Investment advice: Reducing risk through diversification

Malkiel’s Rule 6: Never Forget that Diversity Reduce Adversity

Not only does he recommend holding the different major asset categories (cash, bonds, stocks, real estate), but also diversifying holdings within each category and over time (through dollar cost averaging). He says his advice is not new. Cervantes, in his epic novice Don Quixote, advises that one should not “venture all his eggs in one basket”.

Diversifying in the various investment categories

He includes a few horror stories of people that were doing well invested in what looked like solid investments only to lose much (e.g. Enron stock; internet stocks; Worldcom bonds; etc).

He has a great illustration in his book which is too long to repeat here but that clearly shows that diversification results in much less risk with little reduction in return on your investment. The reason to diversify is fairly simple: as good a deal as individual stock or sector appears, things can change rapidly and unpredictable for a single investment. “By holding a wide variety of stocks, you reduce the risk considerably because economic events don’t affect all companies in the same way and unfavorable company-specific events are likely to be balanced by very favorable events for other companies.”

He recommends investing as many as 100 different stocks to reduce risk. For almost all of us the only practical way to do this is via mutual funds as this is what they do: allow you as an individual investor to own pieces of lots of different stocks.

He does not think most investors need to diversify internationally as there are plenty of good options here and many American companies are global to a significant extent anyway.

He also recommends diversification in bonds (again there are mutual funds for bonds) and real estates investments (via REITs).

Diversification Over Time (dollar cost averaging)

Under his section on “Diversification Over Time” he suggests putting money into the market regularly over time and explains and illustrates something called “dollar cost averaging.” It involve regularly saving (investing) the same amount of money over the long term on, e.g. a monthly or quarterly basis. You do this when stocks are up and when they are down. When stock prices are low, this results in buying more shares; when stock prices are high, you end up buying few shares. He demonstrated that you when you save in this way, you are actually ahead when the market goes down and then returns to its original value verses a market that is constantly going up.

While I won’t take you through the numbers (there are in the book and others as well), here is a great quote he provides by Warren Buffet that helps explain the concept in words:

A short quiz: If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? Likewise, if you are going to buy a car from time to time but are not an auto manufacturer, should you prefer higher or lower car prices? These questions, of course, answer themselves.

But now for the final exam: If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the “hamburgers” they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.

He concludes by warning that dollar cost averaging will not solve all our investment problems. The plan does not protect you if you need to take the money out when the market is down. And there is a time to alter the above. In fact, when the market is down may be the time to buy a few extra shares. The worst thing you can do is to sell when the market is down if you can avoid it.

Next up: Rule 7 – Pay Yourself, Not the Piper (controlling costs)

The above is from my on-going study on investing, from Malkiel’s The Random Walk Guide on Investing. For more, see my summary.

Investment advice: Allocating your portfolio

Malkiel’s Rule 5: Match Your Asset Mix to Your Investment Personality: How do allocate assets.

Once you have started regular savings, you need to decide how to allocate your savings among the 4 investment categories noted in Basic Point 2 (cash, bond, stocks, real estate).

He starts off with a reminder: remember that risk and return are related.   Over the period 1926 to 2002:

  • Cash investments averaged a 3 ½ % return but brought a risk of plus/minus 3%.
  • Bonds averaged 5 ½ % return but brought a risk of plus/minus 9%.
  • Stocks averaged a 10% return, but brought a risk of plus/minus 21%.

His chapter provides more detail than the table above on the performance the various investment options over time but in the end, he comes to this advice:

3 factors that affect asset allocation:

1)      Time horizon. The longer you have, the more of your money you can have in stocks (for greater earnings). The shorter your time horizon, the more that should be in cash and bonds.

Rule of thumb: your age should dictate the % of your retirement assets in bonds (and I think he intends to include cash). Example, if you are 25, can have 75% in stocks and 25% in bonds and cash. If you are 55 (as I am at this writing), he suggests you have 55% of retirement assets in bonds and other safe investments and no more than 45% in stocks.  An exception: money you are leaving to others that do not immediately need it.

2)      Capacity for risk – you may need to adjust the above general rule if you cannot afford short-term loss (i.e. decrease the % to stocks).

3)      Your temperament – similar to #2, you may need to adjust from the above general rules if you don’t have a temperament that can deal with short term losses. It is better to earn less in safe investments than to bail out of stocks when they take a plunge. “Sell down (stocks in your portfolio) to your sleeping point (where you can sleep at night).” He has a useful table on p 94 that related how much you can stand losing in a bad cycle vs what the percent you can have in stocks. It says, for example, if you cannot take losing more than 20% of your investment value in a bad cycle, you should have not more than 50% of your money in stocks.

Re-balance regularly

With changes in the values of various parts of your portfolio (e.g. stocks vs. bonds), your target mix can/will get out of balance with the target you established. When this occurs, re-allocate your investments to return to the right balance. He suggests rebalancing annually. To the extent possible, do this via new investment money (to reduce costs of moving money around (see Rule 7).

