Category Archives for Invest & Retire
Are IPO’s a Good Investment Option?
In multiple previous posts (see posts at link below for more details), I have made the case for why holding index mutual funds is a far superior strategy for individual investors than buying and selling individual stocks.
My Money Blog – Individual Stocks vs. Index Mutual Funds
However, in these postings, at no point did I address the issue of whether or not IPO’s (or Initial Public Offerings) make for good investments. This will be the topic of today’s post.
To begin this analysis, we first need to start with defining what an Initial Public Offering, or IPO, is exactly.
What is an IPO?
According to Investopedia.org, an IPO can be defined as shown below:
- “The first sale of stock by a private company to the public. IPOs are often issued by smaller, younger companies seeking the capital to expand, but can also be done by large privately owned companies looking to become publicly traded.”
Typically, the company going public will team up with an underwriter (usually an investment banking firm) that will help the company the timing of when to begin selling shares of stock on the public market and what price at which to offer them.
Now that we have an idea of what an IPO is, let’s take a look at how they have performed against the test of time.
Performance of IPO’s Over the Years
As you might have guessed, according to academic research supporting the Efficient Market Hypothesis (place link to investopedia.org here), since IPOs are individual stocks, they are already, by nature, less effective than index mutual funds.
So, let’s say that is “Strike 1” against IPOs.
“Strikes 2-5” come to us from four studies cited in Larry Swedroe’s book titled, The Only Guide to a Winning Investment Strategy You’ll Ever Need
. The results of these studies are summarized below:
- Study 1
- Strategy – buying every IPO from 1970-1990 at the closing price of the 1st day of trading for an IPO and then holding each for 5 years.
- Results – IPO investments performed 7% below benchmark performance of companies with comparable market capitalization already trading.
- Study 2
- Strategy – buying every IPO that rose as least $20 million from 1988-1993 (1,006 IPO’s).
- Results – Underperformed Russell 3000 index by 30% in the three years after going public. In addition, 46% of the IPOs produced negative returns.
- Study 3
- Strategy –Buy all IPO’s issued in 1993 and hold until mid-October 1998
- Results – Found that the average IPO returned 67% less than the S&P500 index.
- Study 4
- Strategy – Buying all IPOs that rose 60% or more on their opening day and then holding from 1988-1995.
- Results – Underperformed market by 2-3% per month (24-36% per year). Wow!
As you can see from the pitiful under-performance above, IPO’s, even though they are a very exciting investment option, are definitely not the best choice for individual investors.
By all practical terms, you will never have sufficient knowledge that you would need in order to make an informed purchasing or selling decision with IPOs. Due to this very strong reasoning, IPO’s are best to be avoided by individual investors.
If you do enjoy the excitement that IPOs offer, there is no problem with using a small amount of funds to buy IPOs and place them in the Play Money portion of your portfolio.
For more information on Play Money/how to work IPO’s in to your investment strategy, please click on the link below.
My Experience
Personally, I have never invested in an IPO, and therefore, am curious to learn about experiences you all have had with them.
Please feel free to post a comment below and tell everyone how an IPO fared for you!
Keep on learning!
Jacob
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Are Lifecycle Mutual Funds a Good Investment Option?
, the following case can be made for avoiding Balanced, or Lifestyle Funds.Jacob
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What if Everyone Invested Only In Index Mutual Funds?
In many of my postings on this website (including the post at the link below where I explain my overall investment strategy), I have discussed the numerous benefits involved with investing in index mutual funds.
provides, in my mind, a very good investigation of this question.Keep on learning!
Creating and Implementing Your Investment Strategy – Part 6 – Putting It All Together
- My overall equity/fixed income split is 75 / 25%. Therefore, I would rebalance at this high level if my equity or fixed income allocations are outside the ranges of 70-80%, and 20-30%, respectively.
- My equity split is 29% international / 71% US domestic. Therefore, I would rebalance at this level is my international or domestic allocations are outside the ranges of 24-34%, and 66-76%, respectively.
Creating and Implementing Your Investment Strategy – Part 5 – Determine Your Specific Mix of Equity Investments
-
A Random Walk Down Wall Street
By Malkiel -
The Four Pillars of Investing and The Intelligent Asset Allocator, both by Bernstein
-
What Wall Street Doesn’t Want You to Know by Swedroe.
