Portfolio Recommendation Beats S&P 500 by 9.4% (2009-10-26)

Portfolio Recommendation Beats S&P 500 by 9.4%

(2009-10-26) by David John Marotta

Exactly a year ago I encouraged you to avoid another lost decade in the markets. I recommended a specific balanced portfolio that today is beating the S&P 500 by 9.4%.

At the end of September, the S&P 500 was down 6.9% after one of the most volatile 12 months in the market's history. Even over the past 10 years it lost money with an annualized return of -0.15%. So although buy-and-hold investors are relieved the markets have recovered much of their losses from lows in early March, all is not dividends and capital gains.

To add to their distress, many buy-and-hold investors did not even receive the market return. They purchased closet index funds with overly inflated expense ratios. Excessive fees sapped value from their investments while the underlying strategy proved fruitless.

Many active investors fared far worse. In their scramble to avoid bloodshed, they sold near the lows. They didn't get back into the markets until the recovery passed the point at which they had exited. Timing the markets this past year was nearly impossible. The drop was precipitous, but the recovery was equally steep. Those who rebalanced at the low took money out of safe investments and bought into equities just when the outlook was the bleakest. These fortunate contrarians boosted their returns significantly.

So did those people who simply diversified into the blended portfolio I recommended a year ago. That portfolio experienced a 2.48% gain over the past year in contrast to the S&P 500's 6.91% loss. It beat the S&P 500 by an impressive 9.39%.

We generally do not recommend S&P 500 index funds. The S&P 500 is a capitalization-weighted index. It tends to buy more of a stock when it goes up and hold less of a stock when it becomes more reasonably priced.

If the S&P were a financial advisor it would say, "Let's buy mostly large-cap growth stocks in the industry that did well last year with a high price per earnings ratio." The result would be a very aggressive and volatile portfolio that does better at the end of a bull market than at the beginning. And it does miserably at preserving capital during a bear market--exactly what happened over the last decade.

So if you are invested primarily in funds that mimic the S&P 500, a lost decade should be no surprise. If we use market history to run hundreds of Monte Carlo simulations on a portfolio invested in an S&P 500 index fund, projections indicate returns at or below zero about 6% to 7% of the time. This scenario is an astonishingly accurate snapshot of trends in the past 100 years in which six 10-year periods showed no gains. These periods were the 10 years ending in 1914, 1921, 1932, 1938, 1974 and 1977.

If you were invested in the Vanguard 500 Index, your 10-year average return through the end of last month was -0.23%. The official rate of inflation during the past decade averaged 3.0%, but in reality it was probably at least 5%. If you were invested in an S&P 500 fund, your decade-long progress toward your retirement goals has stalled significantly.

But if you were a savvy investor, you did not lose this past decade. If you committed to a balanced portfolio, you experienced both higher returns and lower volatility.

Even a balanced portfolio of just six different common funds could have boosted your 10-year average return to 6.21%. And it would have lowered your volatility from a standard deviation of 16.25% to only 14.83%, a 6.36% better annual return with 1.42% less volatility.

The portfolio I recommended didn't cherry-pick investments that have done the best recently. Rather it chose widely used funds from each major asset class.

My comparison portfolio allocates 20% to fixed income in the Vanguard Total Bond Index (VBMFX). Of the remainder, it designates 31% to U.S. stocks with 21% in the Vanguard 500 Index (VFINX) and 10% in the Vanguard Small Cap Index (NAESX). Another 31% goes to foreign stocks with 21% in Vanguard Total International Stock (VGTSX) and 10% in the Vanguard Emerging Market Index (VEIEX). The final 18% is invested in hard asset stocks in the T. Rowe Price New Era Fund (PRNEX).

The funds just described have been popular for over 10 years. They have not made their gains from active trading. And they have low expense ratios. These are not necessarily the ideal funds to select today. Nor is this the flawless asset allocation. These are simply reasonable funds in each asset class.

Both in theory and practice, a balanced portfolio has proven to be a far superior way to meet your financial goals. In Monte Carlo simulations, balanced portfolios earn money over a decade, even the bottom 5% of random returns. The exact portfolio construction is less critical than including asset categories with a low correlation to the S&P 500. A well-balanced portfolio should result in good returns with lower volatility. Returns will still vary widely because the markets are inherently capricious, but the worst cases should be considerably better.

