No Debt Plan

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One of MSNBC’s shocking headlines from yesterday, “Jim Crame: Time to get out of stocks“, certaintly got my attention. The tag line of “Financial guru warns that investments could lose 20 percent of their value” definitely makes me want to read on.

As it turns out, Cramer is exactly right… but not in the way the headline leads you to believe.

Sensational Headline, Solid Advice

The headline is over the top to say the least. It doesn’t tell the full story even though Cramer goes on to explain himself further. I suppose the media needs you to click on the article so they earn more for advertising.

Let’s read the second paragraph from the top together:

In what Curry called a “dramatic statement,” Cramer emphatically urged any investor who has money they may need in the next five years tied to stocks to pull their dough out.

Okay… now what has he really said? If you need your investments within five years, you shouldn’t be in the market at all. That’s a bit over the top, but is pretty much on the money.

Short Investment Horizon = Less Equity Exposure

Let’s assume you are 60 years old and plan to retire at 65. You should have a much smaller equity (stocks) stake than someone that is 25 and has 30+ years to retirement. It’s a simple risk question. A 100% equity stake is very risky as pointed out by the currnet market conditions. The S&P 500 has lost 33% of its value since the high in October 2007.

If you have 100% of your money in stocks, you’ve likely lost 33% of your portfolio. Ouch.

Realistically, if you are 60 and follow the 120 minus your age idea, you would have a 60% equity stake. You still took it on the chin over the last year, but not as bad as everyone else. If you are 25, you should have a 95% equity stake and have really felt the pain of the down market.

Equities Provide Growth, Usually

The reason to hold equities in your portfolio is that over time, they have higher returns than safer investments like bonds and certificates of deposit. So while you may still have a 60% equity position that has gone down over the last year… it should, over time, provide the growth to allow your portfolio to continue to grow in retirement. Bonds won’t do that (at least historically they haven’t).

Let’s be honest. It really sucks to see the value of your retirement accounts go down… then down some more… then down some more. But that is the trade off between risk and reward. There are bound to be down markets. Over time you should come out ahead with a larger equity position if you have a long time horizon to retirement.

So Cramer is Right

He is correct to say that if you need your investment money back within 5 years, you’re taking a significant risk. But you would be taking a significant risk regardless of the market conditions. This market just makes it seem that much worse.

For those of you who read this that are in your 20s and 30s… or heck even in your 40s… stick to your investment plan and continue to put money into stocks. Look at it as if stocks are on sale. You’ve got 30 years for the values to recover, even if they go down another 10% over the next year.

As most of you know, the stock market tanked 9% yesterday. Let’s take a quick look at the chart for the S&P 500 for yesterday:

Ugly, huh? The House decided to not pass the bailout bill which set the markets into panic mode.

Is this a good time to invest? Will the market go down again? Will it skyrocket today? I’ve said it before, so I’ll say it again: I have no idea.

What I do know:

• I have 30+ years until retirement and can ride out the current bumps in the market
• I have an investment plan; I can review it and decide to make decisions based off of non-emotional thinking
• I have a monthly amount we invest into our Roth IRAs. This goes along with the investment plan decision — do I keep investing it regularly?

My decision:

• Yesterday I made the move to put a portion of our monthly contribution in a little bit earlier than normal. I didn’t put the full amount in, actually a little less than half. With Vanguard my Roth IRA transactions go through at the closing price of the next business day. So if I put the order in at 3PM yesterday afternoon, the transaction goes through at today’s closing price. If the price jumps up today, I didn’t want to put all my eggs into that one price basket.
• I may add the rest of the monthly contribution today (for tomorrow’s close) or perhaps the next day. We will see.
• It sounds a bit like market timing, which I suppose it is. Then again the market dropped 9% and I think the market as a whole is on sale. So why not buy now when I can? Remember, buy low and sell high. I’m apparently in good company because Consumerism Commentary did the same thing.
• We’re sticking with the plan and continuing to put money into our IRAs on a regular basis. Again, long term view… not short term. No matter how painful the short term might be.

