Finance 101: ideas for broke 35 year-olds

I *hope* none of my readers are broke at 35, though something tells me that, with the building mountain of student debt and poor job prospects post-2008, there are some.

I’m a fan of this blog, which sets out some very basic common-sense approaches to building some net savings 10 years after university graduation.  Once you’ve reviewed the spending principles, head back to mine for basic savings principles.

Finance 101: From the Simple Dollar, retirement on $1,000,000

Just a quick shout out to one of my favourite blogs, The Simple Dollar.  Yesterday’s entry on how to retire on $1 million (or if it can be done) well-illustrates the type of basic analysis underpinning retirement planning calculators everywhere.

My only caveat with the analysis, like most of these simple ones, is the sensitivity to assumptions.  This article tries several types of assumptions, which makes the thing stand out (in my opinion).  But particularly when long time periods are involved, small changes in assumptions can drastically change results.  Given we have basically no idea what the correct figures will be, caveat emptor for those placing too much reliance on one run of the ‘simulation’!

Sadly there isn’t a good fix for unknown parameters in the analysis, but rest assured I’ll let you know when I have a reliable crystal ball.

Finance 101: follow the interest rates, or carry is king

Interest rates are all the rage these days in the media: various countries are cutting base rates to below zero (an idea once thought impossible, called ‘the zero bound’).  The latest culprits are Scandinavian countries Sweden and Denmark – their economies are closely tied with the Euro-area, so the quantitative easing from the latter increases pressure on the Scandi countries’ exporters.  Enter negative base rates.  Longer-term interest rates have fallen as well, with multiple governments now able to borrow at near-zero for 10-year loans.

With all this in mind, let’s consider the big picture, and implications for individuals.

• Definition: an interest rate is the cost to the borrower for getting money now, rather than later.  Seen from the other side, the interest rate is the return to the lender for giving up money now, rather than later.  The interest rate is an example of carry, or the return to an investor for holding an asset (in this case, a loan/bond).
• Usage: we can use the interest rate to help judge one debt versus another.
  • Borrower’s perspective: suppose you have several loans outstanding, or need to borrow, and are considering different types of loans.  Some examples, with typical interest rates are below, in descending rate order:
    • Payday loans: around 400% interest per year.  No security needed, and very short term.
    • Credit cards: around 15% interest.  No security needed, and short term (balances can be rolled forward, as long as credit card company allows).
    • Peer to peer loans: around 10-15% interest.  No security needed, and medium term (3-5 years).
    • Student loans: around 5-10% interest for Federal loans; 7-15% for private loans.  No security needed, though sort of the ultimate security: you can’t get rid of these loans through bankruptcy.  5-15 year term.
    • Home equity loans: about 6% interest.  They’re 2nd mortgages on your house. 5-15 year term.
    • Auto loans: around 4% interest.  Car title held as security; medium term (3-5 years).
    • Home mortgage: around 3-4% interest.  House title held as security; long term (15-30 years).  In the US, mortgage interest is tax-deductible at your highest marginal rate, so the effective interest rate may be much lower.
    • In sum: if I had several types of debt outstanding, I would probably pay them off in the order above.  If I needed to borrow, I’d probably borrow from the bottom up.
  • Saver’s perspective: suppose you have some cash to put to work, and are choosing between the options.  Rates help us here, as the interest rate is the maximum return you will receive on your investment.  There is a clear risk – return trade-off, though.  Anyway, in ascending order of interest rate/risk:
    • Savings account: about 0-1% interest.  Instant access, and government-insured.
    • Certificate of deposit/fixed savings: 1-2% interest.  Government-insured.  1-5 year term.
    • Government bonds (Treasuries): 0-2.5% interest.  Government-issued.  30 day-30 year term.
    • Corporate bonds: 1-6% interest.  ‘Proper’ credit risk – you may not get back what you put in.  Typical 5-year term.
    • Peer to peer lending: 5-15% interest.  Lending to ordinary folks, with no collateral.  3-5 year term.
    • In sum: pick your poison.  If you need the funds at any time (e.g. an emergency fund), better to stick with the earlier entries on the list.  If you’re looking for more risk, head on down the list.  Keep in mind rates are at all-time lows in most places, so maybe keeping with short duration (i.e. sticking with shorter-term stuff) is a safer play.