Of the six holdings listed here, the best return over the past 12 months was the Vanguard Emerging Market Index (VEIEX), up 17.38%. This holding dropped the most a year ago but recovered even faster.

Downward pressure on the U.S. dollar has continued in recent months. So we are still strongly advocating portfolios that hold a significant percentage of assets denominated in other currencies. These assets include foreign and emerging stocks, foreign bonds and hard asset stocks.

Holding on to an undiversified portfolio will, on average, keep on providing inferior returns with higher volatility. Don't continue to wait in vain for a poorly balanced portfolio to satisfy your investment requirements. You can't afford to miss another year or another decade.

from http://www.emarotta.com/article.php?ID=360

Credit Card Karate: The Moves to Block Spending (2009-10-19)

Credit Card Karate: The Moves to Block Spending

(2009-10-19) by David John Marotta

The availability of easy credit does not encourage financial virtue. Five minutes of credit card indiscretion literally can undo a life of financial responsibility, just like flirting at a bar with an available stranger can threaten marital fidelity.

You are trying to stick to your budget and live well within your means. You want to be a supersaver, someone who amasses real wealth by living simply and investing the remainder. To achieve these goals, you have to set rules in advance for how you will handle credit. If you don't, credit cards could undo all your hard work and planning.

A life of credit card debt is like the worst slavery imaginable. Failing to pay just a few hundred dollars a month will cause your debt to spiral out of control. At the end of just three years you could owe about $9,600, the average family's credit card debt.

Credit cards rates of 18% or even more are typical when you fail to pay. It used to be called usury and was illegal. But nowadays it is described as financial services and has become a highly respectable career.

If you don't stop buying that $200 worth of junk on credit, your debt will only worsen. After 24 years, you could be over a million dollars in debt for just $58,000 worth of merchandise. But if you switch that engine from reverse to forward, you could retire as a millionaire simply by saving and investing what you aren't paying on your credit card.

Consider the two sides to using credit. On the one hand, credit cards provide you with convenience, protection and help you maintain your budget. On the other hand, they can be a seductive siren's song leading you to financial ruin.

A few visualization techniques can help you avoid the wanton use of credit cards. Studies show that when people pay with a credit card, they are willing to spend twice as much money as when they use cash. Other research indicates that the biggest savings are enjoyed when people refuse to make small everyday unnecessary purchases. Put these two studies together, and by simply using a credit card you risk doubling your spending and cutting your savings in half. Thus credit card debt can sink families even faster than saving and investing can help them grow rich.

In the first visualization, imagine that everything you buy with a credit card costs twice as much as the number on the price tag. Only if an item costs twice as much will you be as hesitant to purchase it as if you had to pay cash.

To use the second technique, remove the decimal place on the price when you use your credit card. The younger you are, the more failing to save early will cost you when you retire. For example, at age 20, the $8.50 lunch you charge will cost you $850 in your retirement at age 63. If that isn't incentive enough, add another zero. It will cost you $8,500 in your retirement by age 85.

The years after college and before children are a great time in your life to save. You may not have another time to save aggressively until the kids graduate from college. You lose time and squander your resources if your credit card spending dampens aggressive savings. Every seven years you wait to fund your Roth IRA, you cut your retirement standard of living in half.

There's a greater advantage to contributing $2,000 annually for the seven years after college then beginning during the eight year and continuing for the rest of your life. With normal market returns, after seven years of $2,000 annual contributions, your investments will be appreciating at a rate of more than $2,000 a year, without any additional contributions.

Reining in your spending anytime is better than concluding that credit card debt is inevitable. Wait seven years from now and you cut your retirement lifestyle in half again. So visualize cutting your retirement in half or your credit card.

If you don't think you have any problems with your use of credit cards, but you haven't been saving and fully funding your 401(k) and Roth IRA, you do have a problem. If so, put the credit card back in your wallet and start saving.

Using a credit card properly is important. Not abusing a credit card is essential. Unless both partners in a marriage agree on how they handle credit, the cards aren't worth the plastic they are printed on. Either spouse should have veto power regarding the use of credit.

Each partner needs this respect because both parties can be liable for the underlying debt. So if you are part of a couple who are always paying fees or interest, you are better off running your budget with cash and envelopes.