We’ll be back to talk about buying our first home tomorrow. I figured a huge drop off in the market was worth talking about.

So, what are you doing? Did you invest anything yesterday or today? Are you scared? Pulling money out of the markets? Leave a comment and share with the group.

Wall Street has tanked over the past week or so. Drops of 3% or more on some days. Even if you listen to my advice about being average, you simply can’t avoid the impact on your portfolio completely. (To do so you would have to be primarily in cash or in investments that go up when the market goes down.)

So what do you do while the market seemingly crumbles around you?

Don’t Panic

I mentioned this when I told you I was witnessing history and avoiding the panic button. Panic filled (or really any emotion) decisions to make drastic changes to your portfolio are probably not going to be the wisest moves. If everything goes down, your gut tells you to sell everything and get into safe investments.

As we all know, that’s buying high and selling low. When things go down you should see it as an opportunity to buy at cheaper prices (if you have additional capital available).

Take a deep breath and step back before you doing anything drastic.

Look at Your Retirement Timeframe

Are you retiring tomorrow? Based on the results of my reader survey, there are few of you in this situation. Most of my readers are in the 20s to 40s age range.

The older you are the less volatility you want in your portfolio. If the market tanked 20% today on someone who is 62, the odds of their retirement accounts bouncing back within three years is pretty slim. For someone at age 25, you’ve got 30 plus years to have your portfolio go up. You’ve got time.

Now for those near retirement, it is time to take a serious look at your asset allocation.

Analyze Your Asset Allocation

Times like these provide excellent opportunities to take a look at our asset allocation. I talked about asset allocation when I rebalanced my Roth 401k. Essentially asset allocation says I want X% in stocks and Y% in bonds or income assets. If the percentages are out of whack, you sell some of the higher percentage and buy some of the lower percentage to get them back into balance.

It’s another way to sell high and buy low.

Look on the Bright Side

If you are continuing to invest in your 401k or IRAs, take a look at the bright side of life. If retirement is far off into the future, you are being given an opportunity to invest more money at lower prices today. Rather than having the market continually going up and investing at higher and higher prices along the way, you’re getting to invest at rock bottom prices. When the market eventually goes up, your shares will be at a lower cost basis than they would have been otherwise.

Oh, and a final note. To help you stay positive, a last piece of advice: don’t check your balances every day. Stay with your automatic investment plan and just roll with the punches.

I’m curious — have any of you out there made any drastic changes to your portfolio due to the financial crisis? Leave a comment and explain what you have or haven’t done.

I mentioned last Friday during the CGM Focus discussion that I would be telling you about the beauty of being average. Today’s the day. Grab your average coffee, sit at your average desk, and read this (probably) average article.

Average is Easy

When it comes down to it being average is easy. It doesn’t require a lot of effort to be average. A ltitle bit of effort and you’ll maintain the status quo. In some cases you don’t even have to have the effort part.

Think back to your days in school. Elementary, high school, college. Were you a below average student? I doubt it. There were very few of those in my experience. The ones that did fall into the category either didn’t show up at all, or put absolutely no effort in. Average is not equal to no effort.

Being above average required lots of work. Studying and working hard to achieve better results. Those that did work hard were usually rewarded.

But it’s that average piece in the middle. There’s nothing wrong with being average. You’re not that group that has to overachieve and be perfect at everything, but you’re willing to at least participate. You’ll take your low B or C and say thanks on the way out the door.

You Want to Be Average in Investing

The beauty of investing is that average should be your goal. You don’t even need to really worry about that extra effort stuff. Average is the place to be.

Why Embrace Average

Here’s how it works: if you chase fund returns, you will earn a return lower than the average of a major index like the S&P 500. If you see an advertisement for a fund in a financial magazine and it is showing off top-tier returns over the last five years, you’re hopping in at the wrong time. That is counter-intuitive. Your gut tells you to jump on the bandwagon at the top.

Unfortunately, over a long period of time (10, 20, or 30 years) those hot funds today will end up being average. Returns will fall, you won’t be able to find their advertisement in the financial magazine (it will be replaced with the next ‘hot’ fund from the fund company), and you’ll wonder what happened.