There you go.  Other types of carry (e.g. dividends, rental yield) we can pick up later.

Finance 101: Bill Ackman on investment basics

Quick one here.  For those brand new to saving/investing, I recommend this 45-minute overview by the quite successful value investor, Bill Ackman.  Very well-produced.  A few notes:

1. Begin at about 21:30 if you’d like to skip an opening session on starting a business (including the vocabulary around accounting and capital markets).  The second half is purely focused on investing.
2. Mr Ackman speaks of mutual funds being the obvious solution for those not wanting the effort of choosing their own portfolio companies.  I’m sure he wouldn’t begrudge me a pitch for ETFs which do the same things, but usually carry lower fees.
3. Given Mr Ackman’s value-oriented investment approach, I wasn’t surprised to hear his cynicism for investment styles outside of value (namely ‘technical’ or systematic approaches).  I disagree here, noting that both Mr Ackman’s approach and other approaches can work in the long term, and frequently provide different sorts of investment returns.

Finance 101: Rebalancing

Let’s talk rebalancing the portfolio.

Most personal finance websites/books/etc. focus a great deal on trade entry; less on trade exit; and usually even less on ongoing maintenance/rebalancing.  Compared with finding ‘the next Google’ or ‘signs to move to cash’, the monthly/yearly rebalance seems pretty boring.  However, rebalancing is very important to a long-only portfolio performance.

Broadly: a long-only portfolio comprising some mix of assets will, over time, become dominated by the best-performing asset.  The usual example is: a mix of equity/bonds will become more and more invested in equities, given their outperformance long-term.  If you don’t rebalance, you are implicitly creating a momentum portfolio – more investment in winners than losers.  While this may have some merit as an idea (I like momentum), the diversification of the portfolio goes into the toilet.  The portfolio becomes a one-way bet on equities.

Harking back to the CFA curriculum, there are a few broad categories of rebalancing:

1. Constant mix – the boilerplate, constant proportions of (say) 60% equities and 40% bonds.
2. Buy-and-hold – the set and forget approach.  Buy on day 1, then never rebalance.  What I’m warning about above.
3. Constant Proportion Portfolio Insurance (CPPI) – Somewhat the opposite of constant mix, this is a fairly explicit momentum strategy.  Equities get an even larger allocation than buy-and-hold as stocks rise.  The kicker is this: CPPI trades off between a ‘risky’ asset (either 100% equities, or maybe a 60/40 portfolio??) and a ‘riskless’ asset (e.g. cash or T-bills).  So the idea is that you put on more risk as risky markets perform well.

When do you rebalance?

1. Time-based – probably the most common approach.  Every month/quarter/year you look at your statement, then rebalance to your target allocation.  For #1 above, you go back to the original 60/40 split (or whichever mix you’ve chosen).  For #3, you use a formula outlined in places like this.
2. Error-based – for those keeping closer attention to the markets: rebalance back to target whenever the realised allocations stray beyond a certain tolerance.

There have been a multitude of research papers written about when is best to rebalance. The trade-off is pretty simple: how much trading cost is incurred, versus the drag induced by not having ‘optimal’ allocations.  From what I’ve read, my opinion is the following:

• Rebalancing is absolutely necessary.  Buy and hold is consistently beaten by rebalanced portfolios.
• However, rebalancing need not be too frequent.  I’ve read the best results from rebalancing no more than quarterly, when holding an all-securities portfolio (NB: if you’re using options, a monthly rebalance is worth the effort).  Annual rebalances are a good rule-of-thumb.

Finally, let’s look at a (somewhat) practical example.  I’ve taken total return series for the S&P 500 and US 10-Year Treasury Notes, from 1998 until end-Oct 2014 (Source: Quandl).  Starting with a 60% S&P and 40% Treasuries, I’ve created 3 portfolios:

1. Buy-and-hold – initial purchase of stocks and bonds remains unchanged throughout the time period.
2. Constant mix – portfolio is rebalanced to 60/40 at the end of each month.  Notice that, over this period, the constant mix slightly outperformed buy-and-hold, despite equities outperforming bonds handily in the period.  We must be capturing some mean-reversion among the two asset classes.
3. CPPI – the portfolio is rebalanced according to the following parameters: multiplier of 3; cushion value (Treasuries used as cushion) of 80.  Rebalance occurs at each month-end.  Notice that this is a much more aggressive rebalancing technique than the others; due to the equity outperformance, especially in the past few years, this ends up being the best relative performer (albeit with much higher volatility).