There is no shame in alcoholism, only in being a drunk. Similarly, there is no shame in having credit troubles, only in continuing to be spendthrift. Financial troubles sink a great number of marriages, nearly all of them because they fail to admit that for them an open credit line is an empty credit line. Alcoholics struggle similarly with an open bottle.

Thus the only shame around credit problems is an unwillingness to accept help. Many people use credit cards intelligently for nondiscretionary purchases such as bills, utilities, groceries and gasoline. But smaller impulse items, such as eating out or spending on books, music, electronics or clothes, can quickly wreak havoc on their spending plans.

If one type of purchase causes you trouble, stop using credit cards in that area. If one person has difficulty, the other should be willing to bear the burden of paying the bills. Cash accounting means you can't spend too much. It is the perfect exercise of sobriety for your spending habits.

One of my favorite movies is "The Karate Kid" starring Pat Morita as Mr. Miyagi. Miyagi trains his young apprentice Daniel by having him wax his cars, sand his floors and paint a fence. Only after several days of backbreaking work does Daniel realize that his body has learned the defensive moves of karate through the muscle memory of "Wax on, wax off."

You can't learn the critical lessons of finance with the electric waxing machine of plastic credit. By refusing to use credit, you have the visual feedback of money going from your paycheck to a budget envelope and then leaving your wallet in exchange for something you really need.

Most people don't learn these lessons from their parents. And even if your elders handled money well, you still have to learn the lessons for yourself. Having a parent who excels in karate doesn't mean you can crane kick.

So if your spouse vetoes the use of credit, you can either get mad like Daniel did at Mr. Miyagi or you can get busy learning financial karate.

from http://www.emarotta.com/article.php?ID=359

Using a Credit Card Properly (2009-10-12)

Using a Credit Card Properly

(2009-10-12) by David John Marotta

Getting the right credit card for the right reasons is half the battle. Using it correctly is the other half.

When the perfect card arrives in the mail, sign it, activate it and pull the sticker off the front. But before you put it in your wallet and start using it, deny the credit card company the permission to market to you.

Dial the 24-hour customer service number on the back of the card. Tell the representative you want the maximum amount of privacy on your account. The credit cards companies have multiple lists in their system. You may find it challenging to turn off each possible marketing opportunity.

Specify that you want no phone calls, statement inserts or junk mail. That means no phone calls from third parties, no selling your information, no sweepstakes offers and no offers of credit protection.

Most importantly, make clear you do not want any access checks. These checks look innocent, but micro print on the back explains that by cashing the check you are accepting the company's offer to bill subscription charges directly to your credit card.

When you think you have listed every marketing possibility, be sure to ask, "Is there anything else I can turn off?"

None of these offers help you build real wealth, which is why they have to advertise them. You won't miss anything. We've all made the mistake of wasting too much time on a deceptively easy offer that subsequently was very difficult to rescind. Your time is worth more than sifting through the ashes of advertising looking for valuables. Do yourself a favor and repeat the process just described for all of your other credit cards too.

If you have already taken my advice, put all your purchases on your ideal card. If you spend $50,000 and earn 2%, you will receive an extra $1,000 to save and invest. It's worthwhile using a card that pays you.

Debit cards can be dangerous. Every time you use one, you reveal how to access your entire bank account and drain it dry. Hackers are targeting merchants who have debit card personal identification numbers (PINs) as the weak link in their security system. Your bank's computer system may be secure, but the computer in the gas kiosk where you just paid is not. Even using your debit card like a credit card leaves your entire account exposed.

The most you can lose with a credit card is $50, which you can simply contest and refuse to pay. The most you can lose with a debit card is $500 if you wait more than two days to report the fraud. Your liability is unlimited if you wait more than 60 days. And while you are waiting for the money to be replaced, supporting your lifestyle is up to you.

Additionally, debit transactions are routinely approved even you have insufficient funds. The bank processes the $5 charge and tacks on a $35 overdraft fee. It would take $1,750 in spending on your dream credit card earning 2% cash back to pay for one overdraft fee.

Pay the bill as soon as it arrives in the mail. Don't wait until the last minute. You never want to risk paying interest or late charges. Paying electronically via electronic transfer, Bill Pay or by using your debit card is the quickest and easiest method. Because these are bank-to-bank electronic connections, this payment method is secure. You will save both time and money.

