Evaluating Risk and Reward

We all take risks, especially when investing our hard earned money. And, most of us have heard that risk and return are closely linked. Risk is an important factor in asset selection, because if you select an investment that is more volatile or goes down more than you can handle, you may be tempted to make irrational choices at the wrong time – such is typical of the “sell low and buy high” crowd.

As I approach the brink of financial independence, I want to reduce my risk. I won’t need to take so many chances anymore. I will have enough. Of course, I do not want to eliminate all risk as I believe some is necessary to continue to grow, slow and steady. So, how does one go about assessing risk?

It’s easy to calculate the returns on investments, but evaluating the risk is much more nebulous. Everyone has a different definition of risk and how to quantify it. One approach that I have used in the past applies the statistical measure called standard deviation.

Standard Deviation can be calculated based on returns over several years and provides insight into how often an investment's return is different than its mean return and by how much.

How much return does risk-taking buy you? To help answer that question, I created the following table with data that was pulled from this Matt Krantz article in USA TODAY. The analysis begins with the average annual compound returns and standard deviation for several asset classes over a bunch of years. The return data was derived from the market research firm Global Financial Data.

From there, I calculated the 68% confidence intervals for one standard deviation. For normally distributed data, 68% of the values will be within one standard deviation of the mean, while 90% will be within 1.645 deviations of the mean. So, it is very likely that the return for an investment will fall within the minimum and maximum values provided in the table. I then determined the return to risk ratio for each investment type.

The return/risk ratio is the amount of percentage points of return that can be expected for every percentage point of risk. In other words, how much risk is involved in achieving the return. Volatile investments, with average or poor returns, such as oil and emerging markets, have low ratios.

With a little bit of study, the table can provide some valuable information. For instance, you may notice that value-priced stocks have beaten the S&P 500 and are considerably less risky. In fact, its even money for value stocks. Surprisingly, corporate bonds have an excellent ratio providing good returns for low volatility, while municipal bonds do not appear to pay out enough to compensate for the downside risk.

Housing is another interesting asset class that has an extremely low return to risk ratio. It averages 3.5% return, but it has significant volatility. This is one of those asset classes that is difficult to make a broad assessment because property values vary considerably with location. While I have seen steady appreciation in my neighborhood, others have seen sky-rocketing home values and now plunging prices. Another thing to keep in mind when looking at this data is that some of these assets, like gold and housing, have not historically been considered investments.

One other item of note is the years column. This indicates how far the data series goes back – the more years, means more data and more reliable numbers. Gold is the only asset class with data for more than 200 years.

What other information can you glean from this data? Were you surprised by the return to risk ratios associated with certain asset classes?

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The Fed has thrown Granny under the Bus

The recent series of Fed rate cuts are great for banks, lowering their lending rates to each other and encouraging more liquidity, but this action is also sacrificing the rates of return on fixed income accounts, CD rates, and money market accounts, etc. For example, over the last few months, the interest on my brokerage money market account has dwindled from 5.21% to 2.46%. CD rates are not much better ranging around 3.2% to 3.7%. Given the latest Consumer Price Index, CPI, recently reported at 4%, these fixed income assets are a losing proposition. To make matters worse, I think most consumers would agree that 4% is a low number and that the real rate of inflation is higher.

The impact of this rate decrease to my standard of living is inconsequential. I am still working, still making new money, but this is getting ugly for a lot of retired folks on fixed income with a majority of their nest egg in CDs. A huge portion of their income is derived from interest earned from CDs. The Fed has thrown these people under the bus.

If your grandparents are anything like mine, they do not trust the stock market. Years ago the market was akin to gambling and many still think it is today. Consequently, their investments are much more conservative and are concentrated in low interest earning bank accounts, CDs and bonds. According to a common Bogle formula for stock to bond ratios, that is exactly where they should be invested. If you are 90 years old, you should have 80% or more of your assets in fixed income vehicles.