Which method do you prefer?

Finance 101: Slight diversion…Let’s play a game!

Saw this on my weekend reading, from the Phroogal blog.  Looks (and plays) like a fun introduction to budgeting and spending.  For kids of any age, methinks…

Money Metropolis Game

Finance 101: Part 5 – Beginning portfolio construction

Now the components of a saver’s portfolio have been outlined, let’s talk a bit about putting a few parts together.

Here are my fundamental principles for putting together my portfolio, at least, in order of priority:

1. Don’t risk ruin.  I value sleeping well, so at no point could my investments go to zero or below.  That means (for those reading the extension lesson last time) never holding unlimited risk positions, keeping leverage at a reasonable level, and always holding a significant portion of cash.
2. Diversification is king.  Hopefully I’ve convinced you by now.  I like having multiple types of return sources in my portfolio, so that my net worth doesn’t whip around like the stock market.  We’ve had the benefit of 2008 to learn that not all diversification is real (e.g. all hedge funds proclaimed they’re diversifying to equities, but that argument was proven very wrong).  This concept also means I need to keep on top of my investments, as sometimes what used to be diversifying is no longer.
3. Minimise costs.  Market returns are extremely uncertain, but costs are completely controllable.  If I can achieve the same type of return stream with lower cost, I’m there.  BTW, I do still believe there are some superstar managers in super-diversifying sectors which deserve high fees; I just can’t afford them!
4. Be lazy, yet systematic, as possible.  I would like a portfolio which requires maintenance (e.g. rebalancing) roughly once every few months.  I keep a picture of my desired allocation, and rebalance when necessary at those points.  That being said, I’m stretching the truth in my personal situation, as I’ve gone a few steps further.  But for the vast majority (99%+), having a relatively stationary portfolio is key.

So what are the basic ingredients for our beginning portfolio?

• Cash: I am a subscriber to the idea of holding an emergency cash stash.  Opinions vary, but I would keep as much as needed set aside to feel comfortable if and when everyone in the family loses their jobs, and the financial markets are in the toilet.  Probably 3-6 months of expenses, with more if you live in an ‘at will employment’ country (e.g. the US!).  Advice for those working in the financial sector: keep more cash, as your job prospects are directly proportional to rising financial markets.
• Equities: in particular, index ETFs.  They fit the points above perfectly – low cost, diversified, automatically rebalance.  Diversifying across geographies is a good idea – for example, US stocks are currently trading at a much higher valuation than the Rest of the developed world, so maybe worth buying some of the RoW.
• Bonds/Treasuries: hmm.  Why do we usually have bonds in the portfolio?
  • They usually perform well (Treasuries, in particular) when stocks perform poorly.
  • They pay recurring interest – ‘carry’ is good, for the most part.
  • They have lower volatility than equities…mostly.
  • In sum, we should probably have some bonds in the portfolio.  However: remember that interest rates are near all-time lows, so carry isn’t too great, and  bonds can’t offset equity losses as well as in past.  I’m currently massively underweight bonds in our portfolio, replacing bonds with extra cash and a managed futures mutual fund.
  • I’d use ETFs instead of buying underlying bonds, given illiquid bond markets.

What proportions of each?  One of my favourite bloggers/fellow individual investors wrote a great post on creating a low-effort ETF portfolio, with the goal of equalising risk between equities and bonds.  A good start, methinks, for all the cash you don’t squirrel away in the emergency fund.

Finance 101: Part 4, extension – Derivatives

Last post completed a listing of various savings vehicles.  In sum, one can purchase a variety of securities (e.g. stocks, bonds) and/or strategy funds.