Going Against Your Investment Gut

Your gut is also telling you that the funds with the bottom-tier returns over the past five years aren’t likely to go up. Again, if you look over a long period of time, those funds are likely to outperform for a bit to get them back to being average. Then again, they could continue to falter and you’re still missing out on the average returns.

Index Funds Guarantee You Average Returns

If your goal is to be average look no further than an S&P 500 index fund like Vanguard’s S&P 500 index (VFINX). I am privy to Vanguard, but with any index fund you are guaranteed to be average. Guaranteed. The fund won’t outperform the S&P 500, and it won’t lag it either. You are locked in on average returns.

You’re Not as Good as You Think You Are

You will again have to fight against your gut. Your brain thinks you are smarter than you really are. You attribute the gains you earn by yourself as skill, and the losses you incur as bad luck. You also do the opposite for other people — if someone earns high returns you will consider them lucky, if they earn poor returns you attribute it to their poor skills. This is called fundamental attribution error.

So if you have a great year by picking individual stocks or individual actively managed funds, your brain tells you it is because you are just so darn great. If your strategy fails, you tell yourself it was just plain bad luck and we’ll do better next year.

With average index returns, all of the guesswork is removed. You earn the return of the index, that’s it. Case closed.

Your Only Concern: Cost

This leaves one decision to the average investor looking to invest in index funds: cost. If Vanguard is offering it’s index fund for 0.15% fund expenses and T Rowe Price is offering their fund (PREIX) at 0.35% fund expenses… why would you ever choose T Rowe Price?

The choice becomes amazingly simple — you pick the fund with the lowest cost. End of decision. Get back to enjoying life. You don’t have to worry how much your fund outperformed it’s benchmark in order to cover for the higher expenses. You earn the average return and don’t worry about it.

Don’t Be Average in Everything

Just a quick reminder that this average thing applies to investing only. There are a bunch of things you don’t want to be average in:

• work or school performance - you don’t want to be fired, do you?
• savings percentage - Americans on average spend more than they earn. You definitely want to avoid this average.
• the effort you put into your marriage
• how happy you make your spouse
• etc.

So, who is embracing average with me? Leave your comments on how you’ve learned to be average.

(Photo by cogdogblog)

A Recap of the Last Five Days

Well, what a crazy week we just had in the investment world. The market seemed to be in a freefall crash. Businesses being allowed to fail, others being shored up by the government. Valuations going all over the place. The media is all over it and I have five paper Wall Street Journals to document this piece of history.

We are living through history right this very second. The bigwigs in Washington are trying to get their greasy hands on $700 billion — with a b — to shore up the financial markets, and in their eyes, the economy.

Some have said this is Great Depression era intervention. Will we learn any lessons from this? Will the markets stabilize or are we just headed for a big downward spiral?

I can’t answer those questions. But I can tell you how to live through it. First, some perspective.

A positive trading week

What would you say if I told you the S&P 500 had a positive overall return last week? Sounds crazy, right?

Well let’s look at the S&P 500 index from the past five business days:

• Monday: Down 4.7%
• Tuesday: Up 1.75% (down 3% overall since Monday)
• Wednesday: Down 4.7% again (down 7.6% overall since Monday)
• Thursday: Up 4.3% (down 3.6% overall since Monday)
• Friday: Up 4% (up 0.27% overall since Monday)

Monday morning the S&P 500 opened at 1,251.70. It closed Friday at 1,255.07. I didn’t believe it when I first saw it either. The way the media covered this past week made it seem like we were headed for the 1930’s all over again. Perhaps we were. Perhaps the Fed and Treasury Department averted the greatest financial crisis of all time. I don’t know. But if you asked the media, the sky was definitely falling.

Imagine Today’s Media in 1987

I can only imagine what the media would have said on that fateful day in October of 1987. Some call it Black Monday these days which can be rather confusing because that term also applies to the 1929 crash. It was October 19, 1987. Something happened in the Hong Kong markets and spread across the globe as the trading day opened up in each time zoon. The Dow fell 508 points. 508 points is nothing these days, but in 1987 that amounted to a drop of 22.6%.

