401K Lessons (Learning it the Hard Way)

Last year was my first full year at work. I managed to max out my 401K contribution with one paycheck left to go. So for the last paycheck I set the contribution rate to 0%. This week I had to go in to reset it back to the original rate. Boy, was I in for a painfully rude shock - my 401K returns were negative. When I was younger I used to wonder why people who have money still worry about money. But in that one moment when I was staring at the numbers in red indicating negative returns on my hard earned money (that I had scrimped and scrounged to save, I must add) it was suddenly very obvious. The knot at the pit of my stomach did not feel good.

To cut a long story short, things have gone further south since then, and as of today, I am down 5% for the year. And my all-time returns have shrunk so badly that the returns on my 401K statement are beginning to resemble that of my bank statement. I have had 401K on my mind for the past few days, and here are some lessons I am learning.

Do not track the returns of the 401K on a daily basis
This is advice I need to learn to live by, since I value my sleep too much. Until this week, I hardly paid attention to how my 401K was doing, except for an occasional look out of curiosity, and I was doing fine. But now that I know it is not doing well, I have an obsessive urge to check it the first thing every morning. And with the losses going higher each day, it is turning out to be a heck of a lousy way to start the day.

Pay attention to asset allocation
When I started my contributions, since it was still very early in my career, I presumed I should be able to take a lot of risk. So I did. I put 100% in stocks - 20% large cap, 40% in mid cap and 40% in International. And now it is clear to me that this risk level is way too high for me to handle. It is very important to look realistically at what risk you can stomach, and balance it against how much returns you hope to make. So, I finally took some time out to go through all the funds, their volatility levels, their performance history, the expense ratios etc. and reallocated my future contributions. My asset allocation choices are - 50% domestic stock, 32% international stock and 18% bonds. And the funds I have selected offer performance close (though not quite there) to what my earlier allocation did but have much lower volatility. I still have a few questions about some of the funds, and have mailed the fund managers for details. Once I get the information, I hope to finalise my selection and freeze the allocation and only visit it once every 5 years or so to see if the risk tolerance is still OK.

Don't lose perspective
I have at least 30 more years to go before I can retire (assuming I do not retire early). The amount I have in my account is a small drop in the pond when compared to the final balance that my 401K account will have. The 5% loss on that small figure is but a ripple in the pond. In the long run, this experience is just a small blip that might not even register on the radar. It is important to have this long-term perspective to avoid losing sleep and to control the temptation to mess with the allocation every now and then.

Nobody else can determine what is best for you
Our company's 401K plan provides us access to some financial software and I went through it to obtain some advice on what my model allocation should be. I also had several discussions with the better half and some older colleagues. I used all this advice, but in the end, what I chose was uniquely suited for my particular situation. It is easier to let someone else handle the decisions (e.g., financial advisers, spouse, parents etc.) but to really be peaceful, it helped for me to go through the details of the funds and determine what was best for me.

In a way, I am glad that I chanced upon looking at my 401K when it was doing particularly bad. I had not paid much attention before and had randomly picked funds with seemingly good performance in an effort to maximize my returns without really paying much attention to the associated risk level. Now I have put in a lot more reading of the funds offered and have picked the ones that I believe are more suitable for me for the long run. I don't know if this is the allocation I will stick with forever, but for now at least, I feel a lot at peace with my choice.

*Image credit: Photograph by jay d [via Flickr Creative Commons]

~~~oOo~~~

Getting a good math lesson in 401K's is a great way to jumpstart your financial future. There are even several degree programs online which may help you become more fiscally responsible by using educational grants and loans.

~~~oOo~~~

Read More...

Summary only...

If you like this article, you can bookmark it or subscribe to the feed.

Campaign Against Financial Myths: Part 6 - Stock Market Investing

(This article is a part of the series aimed at dispelling some of the popular financial myths. Please refer to the full index for myths related to other financial topics. Oh, and a quick disclaimer: I am not a financial advisor. I have made every effort to research the facts before presenting them here. But, if you have a reason to believe any of the statements are incorrect, please feel free to correct me.)

1. Myth: “You can expect to earn around 10.7% on your investment in the stock market since this is the average long-term returns so far.”

I had not realized this was a myth until I read this article titled the great stock market myth! The premise of the argument made in this article is that the source of the popular number 10.7% is the measurement made over a very long period of 76 years – 1926 through 2001. Since most of us will not invest for such a long time and 10 or 20 years is a more realistic number, looking at the same 76 in chunks of 10 years or 20 years will remove the long term averaging and reveal highly varying averages. Quoting from the article – “If you break the 76 years from 1925 through 2001 into rolling 20-year periods, you get 57 periods. Of those, 22 had average annualized returns of less than 10.7 percent. Returns for the lowest 20-year period were 3.1 percent; the highest was 17.9 percent.” So how much you can expect to make from the stock market? That depends on when you start investing and in what direction the market is headed during the period for which you invest.