If for some reason you are late paying the bill, pay it as soon as you can, and then call customer service. Explain the reason for the late payment, and ask for the interest and late charges to be waived. If you have been a good customer, they may agree but usually only once in a 12-month period.

If paying either interest or late payments becomes a pattern, put the credit cards in a drawer and opt for a debit or cash system. Both people in a marriage should agree on the use of credit, with either partner having veto power about using credit.

Watch out for a few other special situations. Some merchants require a minimum purchase to use your credit card, which violates Visa and MasterCard agreements.

Vendors are also prohibited from adding on a credit card surcharge, but they can offer a cash discount. Although this may seem like not much of a distinction, it means that if merchants have an advertised price, they are not allowed to charge over that price just because you are using a credit card.

If you believe a specific merchant has violated these rules, call either 1-800-VISA-911 or 1-800-MASTERCARD. Merchants need to keep the credit card companies satisfied, which is leverage you can use in a dispute. Having charged a purchase on your credit card can help if you believe a specific merchant has treated you unfairly.

Try to resolve the dispute directly with the merchant if you can. Most merchants are reasonable, but if they are obstinate, the question isn't "Can they do that?" The only question is "Will you let them get away with it?"

Every one of us has felt cheated by being promised more than we actually received. But you may not realize that leverage and the law are on your side if you are willing to take the time to dispute the charge. Wrongdoing thrives when good people do nothing. You can do something.

You can refuse to pay for any charge on your card during a dispute. I've only take the time to fight regarding a few charges on my credit card. It requires lawyer-like patience and an eye for details. Documentation, especially of the portion in dispute, is critical. So is following the rules, which includes putting everything in writing as well as keeping copies for your own records.

Remember that your credit card's financial institution wants to keep you as a customer. Issuing a charge back is easy for them to do pending the resolution of a conflict.

The merchant's bank similarly wants to keep the merchant as a customer, but only if their business practices don't generate time-consuming disputes. They only make money from a seamless volume of transactions.

The final step in using your credit card properly is to record your spending information. Part of wealth management is spending money deliberately. You need a way to keep track of your expenditures.

For couples in financial trouble, establishing and following a budget eliminates fights about the first dollar spent. It frees them to focus on those categories where they went over budget.

Capturing how you spend doesn't even have to take the form of a budget. It can just be a tool to see what you have done, decide together what you would like to do and adjust how you will spend your money going forward. Think of a spending plan as simply the process of adjusting how you spend to best reflect what you value. Nothing is better for a relationship than talking together about what you hold dear and your hopes and dreams for the future.

Simplify whatever method you use by capturing your spending electronically. For every vendor on our credit card statement, we download our information into QuickBooks. But other interfaces such as mint.com or an Excel spreadsheet can work just as well.

Credit cards can provide convenience, protection and a little extra savings. But you must pay promptly and take the time to negotiate a fair resolution if your payment is not received or you don't get what you've paid for.

from http://www.emarotta.com/article.php?ID=358

Make Sure Your Credit Card Has Smart Features (2009-10-05)

Make Sure Your Credit Card Has Smart Features

(2009-10-05) by David John Marotta

Credit cards can be a blessing or a curse. Used correctly, they are both convenient and safe and can help you stick to your budget. But the dark side of heedless use can lead to financial ruin. Rather than rejecting credit cards altogether, however, choose the right card for the right reasons.

You are trying to be faithful to your budget and live well within your means. You want to become a supersaver, someone who amasses real wealth by living simply and investing the remainder. Now you have to set rules for how you will handle credit. If you don't, credit cards could undo all your hard work and planning.

Credit card companies know that people have an irrational loyalty to their first card. That's why they market college students so heavily. You may feel attached to your current credit card, but believe me, the credit card company feels no such allegiance to you.

Because both spouses must live with the consequences, each should have the right to veto any use of credit. Using credit successfully should begin with your choice of card.

Your sole criterion for picking a credit card is to maximize the financial benefit to your family, assuming you use the credit card correctly. You will be paying off the entire balance every month, so certain features, such as the interest rate, are not a concern. Nor do we care about how the company can change the interest rate if you fail to pay.

But to be in this enviable situation, you need significant taxable savings and investments in order to weather a financial emergency. Lacking such discipline, you may want a different type of card.