Can you imagine the panic running through the American psyche at the time? Now put today’s media into the situation. It would be really, really ugly.

Compare a 7.6% drop over three days to a 22.6% drop in one day. A significant loss no doubt, but about 1/3 of the pain over three times the time period.

Avoid the Panic Button

As all of this unfolded this past week, I forced myself not to look at any of my investment or retirement accounts. My fear was that panic stricken instinct would kick in and I would sell, sell, sell as fast as I could to avoid further losses. Instead I forced myself to stick with my investment path. Panic selling only helps the people who buy your shares, in my opinion. (That holds true, of course, unless your position goes completely underwater and you lose everything!)

As Wednesday rolled around and the market had dropped more than 7% it became increasingly difficult to avoid checking my balances. Questions roll through the brain at times like these: Exactly how far down was I compared to the market? How quickly could I sell? When will the downward trend reverse? Will I be able to retire? What if I sell and then the market rebounds?

I didn’t have good answers to any of these questions. I was already in the hole and with the fluctuations in the market I did not want to miss a big runup because I got scared. My retirement is many years (20+) in the future. I could ride this sucker out.

Sellers are Kicking Themselves

For those who could not ignore the panic button and sold, they must be kicking themselves today. If you cashed out around Wednesday when the market was at it’s lowest point this week, you not only locked in all of the losses for the week, you also missed out on all of the gains on Thursday and Friday. A double whammy on your portfolio returns.

If they repurchase the shares Monday morning, they’ve not only lost money, their shares are higher on a cost basis for the future.

I’m not saying this may not be the best move in the long run. I can’t predict what the future will hold. If the government’s plan doesn’t work we could see the financial markets drop 20%. Then again, they could go up for a third day straight. In the long run, these small fluctuations are just that. Small. It’s just hard to see that when you’ve got red charts all over your computer screen. So avoid checking your balances every hour or every evening. Stick with your investment plan unless you see a significant, unemotional reason to deviate. Heartburn or antacid medication optional.

Tomorrow the Carnival of Debt Reduction is here on No Debt Plan, so Tuesday I’ll be back with some tips to help you avoid hitting the panic button.

A few months ago I read an article in Kiplinger’s magazine about “The Savviest Stock Picker in America“, Ken Heebner. He runs a mutual fund called CGM Focus.

Eye Catching Results for CGM Focus

The fund was in the news earlier in the year because it had earned in excess of 70% returns in one year. So if you had $10,000 invested with them at the beginning of the twelve month period you ended up with $17,000. That’s absolutely nuts.

It definitely caught my eye, but I would never considered investing with them. That sounds kind of cocky, and I don’t want you readers to think that I believe I could find better returns elsewhere.

I do hold the belief that while some fund managers are able to pick stocks to earn great 1, 3, or 5 year returns… in the long run those funds will return to average. It’s inevitable.

This is a problem for investors like you and I. I had never heard of CGM Focus until I read the report that it was up 70% in one year. That is definitely eye catching. Heck, it was all over the front of the magazine. Unfortunately it is also probably one of the worst times to invest your money with the fund. Why? Again, they had a great year. The likelihood that they generate another year of 70% returns is very, very low.

On top of that, even if they somehow manage to earn those returns for a second year, they won’t be able to maintain those returns for all of the years from today to your retirement. You would have to know when to sell your holdings in the fund at the top before returns drop to historical averages. Trying to time the market has been proven to be near impossible and timing what a mutual fund is going to do is just as difficult.

What Goes Up, Must Come Down

Here’s a shot of CGM Focus’ returns since the beginning of January 2006. From the beginning of 2007 to the first high point toward the end of 2007 the fund returned 80%. Notice if you had invested at the high point, it dropped going into 2008, but then rebounded.

Let’s assume you did invest toward the top, experienced that drop going into 2008, but stuck it out and it rebounded to where you invested in. You are feeling better and decide to stick it out.

If you stuck it out, you’ve seen your investment drop 28% in the last three months. Ouch.

But what about compared to the S&P 500?