By Malkiel
and The Intelligent Asset Allocator
, both by Bernstein
by Swedroe.
The table below shows the recommended breakdown and categories of mutual fund investments needed to make up the domestic portion of your equity portfolio. I have also, for your convenience, listed the corresponding Vanguard index mutual funds that can be bought for your portfolio if you choose.
To find the overall percentages of your portfolio that each fund should contribute, simply multiply your overal equity allocation % (70% in this example) by the % allocation of the equity portion of your portfolio. This multiplication can be done to all of the funds with the exception of the REIT portion, which needs to make up 10-15% of your overall portfolio, increasing as you age.
The table below shows the recommended components to make up the international portion of your equity portfolio, based on a 30% international / 70% domestic equity split. It should be noted that in several of the books I referenced above, they suggest purchasing Large cap value, small cap, and small cap value international funds as well.
However, since these funds are not readily accessible through Fidelity and Vanguard, I avoid them (they are only available through DFA Fund Advisors).
In place of these categories, I use a Total International Stock Fund offered with low management fees through Vanguard.
Keep on learning!
Jacob
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Creating and Implementing Your Investment Strategy – Part 4 – Determine Your Mix of International and Domestic Equity Investments
At a high level, the reason that you will want to add international investments to your equity portfolio is due to the fact that the price movements are not highly correlated with the returns of US equities. Because of this low correlation, it provides decreased risk and increased returns through the power of diversification.
Optimal Split –
A study published in the Journal of Investing in 1998 took an in-depth look at the performance and risk associated with different portfolios with varying asset allocation levels of international/domestic US equities.
The results of the study showed that the split that showed the optimal performance was an equity portfolio with 40% international and 60% US domestic. This allocation provided the highest returns with the lowest risk/price volatility. In other words, it had the highest Sharpe Ratio.
Finding The Split That Suits You Best –
While the 40% international allocation described above is the “optimal” split, as defined by academic research, it doesn’t necessarily mean that you should allocate 40% of your equity holdings to international investments.
Why is this you might be asking? The answer lies in the fact that an investment strategy is only as good as an individual’s ability to stick to it, even in the worst of times. The worst thing that could happen is that you determine several years from now that the 40% international equity allocation you decided upon is too much risk for you, and it causes you to sell off all of your holdings.
Therefore, in my opinion, the best approach is to use the 40% optimal split as the highest international allocation that anyone should employ in their investment strategy.
In other words, only the heartiest of souls that are very young (in their 20’s) should allocate 40% of their equity holdings to international investments.
For the rest of us, Burton Malkiel describes the following recommended allocations (based on age) in his famous book, A Random Walk Down Wall Street
. As you can see in the table below, even for people in their 20’s, Malkiel recommends that they only have 30% of their equity funds allocated to international instruments. I feel this level is very appropriate.
So, take a look at the table below to define at a high level of how your equity portfolio will be constructed.
In Part 5 of this series, I describe how you can determine the specific mutual funds that should make up the US domestic and international portions of your equity portfolio.
Keep on learning!
Jacob
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Creating and Implementing Your Investment Strategy – Part 3 – Determine Your Specific Mix of Fixed Income Investments
-
______ % of my portfolio will be in fixed income investments and the remaining _____ % (1- fixed income %) will be in equity investments. The total should be 100%.
- For simplicity, throughout the rest of this post, we will assume that the asset split you choose is 30% fixed income and 70% equity.
So, you know that 30% of your investments should be placed in fixed-income vehicles. However, which ones should you choose to make up this 30%?
- Maturity
- No matter what the time horizon is for when your specific cash needs will occur, academic research has shown that short-term fixed income investment instruments have 1) less interest rate risk, and 2) higher returns.
- Because of these two factors, short-term (1-3 maturities) fixed income investments are considered superior to long-term ones.
- Fund Management
- As with equity investments, the fixed income security markets are extremely efficient, and therefore, active management is a loser’s game.
- Because of this, we will only want to seek out indexed/passively managed fixed income instruments for our investments.