2. Myth: “To begin investing, I need to accumulate a lot of money first.” (Variation: “I cannot afford to invest”).

I have to admit I used to believe in this myth too! But the truth is, you can start investing with as little as $20 per month. As long as you make the commitment of doing this every month and stick with your commitment, you will be surprised at how much balance you will have after a while! For example, say at the age of 20 you start investing $20 per month and earn an annual interest rate of 10%. You will have over $188,353 in your account by the time you retire at the age of 65. Yes, just giving up one evening out per month can go a long way in plumping up your nest egg. One way to invest money in small amounts is through DRIP investing. This Fool.com article has more information about DRIP investments and details how to invest small amounts of money every month. Watch out for fees though, which can seriously corrode away the earnings. And remember that this is a long term plan and you cannot expect to get rich overnight!


3. Myth: “I can beat the stock market.” (Variation: “I should invest with a fund manager since fund managers know how to beat the stock market.”)

The stock market is quite unpredictable and there is no magic crystal ball to foresee exactly what will happen next. As a result, it is difficult for anyone – be it an amateur investor or a hotshot fund manager – to consistently beat the market. Quoting from this article, “In 2003, when the bull market began, 61 percent of actively managed funds specializing in American stocks beat the return of the Standard & Poor's 500-stock index, according to the research firm Morningstar. The following two years produced similar results, but in 2006 the figure plunged to 32 percent. […] But there are enough other factors for some analysts and financial planners to conclude that last year is the rule, not the exception.” The general perception is that in the long run 75% of the time actively managed funds will fail to beat the market. If the manager of a mutual fund, whose job it is to track the ups and downs, cannot consistently beat the market, what makes you so different?


4. Myth: “Timing your transactions is very important in order to succeed in the stock market.”

Nothing could be farther from the truth! John Bogle, founder of the Vanguard Group, supposedly wrote: "After nearly fifty years in the business, I do not know of anybody who has done it [market timing] successfully and consistently. I do not even know anybody who knows anybody who has done it successfully and consistently." Need I say more? If you are not yet convinced, check out this list of several studies that show how harmful market timing has historically proven to be. Here is an example quote from that article - “MARKET TIMING: (1999) An Individual Investor article on Market Timing noted that a major timer- Merriman Asset Allocation fund- has returned an average of 10.8% annually for the last three years while the S&P earned 25.4%. Vanguard's funds did 21.4% without timing.”


5. Myth: “I should leave investing to the pros’ since I don’t have enough time to follow the market.”

This is where index investing comes into picture! An index fund is essentially a collection of stocks that aims to replicate the fluctuations of an index of a particular financial market. Since Index funds aim to track the market, you will receive similar returns as the index that your fund tracks, and hence *you* do not have follow the market too closely. Also, since you do not have to pay fund managers to pick the stocks that make up the fund you can save quite a bit on fees as well. Paul Merriman at fundadvice.com wrote a nice article titled 10 reasons I like index funds that is definitely worth reading. And if you want to get started on index investing this investopedia primer is a good place to start.


6. Myth: “Buying stock is like buying a lottery ticket.”

When you go out and buy a lottery ticket, all you receive in return is “hope”. There are not solid assets to backup this “hope”. However, when you buy shares in a company, you actually own a piece of the company. As an owner of this piece, you are entitled to a portion of the profits after all the stake holders (employees, raw materials, utility costs, marketing costs, interest on loans etc) are paid off. So if you do your research well and purchase shares of companies that have a good potential to turn a profit, then buying stocks is nowhere like gambling. Yes, there is an amount of risk and the returns are not guaranteed, but if you make your purchase decisions based on good research then you stand a good chance of making tidy profit on your investment.


7. Myth: “What goes up must come down.” (Alternately, “what comes down must go up.”)

They say a picture speaks a thousand words – so let’s tackle this one with a picture shall we? Here is the chart for Berkshire Hathaway class A stock (Source: Yahoo finance).

Note the logarithmic scale on the Y-axis. Currently the stock trades for $110,000 a piece! Of course this is not likely to be the norm with most common stock, but it does bust the myth that what goes up must come down. The stock market is not subject to the laws of Physics. Rather it is all about how the company is managed and what the investors perceive the value of the stock to be. By picking the right company, you could potentially ride the up wave for a long time. By picking a loser, you could wait and wait and never get out of the rut.


