it.

If you invest in a balanced fund, the fund manager is deciding on any given day what the split between stocks and bonds will be. I think that is a very important decision that should be made based on your personal circumstances, most importantly your tolerance for risk. I’d rather see you make that decision. I’m perfectly comfortable with letting someone else pick specific stocks, but not how much risk you can take on and still sleep nights.

The other objection I have is that the typical fund manager will swing the mix back and forth. Today he may prefer stocks, but tomorrow he will prefer bonds. The record shows that not too many managers are good at figuring out when to switch back and forth, so the manager is probably not adding value. But you need a good mix of stocks and bonds as part of your diversification to reduce risk. The fund manager may be working against your goals, without even knowing it.

This came home to me as an employee who wanted some bonds in my 401k. At the time, the company I worked for did not have an all-bond offering, so I bought the balanced fund. When I purchased the balanced fund, its most-recent report showed that 40 percent of its assets were invested in bonds. Taking that into account, I bought enough of the balanced fund to get the bond holding that I wanted. Six months later, I was wondering why the balanced fund had done so poorly. It turned out that the fund manager had sold a good deal of bonds in order to invest more in stocks. Then the stock market took a dive. I had sought bonds to protect myself from a drop in the stock market, but the fund manager thwarted my diversification efforts. Don’t let that happen to you.

Bill Says: Skip balanced funds. Instead, create and control your own balance by purchasing both stock funds and bond funds.

Hide Drill Down

Drill Down: Lifestyle Funds and Life Cycle Funds

Their name may not help you understand what they mean, but they are becoming increasingly more popular for 401k investments.

A lifestyle fund is diversified across asset classes, so it includes both stocks and bonds, and usually has international exposure as well. What’s different is that each lifestyle fund defines itself in terms of risk: aggressive, moderate, or conservative. You figure out what your risk tolerance is, pick the corresponding fund, and the fund manager takes it from there.

That’s not a bad choice. If the fund manager is doing his job, you are likely to come out well. My only hesitation is that I’m a hands-on guy. I like to know for sure that the manager is doing a good job. I’d like to pick my own asset allocation. But hey, I’m an economist.

If your 401k choices include lifestyle funds, and you are comfortable with using them, then go ahead. If you’d rather make your own asset allocation decisions along the lines outlined earlier, that’s fine too.

Life cycle funds, also called “target date funds,” are a little different. They start with the basic attitude toward risk that lifestyle funds take: aggressive, moderate, or conservative. Then they add a target date for your investment horizon. When that target is decades away, the fund manager will invest heavily in stocks, just as I recommend that younger people weight their portfolio toward stocks. As the target date nears, the asset allocation gradually shifts to include more bonds, matching my recommendation that folks closer to retirement hold more bonds.

Life cycle funds take over the decisions about changing your asset allocation as you age. My advice here is the same as my advice about lifestyle funds. Life cycle funds are not a bad choice. I personally prefer to make my asset allocation decisions myself, but that doesn’t mean you have to. If you’re comfortable with this approach, go for it. But neither is there anything wrong with doing it yourself.

After stating my preference for selecting asset allocations yourself, let me add the best reason for using either lifestyle or life cycle funds: they don’t take much courage. Some people have a hard time investing as much in stocks or overseas markets as they need to. These folks would be better off picking a lifestyle or life cycle fund and calling it good. Do it yourself only if you are sure that you will, in fact, do it well yourself.

Bill Says: Life cycle funds are fine. Or you can select your own asset allocation through time. Either way will work.

Hide Drill Down

Drill Down: Rebalancing

Let’s say that you put your money into these allocations and let a year go by. What then? The allocation percentages will be wrong because some of your mutual funds will have gone up while others will have gone down. (This is not the case if you have all your money in a lifestyle or life cycle fund—it’s rebalanced for you.) Now it’s time to “rebalance.” Pull money out of the mutual funds that are above your desired allocation, and put the money into funds that are lower than your targets.

There’s only one hard part to rebalancing, and that’s psychological. When you rebalance, you sell some of the funds that have performed well. You buy more of the funds that have performed poorly. That feels backwards. Remember, though, that past performance is no guarantee of future results. In fact, it’s rare that the sector which performed the best last year will also perform the best this year. Rebalancing is not about picking the funds most likely to gain this year; rebalancing is about reducing your risk by spreading your money over many different assets. If one sector has taken off, enjoy your gains, but redeploy the gains across the other sectors. They will have their day eventually, and you want to have money in those other sectors when that happens.

Here are the steps to rebalancing:

1. Dig out your target investment allocation: the percentage of your assets that you want in each fund.
2. Multiply these target percentages by the total value of your portfolio. This is the target dollar value you now want in each fund.
3. For each fund that has an actual balance greater than your dollar target, sell the fund in an amount equal to the excess.
4. For each fund that has an actual balance less than your dollar target, buy the fund in an amount that will bring your balance up to the target.
5. The dollar amount of the selling should equal the dollar amount of the buying. If it doesn’t, then double check your arithmetic.

If you are really fussy, you can rebalance every month. Everyone else should just rebalance once a year. The difference between rebalancing once a month or once a year is very small, so don’t worry about it—unless you have a perfectionist personality.

Chuck Says: Although you can “do it yourself” in determining investments, a professional advisor may be able to help you. Often a little hand holding during times of turbulent markets prevents an investor from making bad, emotion-driven choices.

Hide Drill Down

You are not logged in. Log in or create an account.