chipmunk

Break time

2010-02-04T18:33:51Z

I'd just like to share this with my fellow Morningstar posters. I need a break from posting for a while. There have been times when posting here has been, shall we say, an obsession, and I need to step back for a while. A couple of my fellow posters here even pointed this out, and they were correct. There are more important things in life. Yes, it is important to pay attention to personal finances, saving, and investing, and these are necessary for day-to-day life, but they should not be the focus of one's life. An occasional basic question answered here is fine. The older I get, the more I think that an all-in-one balanced or target retirement fund or even just CDs in the bank might just be the best way to go. Let's face it. None of us can outguess the direction of the markets, no matter how hard we try to hedge or perform market timing. We can spend countless hours here researching, and still get no where. Stocks, bonds, currencies, commodities, precious metals, and real estate can all fail, even after we make informed decisions, and there is nothing we can do about it.

Dan

Q&A for chipmunk's Dollar Hedge portfolio

2010-01-04T03:34:34Z

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Q&A for chipmunk's Chipmunk's 2010 Mutual Fund Contest portfolio

2010-01-01T17:51:15Z

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Q&A for chipmunk's Go for Broke Yield portfolio

2009-08-12T00:32:31Z

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Q&A for chipmunk's High Yield Retiree portfolio

2009-08-09T12:57:36Z

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Q&A for chipmunk's Indexed Accumulator portfolio

2009-08-08T14:50:57Z

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Focused intensity for the 21st century

2009-07-30T09:29:00Z

I'd like to title this blog "focused intensity for the 21st century." Clearly, using debt with no savings, spending without a plan, and having few investments was a poor 20th century plan, so we need a new plan. In my opinion, success in personal finances and in life in general is all about focused intensity. We here at M* discuss a lot about investing, but that is only one part of the whole personal finance picture. We discuss the math behind investments, but rarely discuss how us humans actually operate. The 20th century was full of "multitasking" and being unable to focus on a single task at hand. Discussions about active-versus passive or income-versus-growth are meaningless unless one's overall financial picture is strong. We need something new for the 21st century.

What do I mean? Well, a person needs to have very specific goals, and then execute them one at a time in a logical fashion.

Specifically, I'm talking about Dave Ramsey's seven baby steps. Yes, they really do work. Here they are:

$1,000 to start an Emergency Fund
Pay off all debt using the Debt Snowball
3 to 6 months of expenses in savings
Invest 15% of household income into Roth IRAs and pre-tax retirement
College funding for children
Pay off home early
Build wealth and give! Invest in mutual funds and real estate.

Now, some here at M* argue that it is too hard to save 3 to 6 months for the emergency fund, or that having debt is a good thing because you can invest it and "make the spread." Or, you can simply tap investments if you need some cash (likely at a loss). Or, you can simply invest while you're in debt, while you're trying to do three other things simultaneously. Hogwash! I contend that this is old 20th century thinking that lead to the collapse of the housing bubble and the subsequent recession. This business cycle is predictable, and will force an emergency on you even if you don't already have one like divorce, serious illness, job loss, etc.

For you farmers out there, here is an analogy on the emergency fund. You can't eat your entire harvest each year. You need to hold some seed in reserve for planting next year, plus some extra seed for those years where you may not have a crop due to drought, etc.

This stuff can be done, and it really works. The key is to intensely focus on one goal at a time before proceeding to the next goal. Instead of following the culture's ADHD of doing three things at once and never accomplishing anything, focus each day on one goal at hand.

Dan

How bonds work

2009-04-07T21:42:00Z

I noticed that when I post on bonds, the M* community often votes my post up. Thank you very much! That gave me the idea to post a blog here.

As most ordinary investors like myself know, the major asset classes are cash, bonds, and stocks.

A lot of investors seem to be comfortable with cash and stocks, but get lost when it comes to bonds. I thought I would share a simple, straightforward explanation of how bonds work.