8. Myth: “If you are young, invest in the stock market. If you are old, invest in the bond market.”

While generally true, this is not advice that you should follow blindly. If you are a young person saving for your retirement and can leave your funds in the market for a long time, then by all means, you should invest in the stock market. Push comes to shove, if there is a 40% decline in one year, then by sitting tight for a few years you can wait for the market to bounce back. But that won't be the case for people close to retirement. That said, retirement is not the only thing that is on your mind if you are still young and starting out. Maybe you want to save to for a house down payment that will be needed within a few years down the line. In such a case, stock market is not the place to be, no matter how young you are. Rather than looking at whether you should invest in the stock market based on how old you are, you should look at how soon you may have to take the money out and what is your risk tolerance based on the station of life you are in.


9. Myth: “As an individual investor I do not have access to all the information available to a broker or fund manager”

The fact that a company is “publicly” traded means that they *must* make all the information available publicly through quarterly report, annual reports, prospectus, investor guidance etc. With the proliferation of online trading sites, it has never been easier to get access to this public information. In addition, you can subscribe to a zillion news letters and feeds that provide expert analysis on how to interpret these reports. If all else fails you can call the company directly. Peter Lynch, the famous manager of the Magellan Fund at Fidelity Investment wrote the following in his book One up on Wall Street: “Professionals call companies all the time, yet amateurs never think of it. If you have specific questions, the investor relations office is a good place to get some answers. […] If it’s a small outfit, you may find yourself talking to the president.” More often than not, this myth is just a flimsy excuse for not doing the home work.


10. Myth: “A stock that pays out a dividend of $10 is always better than the one that pays out $2.”

Let’s say that stock A pays out a dividend of $10. Also, suppose that the share price of stock A is $100. If you invest $10,000 in stock A, you will hold 100 shares and so when the dividends are paid out, you will make $1,000. Now consider the stock B which pays out a dividend of $2. Suppose its share price is $10. Then, for the same $10,000, you hold 1000 shares of stock B, and so when dividends are paid out, you will make $2,000. I admit that the numbers here are completely hokey, but I hope I did get the point across – when comparing two dividend stocks, the dividend payouts should first be converted into a percentage of the stock price (10% for stock A and 20% for stock B) to get a better idea of the value it provides.

There are many, many more myths associated with investing. Unfortunately, I do not feel qualified enough to delve into the more advanced topics. I would like to thank Sun from The Sun’s Financial Diary for his help in writing this article. If you are an expert in the area of investing (individual stocks, ETFs, Real estate, etc), and would like to contribute a guest post about the related myths, it will be much appreciated. I will highlight it here as an individual post and also include it in the full index (that I will get around to creating one of these days).

Anyway, stay tuned for more myth busting – I have several more topics to go through. Once the series is complete, you should be able to access the full list of myths via this index.

Read More...

Summary only...

If you like this article, you can bookmark it or subscribe to the feed.

$5K in “Extra” Savings: Narrowing down the investment choice.

(This is Part 2 of a detailed post that discusses our thought process on what we did with $5K in extra savings. Please refer to Part 1 of this article to see how we arrived at the conclusion to invest in the stock market.)

So, at this point, we have decided that the best thing to do with the $5K “extra” savings we have (after funding our 401Ks, completing payments on investment real estate and paying off the bills) is to invest it in the stock market. That said, we have no clue where to begin or what exactly to do with the money. As usual breaking it into smaller steps helps tackle the problem. Here is how we got started -

Step 1: Determine the investment vehicle

The first thing we decided to do was to eliminate the options that are not right for us. Neither of us possesses the skills to "play" the market -- so that rules out individual stocks. We can afford to be a bit aggressive at this point -- so that rules out bonds and bond related funds. We do not want to share our hard earned earning with fund managers. That rules out actively managed mutual funds. By now our options are kind of narrowed down to Index funds or ETFs. Determining which one of these two to go with was a little harder. But a lot of discussion with colleagues and some excellent blog articles like this and news articles like this swayed us in favor of Index funds. Our specific reasons were -

• ETF’s trade just like stock. That means, for an ETF, you need to pay a commission each time you buy. In our case, we are starting out with a relatively small amount, and depending on how things look in the future, we want to keep the option open for adding additional small amounts to it as and when we can. If we go for an ETF a lot of our returns will be eaten up by commissions!


• We are beginners in this area. We do not want to have the option to trade our holdings like stock! The way I see it, the lesser the temptation to chase trends, the better off we will be!


• The benefits of ETF’s are: lower expenses and lower taxes. By choosing no-load index funds with low expense ratio and low turnaround rate, we could possibly try and achieve similar benefits from Index funds.


• Index funds have been around for longer than ETFs. So there are more options to choose from and more importantly, there is a lot more information out there about sample allocations for index funds than ETFs. This makes Index funds an ideal choice for newbies like us.