- In my opinion, there are really four different options available to you as an individual investor for the fixed income portion of your portfolio:
- Cash / cash equivalents
- This category would include extremely liquid investment account types.
- Examples include money market accounts, savings accounts, and checking accounts.
-
See following link to read my previous posting on these types of accounts – My Money Blog – Cash Equivalent Savings Accounts.
- Short-Term Indexed Bond Funds
- Offered by Vanguard and Fidelity. Vanguard fund I use is the Short-Term Bond Index, Ticker symbol – VBISX. Vanguard Bond Index Funds
- Feature low cost, passive management and expense ratios.
- Inflation Protected Bond Funds
- Also offered by Vanguard and Fidelity. Vanguard fund I use is the Inflation-Protected Securities fund, Ticker symbol – VIPSX.
- This type of investment instrument provides a hedge against changes in inflation.
- The interest rate associated with the bond fund changes with fluctuations in inflation.
- US Treasury Securities
- Can be used in place of Short Term Indexed Bond Funds. Personally, I prefer to use indexed bond funds due to the fact that they are offerred by Vanguard, and it therefore, keeps all of my investments in one place.
- Bought directly from the US government/treasury.
- Backed by the full faith and credit of the US goverment, and are therefore, very safe investments.
- Still have interest rate risk associated with them, however.
- Select the cash % allocation of your total portfolio, according to the first row of the table.
- Assume that you will allocate 5% of your total portfolio to inflation protected securities.
- Subtract the cash % and 5% inflation protected securities allocations from the overall fixed income allocation you calculated (in previous posts) to obtain the % of your portfolio that will be made up with a short term index bond fund.
For the 30% fixed income / 70% equity asset allocation example above (assuming the investor is below 60+ years old) –
- 5% of your overall portfolio would cash
- 5% would be inflation protected securities
- 20% (30%-5%-5%) would be index short term bond funds.
Note: The data is this table is taken from pgs. 350-351 of Malkiel’s famous book,
A Random Walk Down Wall Street. If you haven’t read it, click on the link to the left to pick up a cheap used copy from Amazon.com.
In Part 4 of this series, I take everyone through how to figure out your specific mix of index funds for the equity portion of your portfolio.
Keep on learning!
Jacob
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Creating and Implementing Your Investment Strategy – Part 2 – Determine Your Fixed Income Asset Allocation
In Part 1 of this series (see link below), I walked everyone through the first two steps in creating a personalized investment strategy.
- Determine the amount of cash liquidity you need for your emergency fund
- Forecast your future cash needs within 20 years in order to determine the minimum amount of fixed income Dollars you need to invest to meet your goals.
Creating and Implementing Your Investment Strategy – Part 1
In Part 2 of this series, we will walk through Steps 3-6 of the process in creating an investment strategy.
The end goal of this exercise is to make a final determination of the appropriate fixed income investment asset allocation.
Step 3 – Determine How Much Variability You Can Emotionally and Physically Tolerate
In investing, there are several certain, simple truths that you need to account for occurring at one time or another. One of these is the fact that your investments will decline and have very bad years from time to time.
The good news is that the “good times” in the market (when the stock market is increasing) usually persist eventually, enabling your investments to obtain a very good rate of return. However, in order to obtain these good rates of return, you must have the discipline to resist panicking and withdrawing your money from the market/equity exposure during declines.
In order to help you determine how much risk you are able to tolerate, we’ll need to analyze the table below (this table comes from Larry Swedroe’s book The Only Guide to a Winning Investment Strategy You’ll Ever Need).
The table matches a worst case investment decline (loss) that can be possibly occur in a year, given a certain % fixed income asset allocation. I also included what the % decline would indicate in real Dollars if you were to have $100,000 in total assets invested.
Exercise:
Imagine in your head what you would do if you were to lose X Dollars in a year. Would you sell all your equity holdings? Would you buy more? Would you hold out until the market recovered?
Be honest with yourself. You are only hurting yourself if you answer incorrectly.
Once you have thought about it for a few minutes, record the minimum fixed income exposure level that you decided on, based on the maximum tolerable loss you can physically and emotionally tolerate within any given year.