First, what is a bond? According to InvestorWords.com, a bond is:

"A debt instrument issued for a period of more than one year with the purpose of raising capital by borrowing. The Federal government, states, cities, corporations, and many other types of institutions sell bonds. Generally, a bond is a promise to repay the principal along with interest (coupons) on a specified date (maturity). Some bonds do not pay interest, but all bonds require a repayment of principal."

Bonds are riskier than cash but not as risky as stocks. Basically, you have a wide spectrum of risk involved, from government/AAA down to junk. You also have foreign and emerging market bonds.

The total return of a bond is the total of its periodic payouts plus the original amount borrowed. For a bond fund, the total return is the total of its periodic payouts plus or minus the gain or loss.

Bonds can go up or down in value just like stocks. Bonds are priced quite efficiently in the market, that is, the price and the yield pretty much reflect the risk involved. This is one case where cost (expense ratio) of a bond or a bond fund really does matter because the lower expected return of bonds compared to stocks means expenses affect the returns.

What are the risks? There are a lot of risks to consider, but the ones most investors are concerned about are default risk, duration risk, and inflation risk.

Roughly speaking, here is a list of types of bonds, from lowest risk of default to highest risk of default (this is not exact, but only approximate):

U.S. government (bonds, bills, notes, and TIPS)
U.S. government agency (GNMA, etc.)
Municipals (munis) (federal and/or state tax-free)
Foreign sovereign (government) and sovereign inflation-protected
Investment grade (high quality corporates)
Foreign corporate
Emerging market debt
Junk/high-yield (corporates below investment grade)

The longer the duration, the higher the risk because longer term bonds are more sensitive to interest rate changes than shorter term bonds. The reason is that if interest rates rise, the holders of the long-term bonds are stuck with the older, lower rates, so the values fall. Conversely, if interest rates fall, the long-term bonds will rise in value. In other words, interest rates and bond prices are inversely proportional. Shorter term bonds can react quicker to changes in interest rates because they can be replaced by new bonds after the old bonds mature. So, shorter term bonds have a lower risk/return, while longer term bonds have a higher risk/return.

Since inflation is always a consideration for bond investors, U.S. Treasury Inflation Protected Securities (TIPS) are a great tool. TIPS have an advertised fixed real rate that is guaranteed, with an additional rate (positive or negative) tied to inflation as measured by the CPI. Other countries are also starting to issue inflation-protected bonds.

From a tax perspective, bonds belong in a tax-deferred account like a 401(k) plan or a traditional IRA. The reason is that they are tax inefficient due to the dividends they throw off. That is why you have tax-free muni's, i.e., for those who want bonds, but have no room in tax-deferred.

Most experts I've read (and I am NOT a professional) say to keep the quality high (average quality government/AAA or AA) and the duration short (average duration 5 years maximum), and I agree. The reason is that you want bonds to buffer the risk of a portfolio, i.e., if your stocks go one direction, you want your bonds to go the opposite direction. This is best done by keeping the risk of your bonds low, i.e., not stretching for yield or duration. Some argue that high-yield is important in retirement, and a good case can be made for that strategy, where the objective is income and not rebalancing a basket of asset classes. However, for those in the accumulation mode, this basic strategy is a good one.

I hope my perspective helps, and happy investing!

Dan

Hurrah for boring!

2009-04-29T16:41:00Z

I was just sitting here thinking about all the slick new investment techniques that have been invented over the past century. Here are a few:

Buying on margin (using debt)
Options (puts and calls)
Shorting
Setting stop losses
Long-short (market neutral) funds
Bear market funds
Long, 2x long, and (gulp) 3x long ETFs
Short, 2x short, and (gasp) 3x short ETFs
Technical analysis (trendlines, moving averages, etc.)
Market timing
Tilting to value, dividends, REITs, small-caps, etc.

This is enough to make your head spin! You could spend countless hours doing research, and still end up losing money, in which case all that time you spent researching could have been put to more productive use. Plus, countless studies show that the average investor does poorly with these techniques -- often buying high and selling low or getting eaten alive by pointless trading costs that only makes money for the brokers.