So, what can one do in this situation? What other options are out there? In the following, I have a listed a couple of ideas, but just remember this information is for educational purposes and is not a recommendation to buy.

1) Municipal Bonds
If you can get granny to open a brokerage account (good luck with that) now is a great time to invest in municipal bonds. Munis are paying decent rates and are very attractive compared to Treasury bonds. They are also free of federal taxes and some are even free of state taxes.

2) Canadian Oil Royalty Trusts
For someone who is willing to take on a little more risk, like myself, I am exploring adding more Canadian Oil Royalty Trusts, or Canroys, to my portfolio. There are several Canroys out there paying dividends of 6% to 15% and a few that trade on the NYSE.

I already have a small position in Harvest Energy Trust (HTE) and am considering adding to that or purchasing another Canroy. However, before I make a much bigger investment, I want to further research the risk versus reward of Canroys and of course write a blog post or two about that.

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Paying off a Mortgage is not for everyone

Sometimes we don’t realize the potential impact of our own words. A casual conversation or blog post ;) about personal finance can have unintended consequences. It’s important to understand that everyone’s situation is different. One financial strategy does not fit all. I came face to face with that reality recently when discussing accelerated mortgage payments with a couple of co-workers.

One colleague feels the hand cuffs of being in debt. He is working to pay down endless debt and is eager to break out of the cycle. He mentions that because of his obligations, he is overly dependent on his employer. He would love to have more freedom, to just know that he could walk away, if he really wanted to. If you have ever had a bad boss, you will understand this desire to be free from the shackles of a job.

The other co-worker is not comfortable with investing in the stock market and sees paying off a mortgage as a guaranteed 6% return. I nod and agree with both of them and add to the conversation that I have paid off my mortgage. They are impressed and inquire - What is it like to have all that extra cash each month? I reply that it's great, but not like they think. I explain that once I paid off the house, I re-routed the mortgage payment money straight to my investments in Vanguard. My standard of living has not budged an inch.

The idea of being mortgage free was appealing to both of them and I could see the wheels turning in their heads. I didn’t give it much thought, a lot of people want to pay off a mortgage early, but very few actually carry it through.

To my surprise, one of the co-workers came to work a few days later and stated that he had paid off the balance of his mortgage! The other mentioned that he was paying extra towards his mortgage, a lot extra. Yikes!

I would have never advised either one of these guys to do what they did. I firmly believe in the maxim that - it takes money to make money. And a mortgage is a great way to leverage money, that is, to use someone else’ s money to make money. That is a proven way to get ahead and reach financial independence. I paid off my mortgage only because I had a high percentage of assets invested in equities (way too high). I wanted to diversify and real estate was a good choice for my portfolio.

Because neither of these guys was comfortable with selecting investments and didn’t want to do the due diligence, they took the easier road and paid down their debt. That's not all bad, but someday they should take the time to learn to invest or hire a financial advisor and do more with their discretionary income than just put it in savings.

This week I participated in the Carnival of Money, Growth and Happiness #39. My article, How much money does it take for you to FEEL rich? was included.

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Replace the Magic Ball with a sound Asset Allocation Plan

Thanks to FinanceBuff for pointing out the Chris Farrell column over at publicradio.org. His recent article responding to a question about the Market Turmoil was straightforward and right on target. A reader asked what should one do in this market crisis? Should we ride it out or sell stocks and buy safer investments? It's the usual magic ball question. “What does your magic ball say about the future of the market?”

Farrell simply advised that one should:

take advantage of this time by figuring out whether you're comfortable with your portfolio. Are you too much in stocks? Bonds? International? How do you wish your portfolio was constructed? Once you've figured that out, then I would create that portfolio over time.

That is excellent advice. Do not allow yourself to be whipsawed around by the market. Get a plan together and stick with it.

To that end, I have been reviewing my bond allocations. I know that they are too low, however, I am not quite as conservative as some investors. For example, the rule of thumb put forth by John Bogle is that the allocation of bonds in your portfolio should be about 10 percentage points less than your age. So if you are 40 years old, aim to have 30 percent in bonds.