Credit cards companies create a host of gimmicks to entice you. Usually these come-ons are themed around a hobby or an interest. I'm certain you are proud of your alma mater and rooting for your favorite sports team. The credit card companies are counting on it. You can even have a photo of your children or grandchildren on the front of the card and change it every six months. Don't succumb.

Selecting the right card is worth about 2% of your credit card purchases. So if you spend $25,000 a year using the card, it means an extra $500 in your wallet. You can buy a lot of sports paraphernalia and photographs of your family for $500. Besides, the credit card companies don't really care about your sports team. They sell a matching card for your arch rivals too!

So forget about how the card looks and focus on the rewards program. Airline miles are the oldest and most common. Unfortunately, they are some of the worst reward programs. Over 75% of airline miles expire unused.

Card companies have also learned to provide themes for the rewards. Although it makes great marketing sense for companies to appeal to an affinity group using an exclusive offer, don't fall for such an appeal. Which would you rather have, reward points that can be spent anywhere or rewards that can only apply to one specific interest?

They may have some appealing offer, but you will be able to get it on eBay for a fraction of what you will miss by not using another card. Cash awards can be used to buy anything.

Get the cash. You could be earning game time with the World of Warcraft Visa. Or a donation could be allocated to the Make-A-Wish-Foundation for each of your purchases. But these may not be the greatest decisions after a year. With cash, you are in control. Get the money, and then decide if you want to buy the game time or make a contribution and take the tax deduction.

Most cards have a rewards program worth between one and three pennies per dollar spent. Oddly enough, themed rewards tend to be toward the low end and cash rewards are apt to be higher. Even the popular cards that fund 529 plans don't pay as much as a cash rebate. So get the cash rebate and then fund a 529 plan yourself, which can also net you a state tax deduction.

I've been using the Platinum Discover card, one of the first cards that offered a cash-back bonus. It used to be 2%. Now it is 1% with a 5% cash-back bonus on certain items you sign up for every three months. Even then it has maximum amounts.

During the process of researching this article, I've learned about several flat 2% unlimited cash-back options, one with Schwab Bank. Because we use Schwab as a custodian for our assets, it makes everything easy. The cash rebate is deposited directly into our investment account. That makes it 2% additional savings instead of 2% additional spending.

Usually I don't mention specific products, but my experience should help illustrate two principles. First, the best choice changes regularly. And second, you should be looking for at least 2% cash back on your purchases. Some savvy consumers literally use a deck of credit cards to take advantage of special offers. One card gets 5% back at Wal-Mart. Another gets 5% back on gasoline purchases. I'm interested in simplicity. Let me know if you find a deal better than an unlimited 2% back on all purchases.

Needless to say, your credit cards should have no annual fee. And the company should allow you at least 20 days to pay your bill before interest accrues. You should never be paying interest.

Another very helpful feature is the ability to download your purchase information electronically. Importing this data into your budget can save you time. Electronic interfaces exist for QuickBooks, mint.com or a simple spreadsheet format. Most people find keeping track of a budget too much hassle, but the right credit card can simplify the process.

Probably one of the greatest time-saving devices is being able to put all your purchases on a credit card, receive 2% cash back and then roll all those purchases into your budget once a month. With QuickBooks, so long as you have purchased from the vendor before, the software remembers how you coded past purchases and automatically assigns a category.

Some credit cards offer to extend the warranty for items you have bought using it. This may be called a warranty manager feature. Usually it doubles the free repair period for up to one year for eligible purchases. I never recommend an extended warranty, but getting a free year for no extra charge can be very worthwhile.

Finally, many credit cards are offering a feature called ShopSafe that allows you to shop online and generate a onetime-use credit card number for Internet purchases. If you worry about your credit card number being compromised on the Internet, this service will give you some additional peace of mind.

Starting with the right credit card for the right reasons will make using it properly that much easier.

from http://www.emarotta.com/article.php?ID=357

The Whip Cracks Both Ways (2009-09-28)

The Whip Cracks Both Ways

(2009-09-28) by David John Marotta

Inherently volatile, the average daily fluctuation of the stock market is about 0.76%. If this movement were always up, the market would appreciate to more than six times its value in a year. If all the movement were down, you would have less than 15 cents for every dollar you invested at the beginning of the year.