Next up:  Rule 6  – Reducing risk through diversification

The above is from my on-going study on investing, from Malkiel’s The Random Walk Guide on Investing. For more, see my summary.

Investment advice: Accelerate savings via tax breaks

It’s now time to look at saving strategies that reduce taxes, esp. the different types of individual retirement accounts (IRAs). IRAs are our federal government’s encouragement to save for our retirement (and kids/grandkids college costs).  This summary will explore the differences in traditional and Roth IRAs and then overview pension plans. We will look at similar plans to save for college costs for kids and grandchildren and close with Malkiel’s “best” tax strategy

Malkiel’s Rule 4: Stiff Tax Collector

Individual Retirement Accounts (IRA) overview (they come in two basic types – pay attention; as other tax breaks use the same basic approaches).

First, be aware there are three different ways to reduce taxes via these IRAs (each type doing only two of the three benefits):

1)      Reduce taxable income (and typically taxes) when you contribute

2)      Avoid being taxed on the growth in investment value over time (in other investments you have to pay taxes as the investments earn money)

3)      Reduce taxable income (and typically taxes) when you withdraw from your IRAs for retirement.

Here are some things that are applicable to both types:

  • Annual limits for IRA deductions (you can do one or the other or both; but in any case, these limits are for the sum): $ 5,000 if under age 50; $6,000 if over 50;
  • both you and your spouse can contribute this amount if you having earned at least that much
  • this limit is reduced if you earn over a certain amount: $90,000 for married filing jointly.

Traditional IRAs. Here you get benefits 1 & 2 but NOT 3.

1) When you put your money in a Traditional IRA, you reduce your taxable income by that account. The contribution to the IRA is subtracted from your income on line 32 of Form 1040, before computing your adjusted gross income. For example, if you are in a 15% marginal tax bracket as many of us are (i.e. for each additional $1000 of taxable income, you pay an additional $150 in taxes), then you can think of it as the government paying for 15% of the IRA through reduced taxes.  In most states, your taxable income for state purpose is also reduced (in KS, many of us a taxed at a 6% marginal state tax rate).

2) The IRA’s growth in value over time is not taxed.

3) However, when pull the money out of the IRA at retirement, it is reported as income and taxes at that time (currently on line 15b of the Form 1040).

The hitch = you must leave the money in a retirement account until retirement age or suffer 10% penalty.

This is still a significant benefit. As is illustrated in the book, at 8%, your money will grow 3 times as fast with this benefit than not. Even considering taxes at the end, you are way ahead vs saving for retirement without the tax benefit.

Roth IRA – In this case, you get benefits 2 & 3 above but NOT 1.

1) So you do NOT get to deduct the IRA contribution from your taxable income in the year.

2) Your investment grows tax-free

3) You can access your contributions at any time without having to claim it as income and without penalty. To withdraw earnings tax-free (and penalty-free), you will need to be at least 59 ½. But follow these rules and your withdrawals are NOT treated as income as with a traditional IRA [it is reported on your tax filing but it is not taxed].

Which type of IRA is best for you? It depends. There are lots of people willing to help you figure it out. In general, if you have plenty of time until retirement, the Roth is best, esp. if in a lower tax bracket.

Pension plans

Some with employers you can contribute at work to a pension plan (typically called 401k or 403b plans). Even when this is not an option with your employer, you can do it on your own (Keogh or SEP-IRAs). The tax benefits and “hitches” and similar to the traditional IRA above. The advantage of these pension plans is you can contribute greater amounts.

What can you invest in and through whom?

A wide range of investments types: stocks, bonds, mutual funds, CD’s.  He will talk about how to allocate between these choices in Rule 5. There are plenty of places to set these up: banks, securities dealers, insurance companies, mutual funds, etc.  More on this topic later as well (Rule 7 and 9).

Priorities:

1)      Retirement plans where your employer matches your contributions

2)      IRAs and non-matching retirement plans

3)      Roth IRAs (can be above number 2 in some cases)

4)      If you have still more, get some help (he has more advice in his book).

Saving for children/grandchildren’s college with tax advantages

529 plans allow for tax benefits like the Roth IRAs for contributions into funds dedicated for use in college expenses for your children or grandchildren. They have a very liberal in definition of educational expenses (including buying apartments for housing your students or cars as transportation).

Many states provide similar state tax benefits for qualified plans.

I encourage you to NOT put the funds in the names of your children (grandchildren’s) as it may negatively affect financial aid.

Educational Savings Account is another option to explore.

His “Best” tax strategy – Buy your own home. It is a form of forced savings. It has tax advantages as well: interest on your loan and real estate taxes can be deducted [however the tax benefit will only occur to the extent your itemized deductions are greater than the standard deduction you can take: for singles that is $ 5,700 and for a couple this is $ 11,400 in 2010).

He also suggests you avoid over-extending buying a house, i.e. limit your mortgage to 30% of your income.

Next time: Stock, bonds, cash – how much do I put where (asset allocation)?

The above is from my on-going study on investing, from Malkiel’s The Random Walk Guide on Investing. For more, see the index page to my full summary.