Millionaire Mommy Next Door » Investing

The Investment Risk-Return Correlation

Millionaire Mommy Next Door — Thu, 19 Aug 2010 01:40:18 +0000

Q: Pam asks, “After my portfolio value dropped by 40%, I panicked and pulled out of the stock market. I have $150,000 sitting in my savings account, earning squat. I know I should put it back to work, but with the state of our economy, I don’t know what to do with it. Any thoughts?”

A: If you’re terrified of the volatile economic climate today and would be an insomniac if you were invested in the market, perhaps it’s best to keep it parked until you are emotionally and behaviorally ready to stomach the ride and stick to a strategy. Preserve your capital while you take some time to reassess your goals and risk tolerance, determine an appropriate (perhaps more conservative) asset allocation, and explore various investment strategies to find a good fit for your goals and personality.

First, let’s address the risk-return correlation. In subsequent posts, I’ll tackle the other pieces.

Generally speaking, the goal of an investor is to be compensated for the amount of risk they take. Better yet, the investor seeks out the best risk-adjusted return — I’ll discuss this piece later.

If you are willing to accept high volatility (investment risk) for a high potential return, consider investing in a diversified portfolio of:

aggressive growth funds
small cap stocks and funds
micro-cap stocks and funds
foreign company stocks
international funds
sector funds
precious metal funds
emerging market funds

If you are willing to accept moderate volatility (investment risk) for a moderate potential return, consider investing in a diversified portfolio of:

large cap stocks and funds
S&P 500 and Wilshire 5000 index funds
convertible bonds
high-yield (junk) bond funds

If you are willing to accept low volatility (investment risk) for a low potential return, consider investing in a diversified portfolio of:

high quality short and intermediate term municipal and corporate bonds and bond funds
US savings bonds
Treasury bills and notes
fixed annuities
money market mutual funds

If you are willing to accept very low volatility (investment risk) for a very low potential return, consider investing in a diversified portfolio of:

CD’s (Certificates of Deposit)
money market deposit accounts
interest-earning checking accounts
savings accounts

You Don’t Need A Broker: 9 Keys to Investing Successfully On Your Own

Millionaire Mommy Next Door — Sun, 20 Jun 2010 02:56:37 +0000

I’m sure there are investment brokers worth their high commissions and fees, but I haven’t experienced one. I burned through five brokers before realizing that no one cares as much about my money and my future as I do. Brokers are salespeople. Naturally, they care more about their bottom line than mine.

Most people I coach don’t realize that they’ve been paying a 5-6% sales commission every time they buy new mutual fund shares because the commission is built into the price, making it difficult for the investor to “see” it. And paying a sales commission has nothing to do with the performance of a fund; you aren’t buying a better fund simply by virtue of paying more for it.

Each year, I’d compare my broker-managed portfolio’s performance with the stock market indexes (Wilshire 5000, S&P 500, Dow Jones Industrial Average, NASDAQ, MSCI EAFE, etc.). I found that despite paying a decent sum to brokers for their expertise, my portfolio usually under-performed the standard index benchmarks. In 1999, I decide that it was worth my time and energy to learn how to manage my own investment portfolio. My efforts have paid off very handsomely. Here’s a down-n-dirty summary of what I’ve learned:

1. Start Today

Start as early as possible to take advantage of the astounding power of compounding growth. By reinvesting the gains you receive from the money you invest, you can double your money in less than eight years assuming a 10% average annual return. Take a look at the following example, then try this calculator to see how much postponing your savings plan could cost you.

Start Now:
Save $10,000 per year for 30 years
@ 10% annual rate of return
= $1,809,434 ending balance

Start Later
Postpone saving for 10 years, then save $10,000 per year for 20 years
@ 10% annual rate of return
= $630,025 ending balance

Cost of waiting = $1,179,409

2. Put Your Investment Contributions on Auto-Pilot

Instruct your bank to automatically transfer at least 10-20% of your gross income to your investment account each month. If you don’t think you can afford to do this then you can’t afford your lifestyle! Get creative, cut expenses elsewhere, and start paying yourself first.