Step 4 – Compare Your Results from Step 2 and Step 3
Next, take the minimum fixed equity % exposure level calculated in Step 2 (based on your forecasted future cash needs – don’t worry to include your emergency fund needs) and compare it with the exposure level you calculated in Step 3.
Take the higher, more conservative fixed income exposure/asset allocation level of the two that you calculated. Proceed to Step 5 below.
Step 5 – Determine How Much Risk You Need To Take On to Meet Your Investment Objectives
The final step in determining your overall equity and fixed income asset allocation percentages is to consider how much money you need/want to have later in life from investing. For me, this decision more specifically means how much money I will need to have to live the lifestyle I want during retirement.
To determine this, click on the link below to see my previous post on calculating how much money you need for retirement.
How Much Do You Need For Retirement?
In the retirement calculator in the post above, the place where determining how much risk you need take on relates to the “Assumed Annual Return” field.
By principle of efficient markets, the only way to increase this assumed annual return is to increase risk. And, the only way to increase risk is to increase your exposure to equity via your asset allocation percentages.
The table below gives approximate equity allocation % exposure levels corresponding to different rates of return required to meet your financial goals.
Using the retirement calculator above and the table below, record your target equity allocation %. To get the target fixed income % allocation, take 1- target equity allocation %.
Step 6 – Finalize Your Overall Asset Allocation Targets
Finally, compare the result from Step 5 (how much risk/equity you need) with the result from Step 4 (how much security/fixed income you need).
How do the levels compare?
As a general rule of thumb, you should take the highest fixed income asset allocation result that is obtained. This will help you have less stress in life. If, however, you find that your result from Step 5 tells you that you need to take much more risk in order to meet your goals, I would start analyzing ways to either 1) cut current spending and save more or 2) plan to live a simpler life style in the future.
To read Part 3 of this series, click on the link below.
Creating and Implementing Your Investment Strategy – Part 1 – The Liquidity Test
In a previous posting series (see 1st link below), I walked everyone through the steps in David Bach’s book Smart Couples Finish Rich
for how someone can create and implement a Purpose Focused Financial Plan.
As a final step to this series, I discussed the specific financial actions that a person can take to put this plan in to action (see 2nd link below):
- Creating a Purpose Focused Financial Plan Series
- Creating Your Purpose Focused Financial Plan – Part 4
In order to save money for longer term life dreams, David recommends using index mutual funds to accumulate wealth.
In the link below where I defined my asset allocation objectives/targets, I mentioned that I had defined the allocation levels based on several finance books that I have read. However, I did not go through the exact step-by-step details of how I arrived at the levels.
Since this is a very useful and interesting process, I wanted to dedicate a series to discussing how I (and you) can do some “self-searching” and arrive at a personalized investment strategy that you can then review with your financial advisor.
Step 1 – The Liquidity Test
The first thing to determine is whether or not you have enough cash or liquid fixed income investments on hand for what is called an “emergency fund.”
As described in the link below, you should keep enough cash on-hand for 6-9 months of expenses. These should be available for you to tap in to in the event that you lose your job or are injured (and cannot work).
Step 2 – Forecast Your Cash Needs for the Next 20 Years
After making sure that you have saved up enough money for your emergency fund (and made a mental note of the quantity), you must now plan for any expected cash needs for the next 20 years. The purpose of this exercise is to help to determine the minimum % of your assets need to be fixed income and which can be held in higher-return-producing equities instruments.
To get you started brainstorming, several cash need examples are listed below:
- Emergency Fund – most important thing
- House down-payment
- College tuition for you or your children
- Purchasing a car
- Engagement ring purchase
- Future vacations
- A high-end $6000 bicycle
- A motorcycle
Once you have thought about what cash needs will come your way in your life, click on the link below to access a template I put together for you to list a written and $ value description of your future cash needs.
Just download an Excel copy of the spreadsheet on to your desktop in order to be able to write your values in. Also, be sure to place the cash requirement in the appropriate year in which it will be used.
Google Docs – Forecast Your Future Cash Needs
After you type in your forecasted cash needs, the spreadsheet will then automatically calculate the total $ value that you need to invest in fixed income securities right now in order to meet your cash requirements/objectives. This quantity is displayed in the light purple cell, designated H3.