“As you get older, you want more bonds; bonds produce income and time is less on your side to recoup losses,” he said.

Once you settle on an allocation amount, it’s essential to be aware of some other significant aspects concerning bond ownership. For instance, most bonds distribute income, and it is important to shelter that income from taxes, if possible. You will want to select a different type of bond depending on what type of account you are wanting to fund. Starting with

Taxable Accounts:

“For taxable accounts, municipal bonds are extraordinarily attractive compared to Treasury bonds,” Mr. Bogle added. He suggests half short-term bonds (one to two years) and half intermediate-term bonds (six to seven years). When interest rates go up, so will the income on the short-term bonds.

To purchase municipal bonds, you will need to have a brokerage account. It helps to have a broker, who will notify you of new issues. But, you can also research and purchase existing munis from brokerages.

Non-Taxable Accounts:
For retirement accounts, like IRA’s, “inflation is a big, big worry,” he said. “Everybody should consider a significant holding of U.S. Treasury inflation bonds or TIPS.”

So what are TIPS? Treasury Inflation Protected Securities, known as TIPS, are securities whose principal is tied to the Consumer Price Index. As inflation grows, the principal increases, while with deflation, it decreases. When the security matures, the US Treasury pays the original or adjusted principal, whichever is greater.

Here is an informative article by The FinanceBuff about purchasing TIPS at auction. You can also acquire TIPS in a mutual fund, such as VIPSX, which is a low expense, Vanguard fund.

As part of my 2008 financial resolution, I want to increase my bond holdings in my retirement accounts. I plan to accomplish that in two ways 1) Convert some existing shares in my traditional IRA to VIPSX and 2) Add the $5000 IRA contribution allowed for 2008 to VIPSX.

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How much Employee Stock is too much?

I work for a large corporation and through my 401(k) I have invested in the company stock. The company has also given me stock as a match to my contributions and I have been fortunate to receive stock options. All of this means, I have a lot of shares in "big mama" corporation.

In fact, my company stock as a percentage of my total portfolio continues to increase steadily. Over the last 6 months, it has grown to 15% of my total holdings. The growth is not so much from the stock appreciating as it is from my other assets shrinking in value!

According to most financial advisors 15% is way too much invested in a single stock, and way too much invested in my own employer. Most financial planners advise that no more than 5% or your retirement portfolio be concentrated in your company stock.

Gee, my company stock has actually been one of the few bright spots in this market. It has held it’s own throughout this credit crunch ordeal, while nearly all other assets have plunged 10 to 20%.

From the beginning I have always rationalized that my employer’s stock is different, it’s a defensive stock, somewhat of a hedge against the market. To this day, that reasoning seems to have been right on target.

However, I have this eerie feeling and can’t help but wonder if Bear Stearn’s employees made similar assumptions. Thinking that Bear was just too big and too important to the US economy to ever fail. Of course, Bear wasn’t allowed to fail, but with the revised rescue plan, the value of the company stock owned by Bear employees is now worth a tenth of what it was just three months ago.

Can you imagine that? Your 401(k) dropping in value from say $200,000 to $20,000 in less than 90 days? Whether you are young or about to retire that has got to sting. Have we not yet learned our lesson from Enron and others about the pitfalls of owning too many company shares?

This NY Times article provides some interesting stats about company stock plans.

In 2001, when Enron filed for bankruptcy, investors in 401(k) plans that offered company stock held 28 percent of their retirement account in employer shares, on average, according to Hewitt Associates, the employee benefit research firm. By the end of last year, that figure had dropped to 16 percent.

That’s a big step in the right direction, but it’s interesting that the article also points out that some 401(k) participants are still making huge bets on company stock.

At the end of last year, nearly two of every five 401(k) participants were putting 20 percent or more of their money into employer stock, according to Hewitt. And about one-sixth of participants were investing half or more of their nest eggs in it.