Let’s complete the picture with probably the most complex, and potentially risky, component of an investment portfolio: derivatives.  These instruments can be used for a variety of purposes, as part of an overall portfolio.  Unfortunately, they require close scrutiny; their inbuilt leverage means you need to monitor your portfolio at least daily.  That probably excludes most savers.

In any case, here we go:

1. Options (puts/calls): these are contracts between buyers and sellers, with reference to some underlying asset (usually shares of stock/indices, or futures contracts).  The option contract gives the buyer the opportunity, but not the obligation, to buy the underlying (in the case of a call) or sell the underlying (put) from the option seller.  So if I buy a call option on AAPL stock, I pay someone for the opportunity (but not the obligation) to purchase AAPL at a pre-decided price.  For the opportunity to do that, I pay the call seller a small premium.
2. Futures: these are contracts between buyers and sellers, with reference to some underlying asset (e.g. shares of stock/indices, certain amounts of commodities, bonds).  The futures contract gives the buyer the obligation to buy the underlying at a future date, at a pre-decided price.  So if I buy a futures contract on soybeans, I have agreed to buy a set amount of physical soybeans, for a set price, at a specified date in the future.  I don’t have to pay a premium for the futures contract – I just post some surety margin with the exchange, to honour my obligation.

• Benefits of derivatives:
  • Leverage: instead of using borrowed money to buy securities, one can use futures and options.  Both have inbuilt-leverage: after all, both are just contracts between buyers and sellers, and both parties want the leverage.
  • Flexibility: particularly in the case of options, the user can specify maximum loss vs maximum gain and/or probability of success.  Instead of basing gains/losses on underlying gaining in price, these derivatives allow shorting and neutral positions (e.g. positions which make money when the underlying doesn’t move).
• Drawbacks of derivatives:
  • Leverage: having the ability to make levered bets is a blessing and a curse.  At its worst, poor money management can wipe out an entire portfolio – even with a relatively small move.
  • Complexity: particularly in the case of options, these are influenced by several factors other than underlying price moves.  Unless the user understands all the contributors to option value, profit/loss will come for unknown reasons!

Reasons I use derivatives in my portfolio:

• Defining maximum loss: I like the feeling of knowing exactly how much I’m going to lose in a worst-case scenario.  For example, with the stock market vacillated around all-time highs, I’ve replaced my underlying securities with options; now my maximum loss is the premium I’ve paid for the position.
• Inexpensive leverage: margin debt is expensive, and I don’t like the idea of needing to liquidate holdings when the market falls (see 2008).  I can achieve the same, or better, leverage with options at a lower cost and no need to worry of forced liquidation.
• Getting paid for time: option values are partially determined by time to expiration – therefore the option seller receives payment (through the amortisation of option premium) for passing time.  Combining this point with the above 2 points, I can get paid for time passing.

In summary: derivatives give a lot more flexibility to an investment portfolio, but requires a lot more TLC.  Most savers won’t ever touch these, but for folks with an interest in derivatives I can recommend the guys over at tastytrade for information resources.

Finance 101: Part 4…part 2: Overview of savings vehicles, alternatives-style

The previous post focused on ‘conventional’ savings instruments – bank accounts, bonds, stocks, real estate.  Most of what I’ve read on other blogs/books/websites stays on these topics.  In fact, even the CFA curriculum stays pretty safe on these topics: Alternative Investments are kept at mostly a conceptual level.  That probably makes sense, as most people won’t go for alternatives; they’re kinda ‘new’ relative to stocks and bonds.

As I wrote in a previous post, I’m always looking for more portfolio diversification: investments which perform at different times (and/or in different ways) than conventional stocks and bonds.  Here is my list of alternative investment vehicles, ranked by my view of increasing risk/complexity:

1. Most hedge fund strategies:  in days of yore, hedge funds used to be high-octane, high-risk performance vehicles.  As the investor base for hedge funds has shifted towards risk-averse institutions, most hedge funds have lowered their risk; often risk is lower than equities.  This bucket includes Long/short equity, merger arbitrage, event-driven, convertible arbitrage, fund of funds… most strategies.  Most individuals can’t access the ‘flagship fund’ (i.e. the fund charging full 2 and 20 fees), unless they’ve a financial advisor who usually charges additional fees on top.  More affordable alternatives include alternative beta mutual funds (e.g. AQR) or ETFs (e.g. GURU).  These funds tend to provide the least diversification to conventional equities, so up to you whether you include.
2. Macro/managed futures/CTAs: both discretionary and systematic macro or managed futures strategies fit here.  For the icons, think George Soros or Paul Tudor Jones: big calls on macroeconomic themes.  From a statistics perspective, these funds are based around momentum trading: buying when prices rise, and selling when prices fall.  For a conventional long equity/bond portfolio, the best bang-for-the-buck diversification comes from this strategy; they were the only guys making money during 2008.  Same with #1, flagship funds typically charge 2 and 20 or more; affordable options are managed futures mutual funds (see earlier post on fees) or ETFs.
3. Master Limited Partnerships (MLPs): the US has a tax-efficient structure (similar to a REIT, covered in last post) for infrastructure investments.  Think natural gas pipelines, cell phone towers, etc.  These are traded on exchange, so pretty liquid.  Dividend yields can be pretty attractive as well, provided they’re sustainable.  MLPs had a very tough 2008-2009, so diversification against equity is good in the good times, but bad in the bad times.
4. Private equity funds: in particular, I mean buyout funds.  The idea is pretty simple: buy a company with a ‘mortgage’ – e.g. borrow a large portion of the purchase price from lenders.  The interest cost is tax-deductible for the target company, so the tax savings alone sometimes makes this a worthwhile investment thesis.  Buyout funds are similar to hedge funds in lack of liquidity (flagship buyout funds frequently lock up capital for 3-5 years) and high fees (buyout funds typically charge 2 and 20, as well).  Affordable alternatives, to me, are buying the shares of listed buyout firms like Blackstone or Apollo.
5. Venture capital funds: let’s find the next Facebook, shall we?  The business plan for these funds is like a baseball player who always swings for the fences: some investments return zero; some break even; and a small proportion return so much, they pay for all the failures and then some.  Similar terms to buyout funds, and diversification benefits versus public equities is up for debate.  Big firms like Blackstone have venture funds; otherwise you may be out of luck getting into these ‘sophisticated’ investment funds.
6. Volatility arbitrage: getting into the more exotic realm here.  The idea is that implied volatility (of options) is almost always overpriced relative to actual volatility (of underlying assets).  This is a prime example of ‘it works until it doesn’t’: many of these funds lost 50-75% of capital when markets crashed in 2008.  Those that survived have made most of it back, I think.  How do you feel about keeping invested in a fund that’s lost 75% of your initial investment?  Anyway, most funds are small, expensive, and near-impossible to access.

What did I miss?  Derivatives! It’s a bit outside a 101 course.  I’ll cover basics next time.

Finance 101: Part 4 – Overview of savings vehicles

There are seemingly infinite options available for savings these days.  I probably understand more than many, but definitely only a subset of the cornucopia one can put money to work.

For those looking for an intermediate text on investment vehicles and strategies, I can definitely recommend Expected Returns by Antii Ilmanen.  I’m sticking with the basics here.

Savings vehicles, listed in order of (my perception of) complexity and risk:

1. Government-insured bank deposits.  No real description needed.  If kept below the insurance level, these balances have a place for instant access and emergency funds.  I recommend Money Saving Expert or Bankrate.com for comparing best rates.  Remember – if the bank is government insured (I’m clenching a bit due to the IceSave situation, but we can talk about that another time), the only factor that really matters is the interest you receive.  It’s all the same otherwise!
2. Bank Certificates of Deposit (CDs).  Same as #1, but this time you’re locking up your funds for a certain period of time.  If you need the cash earlier, you’re paying away some accrued interest or even principal.  Some CDs aren’t government-insured, so be aware.  Use the same resources as #1 for the rate comparison.  Choose a time frame which you’re happy to lock away your money.
3. Government bills.  Treasuries for Americans; Gilts for Brits.  They’re as safe as #1 and #2, but less accessible.  Use TreasuryDirect to buy Treasuries from the government (to avoid brokerage charges).  The DMO in the UK has info on buying Gilts; not as easy as Treasuries!
4. Money market funds.  Most probably experience this as the ‘cash sweep’ option on their brokerage accounts.  These are not insured, but invest in high-rated, short-term government and corporate debt.  Biggest additional risk here is credit risk, but generally minimal.  Another problem these days: yield on these funds may be the same or lower than management fees, so you won’t make any interest!
5. Government bonds.  The difference between #3 and this is duration – similar to the difference between #1 and #2.  If you purchase a 10-year Treasury, you’ll need to hold for 10 years to get the full yield; selling on the secondary market means you may lose more than your initial investment.  With interest rates at near-record lows everywhere in the world, I think long-dated bonds are as risky as they’ve ever been.
6. Investment-grade corporate debt.  This takes #5 and adds credit risk.  According to the book referenced above, there is little to be gained purchasing investment-grade debt rather than government debt in the long term.  Beware, those who chase the extra yield of corporate debt; frequently they’re priced correctly.  Utilise brokerage accounts to purchase these; there is no exchange, so you’ll have to buy directly from a dealer.  Which reminds me of the stories of BMW-driving, mansion-owning bond dealers.
7. Utility stocks.  I put this as in-between debt and equity, for personal investing.  Steady cash flows and high regulation mean these guys have high financial leverage, but can sustain that and recurring dividend payments that frequently exceed corporate debt interest.  Keep in mind that, as interest rates move higher, these utilities will use more of their cash flows to pay debt interest rather than dividends.
8. Broad stock indices.  In particular, S&P 500, the Nasdaq, FTSE 100, MSCI World, etc.  This is generally what is meant by pundits when they say ‘buying the market’ or ‘stocks moved higher/lower’.  Purchase low-cost index tracker funds (see Vanguard, for a start) or Exchange Traded Funds (ETFs), with the smallest possible fees, across a range of geographies.  For the majority of savers/investors (I’d wager), this category represents the vast majority of their portfolios.  Or should.
9. Real estate Investment Trusts (REITs).  These are equities, purchased through your broker, which mirror the returns of holding/building/financing real estate.  They generally pay out healthy dividends, but their capital is very much at risk both to interest rates rising and to an economic downturn.  On the plus side, they tend to diversify a little bit from the overall equity market.  I’d recommend purchasing an ETF basket of several REITs, rather than any single name.
10. Individual corporate equity.  Think you’re good at picking stocks?  It’s extremely unlikely you’ll beat the indices in #8.  A big issue is skewness of returns: purchasing equity in a single company means you have a much higher risk of losing big (that company might declare bankruptcy, after all).  This issue isn’t really an issue with #8.  The same goes for actively-managed stock mutual funds: time after time, these funds underperform #8.
11. High-yield corporate debt.  Why more risky/complex than equities, you ask?  How much do you know about recovery rates, and their correlation with the business cycle?  Can you understand senior/subordinated loans and bonds, either with or without security?  The book mentioned above finds no benefit of owning high yield credit above Treasuries, with the exception of ‘fallen angels’ – companies who become high-yield from previously investment-grade.  Anyway, credit spreads are near all-time lows, so methinks this is a tough area to enter.
12. Real estate.  Yes, this includes purchasing your first house.  Folks in London can’t stop talking about real estate prices, and ‘getting on the housing ladder’.  Here’s why I put this type of investment so low on the list:
    1. Lack of diversification:  putting aside calamities which may or may not be insurable: what if your neighbourhood goes to the dogs?  Your house may not be worth anything like what you’ve paid for it.
    2. Leverage, leverage, leverage:  few folks buy their first house in cash; mortgages are essential.  If you have 5% as a down payment, you now have 2000% leverage on a (non-diversified) investment.  Fantastic news if house prices march ever-upwards; horrible news if you purchased in 2007-2008.  See this fun/depressing map from Zillow to see how many people are still underwater on their houses.
    3. Ancillary costs: who knew prepping a house for sale could be so expensive?  Or the realtor fees?  The market is generally illiquid, so hopefully one can get a reasonable price for the house when it’s selling time.  As for buy to let: management fees and capital expenditure can be unknown and expensive.

OK, off my soapbox on the last one.  I will continue the discussion, into alternatives, in the next post.