3. Maximize Retirement Account Contributions

How taxes are applied to an investment can make a big difference in the long run. There are tax advantages to retirement accounts which is why (in most cases) you should maximize your contributions to these accounts first, then add to your taxable accounts. Additionally, some employers match your contributions — which equals free money. This calculator compares a normal taxable investment to two common tax advantaged situations: 1) an investment where taxes are deferred until withdrawals are made, and 2) an investment where taxes are paid on money that goes into the account but all withdrawals are tax free.

4. Be Mindful of Fees and Do It Yourself

Invest $10,000 each year and use a broker to place your order and you might pay $575 per year in sales commissions. Alternatively, learn to place investment orders yourself and your commission savings, compounding 10% annually, would be an extra $104,042 in your pocket in 30 years. Invest in a low-cost equity portfolio using no-load mutual funds, Exchange Traded Funds (ETFs) and index funds. Even a small difference in the fees you pay on your investments add up over time. Use this calculator to see how different fees can impact your investment returns.

5. Diversify and Build a Balanced Portfolio

Speculative investments are like eggs: when they fall, they make a mess. Don’t place your bet on a single stock or sector. Spread your risk into a variety of market caps and styles as well as domestic, foreign and emerging markets. Proper diversification helps your portfolio weather any ups and downs the market can take. Asset allocation accounts for 94% of the variation in portfolio returns, while market timing and stock picks account for only 6% (Gary Brinson, Randolph Hood and Gilbert Beebower). Review and rebalance your portfolio annually to maintain your desired allocation percentages. The Asset Allocator calculator is designed to help you create a balanced portfolio of investments. Your age, ability to tolerate risk, and several other factors are used to calculate a desirable mix of stocks, bonds and cash.

6. Don’t Invest Money You Can’t Afford To Lose

Rises and falls in the stock market are normal and frequent. Don’t invest your emergency fund into the stock market because you don’t know when you’ll need to use it. Money you may need within the next few years doesn’t belong in the stock market either. Investing for portfolio growth is your long-term goal.

7. Cover Your Ass

Protect your growing wealth with adequate insurance. The number one cause of bankruptcy is major medical expenses. In addition to medical insurance, consider coverage for disability, life (consider a term policy rather than whole life), auto, homeowner/renter, business, and personal liability. Buy policies with the highest deductible you could afford to cover from your emergency fund — and invest what you save from the reduced rates.

8. Understand Your Assets and Liabilities

Most people consider the home they live in as an asset but the truth is, it’s a liability. And if you are counting on future home appreciation, it’s speculation. Stop thinking of your home as a savings account. Don’t believe the sales-pressure hype that homeownership is your best investment: you’re spending money on a property that isn’t producing income. If you insist on owning real estate as a part of your investment portfolio, buy an investment property that produces a positive monthly cash flow.

If you’re finding it difficult to squeeze your budget for investment contributions, downsize to a smaller home. Invest any remaining home equity, plus your new-found monthly savings, into your long-term-growth portfolio.

9. Don’t Invest Until You Understand

Question every piece of advice you are given through the filter of “what’s in it for them?” Unfortunately, there is no shortage of people who are skilled at separating you from your hard-earned money. It pays to be suspicious. If you aren’t committed to learning how to self-manage your investments, consider hiring a FEE-ONLY financial adviser (rather than a commissioned-sales broker) to assist you.

What I’ve offered today is a summary. I’ve shared my opinions and experiences. But don’t just take my word; ask questions and read investing books and web sites. Learn about different investing strategies and styles, assess your own personal risk tolerance, make a plan, then stick to it. Use your head — not your emotions — to guide your decisions. Practice investing first, using virtual online applications (not real money), as you wean off of your high-commission broker.

oooOOooo

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Is The Recession Over? My Gut-Check Impressions on the Future of Our Economy.

Millionaire Mommy Next Door — Thu, 13 Aug 2009 04:34:18 +0000

I’ve been receiving emails lately from people asking questions like:

“Is the stock market experiencing a true recovery or is this just a bear market rally?”
“Do you think we’ll see a V, W, U or L shaped recovery?”
“Should we expect deflation or inflation?”
“When will my house be worth as much as I paid for it?”
“How should I invest my money? Stocks, bonds, cash, real estate, gold, or foreign currencies?”
“Is the recession really over?”