It seems that familiarity with one’s company stock is a big factor. It’s probably comforting to many employees to buy stock in what they know best – their own employer. Isn't that what the luminaries of investing such as Peter Lynch and Warren Buffet have been telling us all along - invest in what you know?

I am willing to risk a little more than 5% in my company stock and a little less than 15%. My goal is to get the allocation back around 10% and maintain that for the long run.

For more personal finance information check out the Money Hacks Carnival #6. My article, "The Real Cost of Outsourcing Tasks" was included.

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Rebalancing when its UGLY out there

If you're like most investors, your portfolio has seen some pretty dramatic swings in the last 3 months. The S&P 500 has declined 19.4% since its high mark in mid October 2007 to its recent low on January 23, 2008.

And because some assets go up or stay steady while others fall, your asset allocation is probably out of whack by more than just a percent or two. It’s probably time to rebalance. Argh. Nobody wants to sell their winners and feed the dogs, c’mon. There has got to be a better way.

The best way I know to keep an allocation balanced, is to adjust my dollar cost averaging scheme. I prefer to affect the rebalance by adding new money to the asset that is lagging. I am able to stomach that more easily since the purchases are in small chunks and I am letting my winners run. I also adhere to the classic rationalization that I am buying more shares at cheaper prices.

When my asset allocations start to deviate from my plan by more than a couple of percent, I take action. I begin by redirecting a DCA purchase from a winner to the lagging asset, which could result in doubling up on the amount of money going into a particular asset.

VGSLX is at the top of my laggard list. It’s a Real Estate Investment Trust fund and it’s the worst performing asset that I own. However, it is a permanent holding, meaning it is part of my diversified portfolio that I plan to hang on to forever. Forever is a long time and certainly this fund will rebound given some time.

Of course, we would all like to buy in at the bottom. I keep watching VGSLX gyrate up and down, but mostly down. How bad are things going to get? Is the economy going to slow down even more? With all these uncertainties – it’s a good thing that I have DCA or I might never buy in!

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Gold ETFs – The good, the bad and the taxes

I have a small allocation of my holdings in GLD. It’s an ETF that owns gold bullion. Each share is valued at 1/10 of an ounce of the Gold spot price. It has performed extremely well over the last 3 years that I have held a position in my portfolio.

Gold is often considered a haven in times of crisis. It’s price typically moves in the opposite direction of the dollar. It certainly provides diversification in a stock portfolio.

However, it also tends to attract emotionally driven and speculative investors who can add to its inherent volatility. In addition, it has much less practical use as other precious metals like copper and silver, making it conducive to even more speculation. Consequently, as gold has been reaching all time highs as of late, I have decided to set a target sell price. I plan to sell the ETF when it reaches that target.

Even though I will net a large gain in the sale, I have actually been dreading that sell date. Because, the ETF owns gold, it is considered to be a collectible and is taxed at nearly twice the rate of capital gains. Therefore, I will have to report it as gains from the sale of collectibles and pay a rate of 28% on those gains. There is no way around this – even though some have suggested reporting it as a stock trade and paying only the 15% rate. That's a good try, but when I make the sale, my broker will supply the IRS with that record, so trying to get around this would not be worth the risk.

It’s interesting that if I had sold the shares after holding for less than one year, I would get a lower tax rate. The short-term capital gains rate for gold or silver ETF shares is the same as for other investments: your ordinary income tax rate. The IRS is essentially encouraging short term trading of gold!

Yes, I know it’s a good problem to have. It was a successful investment. Unfortunately, not only do I not want to sell, but because of the extreme tax rate, I do not plan to buy any more shares of GLD. This 28% tax is so onerous that it actually stifles business transactions.
Instead of purchasing gold in the future, I plan to add to my holdings in gold mining stocks, which are taxed like any other stocks.

Now, before I completely eliminate the possibility of ever having gold bullion in my portfolio there is one other way that I could possible buy gold again. This may be surprising to some…..