Over the last 12 months, CGM Focus and the S&P 500 have very similar returns. CGM is down 17.82% and the S&P 500 is down 18.02%. Sure, CGM has been affected by the credit crisis and the turmoil in the markets. Their stock picks could rebound very quickly.

Then again, they could also trail the S&P 500 or just match the S&P 500’s return. And with an expense ratio of 0.99%… you are paying a high cost to be average.

The Better and Easier Path

Instead of chasing the hottest mutual fund returns, the easiest option is to grab some broad index funds that charge low expense ratios. You can get Vanguard’s S&P 500 Index (VFINX) for a mere 0.15% expense ratio. That ratio is 0.84% less than CGM Focus, and you are guaranteed to be average.

(Being content with being average is something I’ll discuss next week. Seriously, it’s a good thing.)

For now, what do you think? Had you heard of CGM Focus before reading this post? Did you invest?

I’ve had several magazine subscriptions over the past four or so years. Money Magazine and Kiplinger’s for personal finance. Inc. for small business and entrepreneurship. Bimmer magazine for my BMW fix. I also was a member of the BMW Car Club of America (BMWCCA) and received their awesome magazine, Roundel.

You would think I might read the magazines, enjoy the articles, and throw the magazine away. You would be sorely mistaken.

It seems my ‘thing’ is to take these magazines and put them in a box. The box goes in a stack with other boxes also full of magazines.

Why keep old magazines?

I’m sure my wife would love a logical explanation as to why I do this. I keep the personal finance magazines with the thought that someone might ask me a question on a specfic topic, and I would remember it was in one of my magazines recently. I could think go digging through the boxes, flipping through the pages, in hopes of finding that golden nugget of information.

I kept the car magazines because of the nice photography on the covers. I planned to one day have a “man room” and I would decorate the walls with these awesome magazine covers. Or perhaps I could put them up in the garage.

The Lure of “Stuff”

I had plans for those magazines in those boxes, but I’ve rarely used or looked at them. Last year I went through and purged a lot of the personal finance magazines because they were no longer relevant. I need to do it again, but I don’t want to lose valuable information. I need a system to deal with this stuff.

The car magazines, admittedly, I have held onto. I don’t know if I’ll ever put them up like I originally planned to. They don’t take up too much space for now.

This is a classic tale of how stuff works its way into our lives. Perhaps you’ve got boxes of computer equipment that is old, but you can’t force yourself to get rid of it. Or an old digital camera, laptop, or clothes that don’t fit.

It’s the lure of stuff. It seems to seep through the window sills and under the doors until we are surrounded with it. I think we do a pretty good job of keeping it at bay, but I’m always interested in new tips.

So dear readers, tell me, how do you fight “stuff”?

If you’ve been following No Debt Plan for a few months you’ve probably caught on that we are debt free (expect mortgage and my current small student loans still in deferral). We’re on our way to building wealth — to financial freedom. I’ve got a 401k, my wife’s school system has a retirement plan, and we’ve opened up a Roth IRA in my name with Vanguard.

We also recently just completed our 3 month emergency fund. We’ve also saved up some money for a planned trip to New York City next summer. We seem, for now, to be in good financial position.

Our Roth IRA contributions come out each month (manually). The plan is to max them out every year — this is our first year so we are paying into the IRA with rather large payments each month so we can max out before April of next year. If we can somehow swing it, we’d eventually like to max it out by the end of December for that tax year.

My IRA is nearing it’s limit for this year; we need to open an account in my wife’s name. However, with Vanguard you need $3,000 to invest in all but one of their funds. At our current rate of saving it would take two or three more months to get to that point (we have some saved already).

I am considering taking money out of the NYC trip fund and opening the IRA at the end of this month. We would then be invested in the market, have the account open a few months earlier, and pay back the “loan” to ourselves over the next two or three months.

I don’t see any major flaws in this plan, but wanted my astute readers to think it over and give me their thoughts. Remember, we have an emergency fund and there are no expected drops in income coming. Our cash flow should remain steady, leaving us with this money to save/invest every month.