Most of this fluctuation is like the beating of a hummingbird's wings--lots of movement but no progress. Every year after matching all the up days and down days, you are left with about seven days that represent the entire year's investment gain or loss. Thus daily movements are 97% noise and 3% direction.

Volatility, therefore, is a matter of perspective. Are you watching the hummingbird or its wings?

I've charted the movement of the S&P 500 total return since 1950 from eight different perspectives in what I call a "whip chart." Each measure of risk and return is analogous to a different part of the whip.

Out at the very end of the whip is a bit of thread called the cracker, or popper. As all the momentum of the heavier whip flows into this light thread, it curls back on itself. The snapping sound comes from the cracker accelerating beyond the speed of sound, creating a tiny vacuum and sonic boom as the air rushes back in.

We can compare the cracker to the six-month activity in the market. On average the six-month movement is up 6.4%, equivalent to a 13.2% annualized return. For the sake of just measuring speed, we convert all the market movements into how far they would have moved at that speed over a year.

On an annualized basis, six-month returns deviate wildly, about 23.7%. The standard deviation (SD) measures volatility statistically, or how much room it takes for the cracker to snap. Approximately 68% of returns will curl around within 1 SD (±23.7%), 95% will fall within 2 SD (±47.4%) and 99.7% will fall within 3 SD (±71.1%). Stock market returns are by nature capricious and exceed the statistical norms for returns that fall outside of three deviations.

In fact, the past six-month period was more than 3 SD above average, earning 40.5% (97.5% annualized). And the six months preceding that were below 3 SD, losing 41.8% (66.2% annualized). Because six-month returns are compounded, when annualized the positive side multiplies and the negative side is diminished. Therefore the 3 SD isn't exactly ±71.1%. The 3 SD return is compounded as +89.2% to -55.6%.

Unlikely ups and downs like these are sometimes labeled "black swan" events. Or they may be described by the number of SDs they fall within. For example, because these two recent events are slightly more than 3 SD, they are called "four-sigma" events.

Four-sigma events should occur less than 0.3% if market returns conformed to a Gaussian bell curve, but they do not. The markets are inherently volatile. Market returns are better described by a branch of mathematics known as power laws. Instead of a neat statistical bell curve, these formulas are used to describe fractals where the same patterns can sometimes be wildly larger or smaller than the one you are looking at. Having just experienced two four-sigma events, these are not simply academic musings.

Every time the cracker pops, and the news is talking about how good or bad the markets are doing, should signal you to rebalance your portfolio. Having just finished a four-sigma positive market run, now is an excellent time to take some money off the table. The cracker snapped up, and if you rebalanced at the bottom your asset allocation now tilts more toward stocks. By rebalancing your portfolio you will reset your portfolio to an allocation ready for the next move of the whip.

Annualized returns are slightly better behaved, more like the "fall," a bit of unbraided leather at the end of the whip. Annual returns within one sigma range from +29.2 to -5.2%. The two-sigma range is +46.4% to -22.4%. And the three-sigma range is +63.6% to -39.5%.

The leather fall attaches to the braided thong with a fall hitch. And a knot called a keeper holds the braided thong to the handle. Just as each of these parts of a whip experience smaller movements, so the SD continues to diminish for returns over a year and a half (fall hitch), 3 years (thong), 5 years (keeper) and 10 years (handle).

The handle of a whip, our 10-year horizon, is much more manageable. The one-sigma range for an annualized 10-year return is +16.2% to +6.33%. The two-sigma range is +21.1% to +1.40%. Not until a three-sigma event can a decade-long return for the S&P 500 turn negative. The three-sigma range is +26.1% to -3.5%. The past 10-year return has been -0.8%

The 10-year return (the handle) swings more than a 20-year return (the arm), which moves more than a 40-year return (the shoulder). Volatility begins to lessen as you move further and further away from the end of the whip. From the perspective of a whipping cracker, volatility is extreme, snapping faster than the speed of sound. But if you are a fly sitting on the shoulder of the person wielding the whip, you haven't moved.

At every stage of the whip, the average trend is more than 11% positive. Picture the person holding the whip as riding an escalator that is slowly but constantly ascending. Despite the whip cracking up and down, the general trend is upward.

Rebalancing frequently recognizes and takes advantage of the volatility of this trend. Staying invested during market gyrations takes advantage of the escalator.

from http://www.emarotta.com/article.php?ID=356