Even though the IRS considers gold to be a collectible and collectibles are not allowed in an IRA, the IRS has made an exception. As of August 10, 2007, the IRS privately ruled that:

Shares of ETFs in the form of a trust that mirror the price of physical gold and silver do not constitute an acquisition of a collectible if they are acquired in an IRA.

The IRS has created yet another double standard. As a result, a gold ETF in an IRA will not be subject to the 28% long-term tax rate on collectibles. So there’s no reason (at least at this time) to worry about avoiding the collectibles tax rate when holding gold or silver ETF shares in an IRA.

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Speculate some, but Diversify more to build Wealth

CNN money has an interesting article on how the experts invest. As you might expect not all of them follow what they preach/teach.

The article presents results from a survey that was conducted of more than 600 finance professors at major U.S. universities to find out how they invest their own money. The survey found that in their classrooms, these professors lecture on complex theories of how markets balance risk and return, while in their portfolios only two-thirds of the professors have diversified the bulk of their assets into index funds.

What about the other one third? They are throwing the theory out the window and chasing stocks based on price growth - not fundamentals.

It seems that a lot of these professors are just like the rest of us. We all know how hard it is to beat the market, but we never stop trying. We are not satisfied with getting anywhere slowly.

The article culminates with some interesting lessons from the survey.

First, whenever anyone tells you that research "proves" a novel method of investing is a market beater, bear in mind that the professor behind the paper is most likely an indexer who has never road-tested his theory in the real world of trading costs, taxes and other expenses.

Second, remember that even many of the people who know best can't resist chasing hot stocks, so you have to control your behavior in advance.

Get rich quick schemes rarely work. Since it is so difficult to control this tendency to chase the latest trend, hot stock, etc, why not strike a compromise? You don’t have to give up completely on trying to beat the market, but you must have a foundation. Just in case you don’t hit it big!

Why not develop a diversified core holding of index funds and then enhance that with a handful of select stocks? This allows for some speculation to feed those "get rich quick" tendencies we all seem to have, while still ensuring that the majority of your funds are working towards "getting rich slowly".

Free Portfolio Analysis by Vanguard

Vanguard offers a portfolio evaluation tool called Portfolio Watch, as part of its Voyager select services. The analysis compares your stock and mutual fund investments with overall market weightings in terms of capitalization, style, and industry sector. The concept is that the more your holdings vary from the market bench marks, the greater the probability that your returns will differ, higher or lower, from the market.

The exam included an evaluation of overall market risk, mutual fund costs, tax efficiency and concluded with steps or recommendations to update and fine tune my investment strategy.

Before we get to the analysis, let’s take a look at my portfolio asset allocation. I call it the CoffeeHouse Portfolio with a Double Espresso Shot. The allocations for each holding are shown in the following table. The dollar amount of the asset is divided by the total dollar amount of the portfolio to arrive at the “weighting” for each fund or stock in the portfolio.

The Fixed Income asset type is a money market account. The 40% allocation to Large CAP stocks has been broken down into three subcategories: Health care fund, defense contractor stocks and technology stocks. So, health care is actually 28% (0.7*40) of my holdings, defense is 10% and technology 2%.


















Cautions
Throughout the analysis VG provided advice, tips and made note of a few cautions. VG states that these cautions are areas where my portfolio differs from the broad market target. I have listed each of the four cautions below. I have also summarized my assessment and what my plan of action is concerning these cautions.

Bond allocation is low
I have never been comfortable settling for the significantly lower returns of bonds. In Bogle’s book, Bogle on Mutual Funds, he talks of bonds returning 7% and equities 8%. This was back in the 90’s - I would like to find a quality bond at that rate, today. Bonds are not risk free and have much less upside than stocks.

Certainly as one moves into retirement it is prudent to add more fixed income assets to reduce risk and smooth out the market ride. I have been accumulating cash in a Money Market account as MMs have outperformed bonds in the last few years with minimal additional risk. I plan to direct that cash towards the purchase of TIPS and Municipal bonds in the near-term future.

