What’s working in your Investment Portfolio?

This past year has been brutal for equities across the board.  In times like these, when nearly everything is tanking, I can’t help but notice the miniscule portion of my portfolio in US savings bonds that is leading the way with positive returns.  I never thought I would see the day.  I have been purchasing savings bonds over the last 20 years mainly to keep my employer off my back.  Every year, the company recruits employees to canvass the masses and urge all to participate through payroll deduction.  I have been one of those canvassers and I can attest that convincing engineers of the financial benefits of bonds has always been a hard sell, so instead the canvassers tout patriotism!  Love America, buy a bond.

To track my bond holdings, I use a Savings Bond Wizard tool and it is currently reporting that many of my EE bonds purchased 10, 15 and even 20 years ago are yielding a whopping 5.6 %. I’m thrilled!  A snapshot example of the wizard screen is shown below.  For those of you holding savings bonds, the wizard software, available for download at the TreasuryDirect website, is an easy way to keep track of this newly, exciting asset class.  Once you have entered the serial number of each bond, the wizard will track it, provide accrual and maturity dates, automatically update to the latest rates and yields and provide the current dollar value of the bonds all free of charge.

This past year was a great time to be holding bonds, but what about previous years?  For some very interesting data check out this graph provided by The Savings Bond Advisor comparing the value of equal monthly investments in series I savings bond and the Vanguard Index 500.  The differences between the two over the last year are pretty dramatic, but the data also shows that savings bonds have been in the running over the last several years.  Hmmm, an investment paradigm shift may have finally arrived for at least one engineer.

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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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Discoveries for a Sunday Razoo

This week seems to be marked by a heightened interest in the tax rebate stimulus package. Everybody is asking the question, “where’s my check?”

I am not receiving a stimulus check, but I was quite impressed with the efficiency of the IRS in processing my tax return this year. I mailed in my return and check on the 14th and by the 17th, the IRS had pulled funds out of my account! They don’t mess around. If you would like to check the status of your tax refund, the IRS has a website for just that.

While cruising the PF pages, I came across a couple of useful posts this past week on my most recent Internet Razoo.

The best blog posts are those that provide useful, practical info that makes life a little easier. That is exactly what I found here at CashMoneyLife. I went through most of the items on this list to improve PC performance and it does appear to have helped.

Another interesting article offers an explanation for the US Treasury’s I-bond refocusing program. First, the US Treasury Department sharply reduced the annual limit on investments in I-bonds, from $30,000 to $5,000 beginning in 2008 and now, this week, they have zeroed out the guaranteed rate! Just when inflation indexed I-bonds started to look like an attractive investment, the Treasury knocks them out. What’s behind this? If we read between the lines, or just read the article linked above, it is very likely that the Treasury expects higher inflation and wants to limit its future liabilities (payouts).

Another theory concerning the I-bond situation was provided here by Chris Farrell. He postulates that the US Treasury’s actions are meant to bolster Wall Street. By limiting the amount an individual can invest in savings bonds, the US Treasury is forcing those to invest their remaining funds in something else – like the stock market, and in turn helping corporate America.

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I Bonds take off with Inflation

The US Treasury recently reported on April 16th that Inflation now stands at 4.83% for the last 6 months. The rate is based on the difference between the Consumer Price Index (CPI) in September and the latest CPI in March.

If you are holding any Series I Savings Bonds this is uplifting news. To determine what I bonds will earn during the next six-month rate period, just add the fixed base-rate to the 4.83% inflation rate. The fixed-base rate for your I bonds can be anywhere between 1.0% and 3.6%, depending on when the I bond was issued.

Gee, don’t we all wish we had more I bonds? You can purchase some today with the current fixed base rate of 1.2% to earn a composite rate that is over 4.2% for the next six months, which will then be followed by six months at over 6.0%. That rate certainly beats money markets, saving accounts, CDs, US Treasury securities and even Treasury Inflation Protected Securities (TIPS).

Maybe we should all go out and load up on I bonds? Only problem with that is the US Government limits the annual purchase amount for savings bonds. As it currently stands, we are limited to $5000 per social security number per type of bond. For some reason, the Treasury considers paper and electronic bonds to be different types, so you can purchase $5000 in paper I bonds at a bank and another $5000 electronic I bonds at Treasury Direct for a total of $10000.

Investing in Series I Savings Bonds can help protect a portfolio from the risk of inflation as well as the risk of capital loss. Unfortunately with the limits on Savings Bond investments, the help this strategy can provide is also limited.

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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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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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Understanding Total Returns for Bonds

As part of my 2008 Finanical Goal, I plan to evaluate various types of bond investments, post about them and then select one for purchase. First, I want to examine how individual bonds provide returns.

Understanding stock returns is pretty straight forward - market price plus dividend, but Bond returns are a little more complex. In talking with friends and co-workers I realized that very few people are comfortable with how bonds work. In the book, Bogle on Mutual Funds, there is a very good explanation that I bookmarked for future reference. I have summarized Bogle’s description and added a few of my own comments, of course.

Bond returns are comprised of three items:

• Initial yield
• Reinvestment rate
• Impact of Rate change on market price

The primary factor by far is the initial yield – it is the major determinate of the future return on a bond.

One might assume that a bond with an 8% coupon would achieve a return of 8%, if held to maturity. This is not always correct, because of the reinvestment factor. US Govt bonds pay a semiannual interest coupon that is reinvested at the current rate (not the initial rate). If the new rate is less than 8% the return will also be lower and conversely if the reinvestment rate is higher the corresponding total return will also be higher. The following table illustrates the importance of the reinvestment factor for a 20 year Govt bond (8% coupon, $10,000 investment).

The third item, rate change, impacts the bonds market price and is only a factor if the bond is not held to maturity. An increase in rates will reduce the market value of a bond. Many have trouble with this concept. Here’s my explanation. If rates are increasing and you are holding a bond at a lower rate it is no longer as desirable (valuable) because better rates can now be had. You are locked in to your initial rate, but of course the semiannual coupon is being reinvested at this new higher rate. So not all is bad with raising rates – just don’t sell into that environment.

The table is somewhat misleading because rates rarely stay the same for 1 year let alone 20. For a 20 yr bond there will be 40 semiannual reinvestment dates. That will result in a lot of averaging of the overall reinvestment rate. The effect of averaging over a long time period explains why the impact of reinvestment rates is not the primary force in bond returns.

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.