Summary:

• 3 month emergency fund
• NYC trip fund
• opening up new Roth IRA, dipping into NYC trip fund and paying it back over the next few months

Do you see any flaws? Would you do it?

Back in March, I wrote an article that I titled “Should You Invest in Visa?” At the time, Visa was very new to the stock exchange, having just experienced their IPO. At the time there was a lot of hype surrounding the stock. People compared it to Mastercard which had experienced 381% growth over a two year period.

I argued at the time that there was no guarantee that Visa would experience the same growth. I also mentioned that my wife and I would not be investing in Visa because individual stocks did not match our current goals. (If they had, I would have looked at Visa.)

So, was it a good call? Let’s take a look at Visa’s stock price since then. March is the furthest back the chart goes on the left.

As you can see about one month later at the end of April, Visa began to climb, dipped a bit, and then settled back down in the mid 70’s. As of the close yesterday, August 14, Visa traded at $75.78.

Should you have invested in Visa?

As you might imagine, “it depends”.

• If you bought at $60, when I told you I wasn’t buying, you’ve earned a 26% return (before trading costs). That’s very, very healthy. You look like a genius.
• If you bought into the hype, but wanted to see if Visa was going to be like Mastercard you may have gotten burned. If you waited until the top — $89.84 — you’ve lost 15%. I look like a genius.
• If you bought somewhere in between you might not be content because your investment hasn’t gone much of anywhere in 5 months.

What’s the lesson here? Don’t look at short term gains. Even if you bought at the peak of almost $90, you may still be getting a steal on Visa if it jumps to $250 per share. Then again if Visa never rises above $80 again, you’re going to take a loss on the shares.

I stick by what I said back in March. Buying individual stocks is not part of our plan right now. I prefer diversification with the size of our portfolio currently. In the future, I might dabble into individual stocks with up to 5% of our portfolio. Right now that 5% isn’t even worth trading because the trading costs would be too large of a percentage of the investment.

I’m going to continue to track Visa. I’ll be happy to admit when I’m wrong. Again, it depends on your goals. Right now, buying Visa doesn’t make sense for our portfolio.

What about you?

There used to be a mantra in personal investing that helped define your asset allocation. Essentially, you took 100 and subtracted your current age. The result was how much of your portfolio should be invested in stocks. The remainder would be invested in bonds.

However, times have changed. People are living longer and want to retire earlier. That means your portfolio needs to last much longer — it’s being stretched both ways. The old rules are being replaced.

It’s time for a new rule of thumb

If we applied the old heuristic, at my ripe young age of 24 I would have 76% of our portfolio in stocks. 24% of my portfolio would need to be in bonds. That seems absurdly conservative. Correct that, it is extremely conservative.

I’ve read in a few personal finance magazines that a new rule of thumb is being applied. Instead of subtracting your age from 100, you subtract from 120. A simple change, but a significant impact. It moves the bar up 20 percentage points.

With the new rule of thumb, I should have 96% of my portfolio in stocks. That seems more accurate. I’ve got at least thirty year to retirement. I can take the extra risk.

Why stocks are important

You might be thinking “So what’s the big deal if 16% of your portfolio is in bonds? I thought bonds were safe investments.”

It is true that bonds are generally safer than stocks… and due to this returns are going to be lower over the long term. Stocks carry a risk premium. As an individual investor, you need incentive to take risk. That incentive with stocks is — over the long run — higher returns. If you couldn’t earn higher returns in stocks then everyone would invest in safe assets like bonds, CDs,  and saving accounts. There would be no incentive to take the additional risk.

Stocks provide portfolio growth in the long term. Since my investment horizon is so far out, I need to maximize my opportunities for growth. Stocks should trump other investments over the next 30 years.

A Word of caution

Any heuristic — or rule of thumb — should be used with a grain of salt. They all will have flaws in different situations. Whether it be the 120 minus your age formula or looking for stocks with a low P/E ratio, don’t just use the ideas without any deep thought on your part.

For me, the 120 rule seems to work. We’ll slowly adjust our portfolio to become more conservative over time. Our target retirement funds will make that pretty easy for us as well.