Hold Less than 5% in company stock
VG recommends not holding over 5% in any one stock. This is sensible advice given the volatility of individual stocks. I have not made this change because the stock that I hold at 10% is a non-cyclical, defensive stock that should do well in volatile markets and recessions. I am well aware of the Enron debacle, but I think every situation needs to be evaluated in it's own light.

Increase Emerging market holdings
Given the capital and liquidity issues that are occurring in the US (see financial mortgage meltdown), I am hesitant to invest in new developing countries that may require extensive amounts of capital for business development. I prefer to invest in developed international markets which have less risk. Additionally, Emerging markets have had a significant run-up in performance lately and are not a good value buy at this time, anyway. This is a sector that I have researched, but never felt compelled to pull the trigger.

Hold Growth and Value stocks in similar proportions
VG recommends a portfolio with equal weight in growth funds and value funds. This is an area that I have been working on to get to at least a 2:1 ratio (Growth equals 2 X Value). I will continue to add new funds to the value side of this as I move into retirement phase. In addition, I am interested in increasing my holdings in Berkshire Hathaway stock – which I consider to be a large cap value stock.

Overall take
The analysis and charts are organized and informative. The advice is straightforward and easy to understand. I especially liked the “xray” ability that VG used to dissect some of my fund holdings. For instance, one fund has a 15/85 split between international and domestic holdings. The tool actually split the fund by the appropriate amount into each of the two sectors, so that my total portfolio allocation reflected this split.

The analysis confirmed my suspicions about some of the shortcomings of my asset allocation strategy. The second opinion was helpful and motivational. After reading through the analysis a couple of times, I have been encouraged to make some changes to my bond and value fund allocations.

The Benefits of Paying off a Mortgage are Priceless!

Mortgage prepayment can be a hot topic, for some. The debate can get emotional fast with lots of facts and figures being thrown around. But, sometimes the most important factors can not be measured. We all know that these factors are important, but they just can not be quantified easily. As a result, we analyze only those things that are readily available for analysis. And then we overweigh our decisions based on that available data. These are common mistakes that lead to human misjudgments.

Don’t overlook the unquantifiable, but key, critical factors. For instance, below are a few benefits to paying off a home mortgage, some can be measured while others are priceless!

1. Asset Allocation. Most Financial planners will advise you to diversify your portfolio. Many recommend allocating 10% to a Real Estate Investment Trust (REIT). Why not invest in your own real estate – your home. The gains are sheltered from taxes and the home does not distribute any taxable dividends.
   
2. Guaranteed rate of return in the neighborhood of 6% (varies with mortgage interest rate)
   
3. Security is priceless. Miss a couple of mortgage payments and see how long before you are kicked out of “your” home.
   
4. No Fear of the future. When times get tough during economic downturns or when you are facing uncertainty with your job, you can rest assured knowing that you are financially stable and you can face the future with courage.
   
5. Enables you to operate from a position of power. This factor can impact your entire life and how you make decisions. You WILL gain confidence from paying off your house. It is a huge accomplishment.


6. Ownership. Pride in ownership is another immeasurable benefit.


7. Control your own escrow and pay your property taxes on your own schedule. This will allow you to pay two years worth of property tax in one year to maximize your tax deductions.

If you are still on the fence trying to decide whether paying off a mortgage is the right thing to do consider the following question.

Are your investments diversified? Paying off a mortgage, while not having any other investments or an emergency fund is not a good asset allocation plan. A better choice may be to split the money three ways: add a little extra to the mortgage payment each month, save a little to an emergency cash fund and invest a little in equities.

Testing an Asset allocation in Bull and Bear markets

Ever wonder how your portfolio would hold up in a prolonged down or Bear market? How about evaluating the upside during a Bull market? With so many different asset allocations (Couch Potato, Intelligent Asset Allocator, Coffeehouse, Bogleheads, etc ) how do you know if you have the right mix?

One way to better understand your asset plan is to take it back in time to Bull and Bear markets. This can prepare you for what might happen in the future and help you evaluate how much risk you are willing to take. If the returns projected for a Bear market make you uncomfortable then you can use that information to adjust your holdings.