This total quantity is found by multiplying the cash needs by the appropriate (1- Maximum Equity Exposure Percentage) rate.
Once you have entered your forecasted cash needs and obtained the $ value from cell H3 that you need to have invested in fixed income investment instruments, you then need to perform the following steps.
- Enter the total amount you have available to invest in cell I3. The spreadsheet will automatically calculate the % of your assets that you should have invested in fixed income securities in cell J3.
- Next, perform a reality check.
- Compare the $ value that you should have invested in fixed income securities to the total amount of money you have available for investing.
- If the number is greater than the total amount you have available to invest, you may need to reduce your cash needs.
- Ask yourself – “how fancy of a house can you really afford?” – Maybe you cannot afford as high of a downpayment as you expected.
- Ask yourself – “do I have enough money to pay for my future child’s education?” If not, you should not feel bad about the fact that you need to secure your own financial future before setting aside money for their education.
- After making any adjustments needed to your forecasted cash requirements, make a record of your finalized % of your assets that should be allocated to fixed income instruments from cell J3.
- This value will be used going forward in the next post of this series to make a final determination of the % that you should allocated to fixed income instruments.
To read Part 2 of this series, click the link below.
Homeowner’s Insurance
- Homeowner’s insurance should only be purchased to protect yourself against “financial catastrophes.” It should not be used for to recover from a small loss.
- An example of a catastrophic loss would be if a storm caused a tree to fall on your house.
- An example of a small loss would be if someone broke in to your house and stole only your TV you purchased for $1000.
- Take the highest deductible that you can afford.
- For the uninitiated, a “deductible” is the amount you have to pay out of pocket to your insurance company before your insurance policy will pay you out for the coverage you have.
- By taking the highest deductible you can afford, it ensures that you will only tap in to your insurance policy for catastrophes.
- Typically, the options available for deductibles quantities are $250, $500, $1000, $2500, and $5000. Choosing a higher deductible can save you huge money on your monthly insurance premium payments, as shown below.
- If you increase your deductible from $250 to…
- $500 – save up to 12%
- $1000 – save up to 24%
- $2500 – save up to 30%
- $5000 – save up to 37%
- The highest deductible that each person can afford varies (as you probably guessed). However, for my situation, I would go with a $2500 deductible, since I keep a good amount of funds available in my emergency fund savings account.
- Buy broad coverage insurance that covers all types of “perils,” or possible bad things that could happen to damage your home.
What does homeowner’s insurance consist of?
Provided that you purchased broad insurance (called HO-3 in technical circles) as mentioned above, your homeowner’s insurance policy will consist of three types of coverages – dwelling, personal property, and liability.
- Dwelling Coverage
- Dwelling coverage insures the cost of rebuilding the structure of your home, in the event that it were to be destroyed.
- In your insurance policy, you will want to make sure that you have a “guaranteed replacement cost” provision. This provision ensures that your insurance will pay to rebuild your house’s structure, even if it costs more than the Dollar value amount of the coverage you obtained.
- Condominium Dwelling Coverage
- Dwelling coverage for condominium’s works a little differently than with single-family homes.
- The condominium’s Home Owner’s Association (called HOA) will have a master policy that covers rebuilding the structure of the building in which your condo unit is located. If you are buying a condo, you will want to make sure that the dwelling coverage on the building in which your building is located is sufficient to rebuild the structure. For example, in reading through the HOA master policy for the condo I am moving in to this fall, I found out that the coverage for the 10 unit building in which my unit is located is only $750K. This seems a little bit low to me, meaning that I will want to look in to that issue going forward.
- However, the HOA master policy will not cover the replacement of the interior of your unit. For this purpose, the dwelling coverage portion of a homeowner’s insurance policy for condos will cover the following interior structures of your unit:
- Walls
- Wall coverings
- Carpeting
- Built-in cabinets
- Shower modules
- Sinks
- Personal Property Coverage
- Personal property coverage insures the “stuff,” or contents that you keep inside your home.