Step 2: Determine the company to open an account with.

Index funds can be obtained either directly from the companies that offer them or from brokerage accounts (unlike ETF’s, for which you *must* have a brokerage account). At this point we have decided to skip the option of opening a brokerage account and to stick with a well-known company that offers index funds. Based on our discussion with colleagues and hours of searching related threads on ask meta filter and fat wallet finance forums we finally decided to go with Vanguard for their large selection of low-cost index funds and minimum entry requirements of $3,000. (By the way, they also have a fund with a minimum of requirement of $1,000 called Vanguard STAR Fund (VGSTX) if your are interested in looking up).

Step 3: Determine the Index fund.

Even after narrowing it down to Vanguard Index Funds we were still quite overwhelmed with the number of choices we had. So, we decided to keep it simple by starting out with the list of index funds in CNN money’s Money 70: The best mutual funds you can buy listing for 2007. Among the 12 Index funds listed (the remaining are actively managed funds, ETFs and Target retirement funds), 9 were from Vanguard, which is great! Among these 9, 2 are bonds funds and so we eliminated them. 1 is a real estate fund, and since our focus is on diversification, we decided to stick with blended funds instead of specialty funds. Among the remaining funds, the one that attracted us the most was the Vanguard Total International Stock Index Fund (VGTSX). Of course the main reason it attracted us is that it has the second best returns among the 6 funds remaining and the lowest expense ratio. So why did I choose this instead of the best performing fund (Vanguard Emerging Markets Stock Index - VEIEX)?

Here are our reasons:

• VGTSX has a lower expense ratio (0.32%) Vs the VEIEX (0.42%).


• VGTSX has a Morning Start rating of 4 starts Vs the 3 star rating for VEIEX.


• VEIEX may have higher returns but it comes with the risk of higher volatility.
  
  
  1. VEIEX has a higher alpha than VGTSX in reference to S&P 500 index (13.2 Vs 9.82), meaning that if S&P 500 returns 0, then VEIEX can be expected to return 13.2%, while the VGTSX can be expected to return 9.2%. But this comes at the risk of higher volatility -- VEIEX has a beta of 1.7 compared to 1.03 for VGTSX. This means that VEIEX is 70% more volatile than S&P 500 compared to VGTSX being 3% more volatile.
  
  
  2. VEIEX has a higher mean return, but also a higher standard deviation. Based on this, sharpe ratio of VEIEX is less than that of VGTSX. What this means is that VEIEX has a lower reward-to-risk ratio compared to VGTSX. I used this sharpe ratio calculator with the mean and standard deviation for the two funds obtained from the CNN money website linked above (fund details provided by Morningstar) and a risk-free rate of 5% corresponding to the interest rate on my HSBC online savings account.
  
  Based on these, even though both have relatively high risk, VGTSX seems to be a better option for us.


• VGTSX is a blend of three different index funds -- European, Pacific and Emerging markets (yes, VEIEX). This gives us better diversification than just owning VEIEX.

So I finally we chose to go with VGTSX. VGTSX (or its component funds) are a staple in many of the sample allocations listed here. I browsed through several sample allocations on the Net and found more portfolios that do not have VGTSX (or its component funds) than those that do. But for a beginner like me the fact that it was used in several of the lazy portfolios mentioned on the site above is still quite reassuring.

Step 4: Look at the big picture.

While this is our first investment into the stock market in a non-retirement account, we do have a bit of money in retirement accounts (401K) that is invested in the stock market. So, before we open an account we need to revisit our 401K and check our allocation there. As it turns out, between the better half and I, we have about 35% of our 401K in international funds. With the addition of this fund, it will take our total allocation in international funds to 37%. That is not so much different from the previous allocation we had and we believe it is the amount of risk we can handle at this point. We did consider splitting the amount into the Vanguard Total International Stock Index (VGTSX) and the domestic index Vanguard Total Stock Market Index (VTSMX). However, this option would require us to raise another $1,000 (since each fund had a minimum of $3,000) and so after going back and forth a few times, we concluded that at this point we will go with just VGTSX. In the future if we do add more money to our investment funds, we will certainly come back and revisit VTSMX.

Step 5: Finally, pull the trigger.

Opening a Vanguard account online was a breeze. In about 10 minutes, I had set up the joint account and placed the purchase order. Vanguard charges $20 per year in fees if your total balance is less than $10,000. However, this fee will be waived if you sign up for electronic statements. I have not done this yet since the account is still in the process of being set up. Must remember to get back to it next week.

Read More...

Summary only...

If you like this article, you can bookmark it or subscribe to the feed.