Note that there are many types of bear markets. Some hit the financial sector hard, while others hit technology stocks and so on. But in general, for a market to be considered a true bear market it will weigh down almost all types of stocks, just in different degrees.

Asset Allocation
As part of my personal financial plan, I have set up an asset allocation for my holdings. I call it the CoffeeHouse Portfolio with a Double Espresso Shot. The allocations for each holding are shown in the following table. The dollar amount of the asset is divided by the total dollar amount of the portfolio to arrive at the “weighting” for each fund or stock in the portfolio.

Now for more explanation on the allocations. The Fixed Income asset type is actually a money market account. The 40% allocation to Large CAP stocks has been broken down into three subcategories: Health care fund, defense contractor stocks and technology stocks. So, health care is actually 28% (0.7*40) of my holdings, defense is 10% and technology 2%. I broke these out because their performances vary drastically.

Market Returns
Now that we have the weightings, we need the returns for each market. The return data is based on stock or fund price data with the exception of the Fixed Income (Money Market fund). Because MM funds maintain a constant $1 price, the yield data was averaged across each time span. The stock and fund price data that was used in this table does reflect distributions as the price is adjusted when capital gains and or dividends are distributed. All of the price data was gathered using historical data from Yahoo finance.

For the Bull market example, I used the recent run from January 2006 to December 2006. The Bear market returns are from the couple of years following the irrational exuberance of the 90’s. I used prices beginning on 8/25/2000 and ending 10/7/2002 to calculate the total return during this Bear market. The next step is to multiply the asset weighting times the Bear or Bull returns for each asset class. For instance, the 5% fixed income allocation times the 3.8% bear return equates to a performance weighting of 0.19%. Each performance weighting is calculated and then added up to arrive at the total performance for the portfolio.

Bear and Bull Performance
This is how my portfolio would have performed in a Bull and a Bear market. For the Bear market, the portfolio would have returned 2.01%. It’s a small amount but at least its positive. Most people during this time frame lost a lot of money. For the Bull market, the total return was 21.98%.


If we look a little deeper into the mix, its apparent that Gold and Defense stocks were huge positive factors during both of these runs. Real Estate (REIT) was also a bright spot. One might be tempted to overweight in these sectors, but that could make this portfolio vulnerable to other types of bear markets.

When I first started this exercise, I wasn’t sure what to expect. But, I am pleasantly surprised. From this data, it appears that the portfolio has a good mix of assets that includes sectors that have low correlation to one another. This is a key to any asset allocation. However, I would like more data points. I plan to take this portfolio back in time again to several other Bear markets and post about it within the next month.

CoffeeHouse Portfolio with a Double Espresso Shot

I came across the Coffeehouse portfolio one day several years ago while evaluating various ‘couch potato” investing approaches. The first thing I noticed was that the Coffeehouse is based on low expense Vanguard index funds and then I noticed that it was comprised of a lot of the same funds that I already owned. Wow, I was in the Coffeehouse and didn’t even know it. I agreed wholeheartedly with the simple low cost approach and with diversification across a broad spectrum of the market. I decided to adjust my plan percentages to align more closely….. with one major exception that I will explain later.

First, here is a Coffeehouse investment portfolio that employs a simple philosophy of diversifying in different baskets and capturing the entire return of each basket. Note this portfolio can be constructed using a fund company other than Vanguard, but its hard to beat VG’s low expenses.

The performance results of a simulated Coffeehouse portfolio projected back in time is provided below in comparison to the annualized S&P 500 results. The performance is based on rebalancing the portfolio yearly to its original allocation. The simulation resulted in an annualized 16 year return of 11%.

This is a very stable portfolio with little downside risk. It is interesting to note the performance during the bull markets of the late 90’s and the bear markets that followed. The large swings that many experienced during those times have been smoothed out considerably using the Coffeehouse allocations.