Here's a thought. What about something I like to refer to as 'basic strategy.' Yes, I know, it is boring and unsophisticated, but it not only works long-term, but it helps support business and the free market system by providing a steady flow of capital. Plus, you don't have to spend needless hours researching 'new' investing techniques (thus, freeing up your time for more important things, like bidding on that Batman Pez dispenser on eBay to finish your collection).

Okay, here is the secret: Set an asset allocation that becomes more conservative over time, pick low-cost funds to fill those asset classes, and then rebalance. Or, pick an all-in-one balanced or target retirement fund and set-it-and-forget-it. Oh yeah, dollar-cost average too. That means, keep investing each and every month, regardless of what the market is doing. Be patient, and think long term. The best way to get rich quickly is...to get rich slowly.

That's it, but I just want to say 'hurrah' for boring! How exciting is that? ;-)

Dan

The scoop on mortgages

2009-04-16T12:40:00Z

I'd like to share my knowledge on mortgages, so here is the scoop from having been through the mortgage process many times.

There are many types of mortgages, including fixed-rate, adjustable rate, interest-only, and 80/20. There are also conventional, FHA, and VA.

A fixed-rate mortgage can be 15, 20, 30, or even 40 years. The interest rate is fixed throughout the life of the loan. An adjustable rate mortgage (ARM) starts off with a low "teaser" rate that is typically easier to qualify for, but then adjusts one or more times. An interest-only mortgage, also typically easier to qualify for, is one where you pay the interest only, so the balance is never reduced. An 80/20 mortgage is actually two mortgages: one for 80% of loan-to-value (LTV), and a second for 20% of LTV. This avoids the problem of private mortgage insurance (PMI), which is required for less than a 20% down payment, but is almost always more expensive than paying PMI. PMI is insurance that you pay to protect the lender in case you default on your loan, and it can be expensive.

A mortgage is either conventional, FHA-insured, or VA-insured. FHA and VA mortgages typically have stricter inspection requirements than conventional mortgages, and thus tend to be more expensive on closing costs and sometimes also have a slightly higher interest rate. FHA mortgages allow smaller down payments than conventional mortgages. VA mortgages can be made with no down payment at all if you are a veteran.

There are also jumbo mortgages for balances that exceed the norm for a particular area of the country. These typically have slightly higher interest rates due to the added higher risk.

Investment properties (non owner-occupied) typically have higher interest rates, also due to the added higher risk.

Closing costs, like interest rates, vary by lender. Points and origination fees are both prepaid interest, and are equal to 1% of the loan amount. These are sometimes paid up-front in exchange for a lower interest rate.

The ideal mortgage is the 15-year, fixed-rate conventional mortgage with at least 20% down. It can often be paid off even sooner than 15 years, thus freeing you of the debt as quickly as possible.

Prior to getting a mortgage, you should be completely debt-free with a fully-funded 3-6 month emergency fund. Never buy a house with no money in the bank, as that is asking for trouble. Things can and do go wrong, and you need some cash to handle the emergencies that may occur after you move in.

The monthly payment is sometimes referred to as PITI:

P = Principle (portion of amount borrowed)
I = Interest (interest paid on the balance)
T = Taxes (escrowed and paid by lender annually)
I = Insurance (escrowed and paid by lender annually)

Sometimes there are additional fees, including:

PMI if LTV is more than 80% (usually added to payment)
Subdivision or condo/townhouse fee (usually paid separately)

The total monthly payment is equal to PITI plus these additional fees, if applicable.

The rule of thumb for a mortgage payment is this. The payment should be no more than 1/4 of your monthly take-home pay. Lenders will usually qualify someone for more than this (formula is a percentage based on both total debt and mortgage debt only), but, as we have clearly seen by the recent housing market collapse, this is dangerous.

I am quite conservative, and most people can easily bypass the steps I outlined, but the more steps you skip, the more you put your financial life at risk. In fact, if you take things slowly and patiently, you can often get a deal on a home. Patience is the key word for buying a home, so don't get house fever and end up making a mistake that could take you years to correct.

Dan

Q&A for chipmunk's Simple Global Index portfolio

2008-09-16T20:16:08Z

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