Some are saying that I’m prescient (have knowledge of events before they take place). As much as I wish this were true, it isn’t, I promise. I got out of real estate and stocks before many others simply because I stopped listening to mainstream and acknowledged the writing that was already plastered on the proverbial wall.

Like many of you, I hear and read convincing forecasts made by a variety of so called experts who support opposing arguments and recommendations. And each time, I try like hell to take a step back and take a gut check. What seems to make the most sense to me? Is there evidence to support it and if so, who or what is the source? What emotion am I feeling and what does this emotion “want” me to think? What is the worst thing that can happen if a particular forecast comes true? How can I reduce the risks associated with various outcomes? And last but not least, what decisions will allow me to sleep well at night?

I’m hesitant to share my recession outcome opinions with others for a few reasons: 1) I don’t want anyone to make decisions based on my guesses, 2) Discussion of possible outcomes often turns to politics — and political discussion tends to get overheated, 3) Some might take perverse joy from pointing to this post in the future, with a wagging finger, telling me how wrong my guesses ended up.

But I’ve decided that I’m as entitled to guesstimate forecasts as anyone else, so here it goes, for nothing more than entertainment value and for exposing my potential bias. Normally I provide hyperlinks to information, statistics and educated opinions that support my writing, but not today. If you want to read the news or hear what the “experts” are saying about this stuff, use Google, turn on the boob tube, crank the radio or grab any newspaper. There is no shortage of opinions thrown about. Please come to your own conclusions.

Here are my gut-check guesstimates on the future of the economy:

I think the stock market will climb a bit more, then retest the March lows. Minus some funky blips, I think we’re in for a long “L” shaped recovery; or really, one that looks more like a long bathtub:

(March ’09) /\_____________/ (several years later)

Note: The bottom of my tub diagram should have an overall slow gradual curve to it plus a few wicked and jagged up-down points but I don’t know how to illustrate this with my keyboard. My bathtub edges should look taller, too. If it wasn’t so close to my bedtime, I’d draw you a picture instead…

I think we’ll continue to experience deflationary pressure. I think the Fed will continue to “stimulate” the economy but will face an upward battle trying to make it stick. If and when deflation is curbed, measures will be needed to tighten the money supply to prevent hyperinflation. I think these measures will be taken. From what I understand, it is easier to curb inflation than it is to stop a deflationary spiral.

I think housing prices have further to fall in most areas. Besides the probability of an overcorrection, Baby Boomers are beginning to hit retirement age and because much of their net worth in real estate and stocks has been wiped out, they will be downsizing en masse. McMansions will languish on the market or they’ll be repurposed into multi-family or extended-family units. Commercial property will be hit with a sledgehammer.

I think I will continue to stash most of my cash because with deflation, cash is king. When I do buy ETFs (only the ones that are experiencing upward momentum), I will keep tight stop losses in place. I will take a look at the currency market (certainly not my area of expertise) to see whether or not it’s a good fit for me. Overall, during this extremely volatile market, my main focus is capital preservation. This keeps me sleeping as snug as a bug in a rug.

In this economy, I think one of the best places to invest is in one’s own skills and education. I think vocational schools will see an increase in enrollment while universities see a marked decrease.

Entrepreneurs most likely to succeed will be the ones who bootstrap, sell low-priced necessity items, entertainment or services and keep overhead extremely low. Most of them will operate from in-home offices.

Because I think prices will continue to fall, I will continue to put off large purchases.

And finally, as painful as the process is likely to be, I think the Great Recession will ultimately be the Great Shake Up our society and planet needs to get on the financially and ecologically sustainable track. (Wow, that’s a mouthful.)

Okay, now it’s your turn. What do YOU see in your magic crystal ball? Please share your opinions and guesstimates in the comments. Have fun and play nice.

Relevant Post: Hyperinflation or Prolonged Deflation? Coping and Investing Strategies For Either Scenario