The Double Shot
The biggest difference between my portfolio and the Coffeehouse is my allocation to Large Cap growth stocks at the expense of fixed income investments. As a young investor with a long investment timeframe, I have been willing to take considerably more risk. As a result, I have a much larger weighting in Large Cap Growth and much less in bonds and cash. I also favor international funds with a higher percentage (18%) and have an additional small exposure to Gold (2%).

Watering it down
As I transition to retirement, I am more interested in stability and steady growth. Consequently, I anticipate making incremental changes to my portfolio so that I will eventually arrive at the Coffeehouse allocations. The first change will be to convert a portion of my IRA holdings from equities to bonds. This strategy will also take advantage of the tax efficiencies of holding bonds in a tax sheltered account. For more on this see: Improving your Tax Efficiency.

Improving your Tax Efficiency

The following list by Taylor Larimore over at diehards.org is often cited on the internet as the rule for tax efficient fund placement. The basic idea is to shelter tax-inefficient funds in tax advantaged accounts. Tax in-efficient funds are those that distribute dividends and/or have a lot of portfolio turnover resulting in capital gains distributions.

4-Step Rule for Tax Efficient Fund Placement:

1. Put your most tax-inefficient funds in 401ks, 403bs, Traditional IRAs and similar retirement accounts. When full..

2. Put your next most tax-inefficient funds in your Roth(s). When your Roth(s) are full..

3. Put what's left into your taxable account.

4. Try to use only tax-efficient funds in taxable accounts.

Here is a list of securities in approximate order of their tax-efficiency. (Least tax efficient at the top.):

Hi-Yield Bonds
Taxable Bonds
TIPS
REIT Stocks
Stock trading accounts
Small-Value stocks
Small-Cap stocks
Large Value stocks
International stocks
Large Growth Stocks
Most stock index funds
Tax-Managed Funds
EE and I-Bonds
Tax-Exempt Bonds

The underlying issue here is the disparity in tax rates. The IRS taxes dividends from bonds at your income rate and that rate is typically higher than the capital gains rate. For example, if you receive the same amount in dollars in capital gains from an equity mutual fund as dividends from a bond fund you would still pay more tax on the bond dividends. Consequently, it is possible to significantly reduce a tax bill by sheltering bonds in tax advantaged accounts.

Given the current marginal tax system, the tax bill for a single taxpayer earning $60,000 in dividend income would look like this:

10%*7825
+ 15%*(31850-7825)
+ 25%(60000-31850)
-------------------------------
= $11,423

Compared to the tax bill for $60,000 on long term (held 1 year or more) capital gains

15%*60000
= $9,000

That’s a savings of over 21%

I currently have very few bond holdings. As I near retirement, my goal is to gradually increase my bond allocation. In light of this tax information, I plan to convert approximately 20% of the funds that I hold in my Roth IRA to a bond fund. In the next few months, as part of my 2008 financial resolution, I will be evaluating several different bond options, posting about each and eventually making an investment within my Roth.

My 2008 Financial Resolution

It's never too early to get a jump start on your new years resolutions. Especially when Cash money life is offering a chance to win a 4GB iPod nano for writing out a financial goal for 2008.

My 2008 financial resolution is to learn and evaluate several bond options and make an investment.
Using the S.M.A.R.T goal format:
Specific - I want to increase my knowledge about investing in bonds to include mutual bond funds, US govt bonds, TIPS and municipal bonds.
Measurable -. I will evaluate each of these, make blog postings on each and make an investment in the bond instrument that best suits my financial plan.
Actionable - This is 100% possible. I have books that cover the subject, internet resources to mine and I can draw upon the experiences of individual friends and family that have invested in various types of bonds.
Realistic – I want to learn enough to feel confident in my bond investment. I do not expect to become an expert or become a bond trader.
Timely – I plan to start this month, evaluating a different bond instrument each month and then making an investment in April of 2008.

What is your financial resolution? The giveaway ends December 4th at 11:59 PM, Eastern Daylight Saving Time and the winners will be announced Thursday, December 6th.