- As mentioned with dwelling coverage, you want to make sure that the personal property coverage contains a “replacement cost guarantee” to ensure that all of your items are replaced by your insurance (even if the price is higher than you thought), in the event of a loss.
- Personal property coverage is generally based on a percentage (usually 50-75%) of the dwelling coverage Dollar value. This is usually more than enough.
- Liability Coverage
- Liability coverage insures you in the event that someone is injured on your property (or by your pets) and sues you for damages.
- The general rule of thumb with this coverage is to obtain the larger Dollar value of either 1) 2X the amount of your dwelling coverage, or 2) $300,000.
Determining how much coverage you need
- Take a written and pictorial inventory of your property
A good place to start with in determining how much coverage you will need from your homeowner’s insurance policy is to take an inventory of all of the contents of your current apartment or home. Beside each item on the list, you will want to record the replacement value of the item (make sure to list what the item would cost to replace at today’s prices, not the price that you paid for it). Making this inventory will also help you if it ever comes time to file a claim to receive your insurance.
To get you started, the link below is a good resource from State Farm that shows the items contained in a typical house, along with their approximate replacement value. In addition, the Insurance Information Institute offers a great FREE pdf brochure available for download that will guide you through this inventory taking process.
Depending on the type of structure your home is, you will want to add replacement cost to 1) rebuild the actual house structure and 2) replace any permanent attachments, appliances (water heater, air handlers, wiring, etc), or improvements you have.
State Farm – Personal Property Inventory
Insurance Information Institute – Home Inventory
After you have done this, you will also want to take pictures and/or a video of EVERYTHING in your house. This will provide even more evidence that all of the items are real, in the event of a disaster occurring.
Key point: Remember to store the inventory AWAY from your house, so that you do not lose it along with your other items in a disaster. For the written inventory, a good way to store the Excel file with the listing of all of your items is using Google Docs. It is a free online platform that allows you to securely store and share documents.
What is covered by your homeowner’s insurance policy?
If you have a broad coverage insurance policy, the following “perils” are typically covered:
- Losses caused by fires, lightning, tornadoes, weight of snow, wind storms, hail, explosions, smoke, vandalism, theft.
- Losses caused by a pipe bursting and spilling water all over your house
- Losses caused by a tree falling on your house during a storm (only if the tree was alive before falling).
For more information, the brochure (available for free pdf download) at the link below goes through numerous scenarios that are and are not covered by home insurance.
Insurance Information Institute – Am I Covered?
What is not covered by your homeowner’s insurance policy?
- Damage caused by floods or earthquakes
- Damage caused by water seepage from the ground
- Food spoilage
- Expensive jewelry, furs, or firearms
- Damage caused by birds, rodents, insects, or pets.
- Damage caused by business activities
Obtaining flood and earthquake insurance
Since flood and earthquake insurance is not included in the regular homeowner’s insurance policy, you will have to purchase it separately.
For earthquake insurance, it can be purchased directly from the insurance provide of your homeowner’s policy. Simply ask your agent to get coverage added on for that element.
On the other hand, flood/mudslide insurance must be purchased from the National Flood Insurance Program (government program). To find out more about flood insurance, please click on the link below to go to the program’s website.
National Flood Insurance Program Website
On the website, there is a very handy feature where you can type in your address and get an instant analysis of your risk potential for a flood occurring, along with estimates on what flood insurance would cost per year.
Give it a try for yourself! Even though the result for my condominium came up to be moderate-to-low risk, I believe that I will still purchase flood insurance to protect myself against catastrophic loss (and because it is very cheap).
The link below is a great resource from Net Quote that lists some way that you can save money on home insurance.
Net Quote – Ways to Save on Homeowner’s Insurance
Several of the methods to save money that stuck out the most to me are listed below:
- Asking for a multi-policy discount, in the event that you also have auto, life, or business insurance from the same insurance provider to which you are applying for home insurance.
- Install home security (burglar alarm) and home safety (fire extinguisher) devices.
- If you live in Canada, a good resource for information on home security is Home Security System in Canada.
- Stop smoking (reduces risk of fire burning down house).
Keep on learning!
Jacob
To receive updates on topics such as this one as soon as they are published, click on the link below to subscribe to My Money Blog: