Saturday, May 16, 2009

Bond Fund Breakdown

Many investors who have stayed away from bond funds in the past are now pouring money into them.  A bond fund may be riskier than you think, let’s take a look at how to break down a bond fund.  

Let me first describe want a bond is.  Simple put it is a loan.  You can loan a company, government, or government agency money (principle).  They promise to pay you back with interest (coupon) over a certain period of time.  If you hold the bond until its maturity date you will get all your interest and principle. 

Bonds carrier a risk of default and therefore have a credit rating associated with them.  U.S. Treasury bonds, bills and notes have the highest rating of AAA. The scale goes down from there and it depends on how the rating agency assigns letter ratings to determine risk.  A bond fund will breakdown how much of the fund in is each rating or give you the average rating.  

The longer the term or maturity of a bond generally the greater the risk of price fluctuations.  Bonds are traded on the open market.  If you needed to sell your bond before maturity you may sell it for a gain or a loss.  Generally speaking if current interest rates are less than your bond you can sell it for a gain, but if current rates are higher you have to discount your bond and sell at a loss.  Bond funds have a measurement called duration expressed in years.  If the duration of a bond fund is 8 years, that means a 1% rise/decline in interest rates equates to an 8 percent loss/gain all other things being equal.   

For investors currently looking to add bond funds to their portfolio consider the environment.  Current interest rates are very low and have little room to go down and we are in a recession.  When analyzing a fund look for a fund with most of its money in A rated bonds and an duration of 5 years or less.  If you want to take less risk go with a fund whose duration is under 3 years.  

Since bond funds are interest bearing instruments the expense ratio is extremely important.  There are plenty of bond funds with expense ratios under .70%.  Any higher than that and I do not know how a company can justify the cost.  

Bond funds are a great addition to a portfolio but do carry risk.  With the current economic environment do some research before jumping in. 

Tuesday, April 28, 2009

Bank of America; Point of no Return

Back when Bank of America was trading under $5 a share I was thinking of buying some of the stock which I already own at about $42 a share. My logic was simple.

The government is at the point of no return with the big banks. They have poured billions of dollars into these institutions and are not going to let them fail now. I held off and did not buy. Then I read a Wall Street Journal article about the testimony of the CEO of Bank of America. What I got from the article is that the takeover of Merrill Lynch was forced on Bank of America’s shareholders and the shareholders were to be kept in the dark about the details of the deal. Correct me if I am wrong but as a shareholder, if BofA did fail I feel as though the shareholders have a class action suite against the government.

I am not concerned about starting a class action suite against the U.S. Government, but I think this supports my logic that there is no way the government is going to let BofA fail and is still a buy at its current price of $8 a share. I have not pulled the trigger, but will be watching the stock all week and in all likelihood will but is a market order.

Tuesday, April 14, 2009

Performance Guaranteed Variable Annuities

After the market collapse I was getting grief from some individuals that I talked out of purchasing variable annuities with a minimum guaranteed rate of return.  The annuities go by many names and are different in their benefits and features across companies.  The bottom line is that they all guarantee a minimum rate of return no matter what the performance of the underling funds you select.  This made many individuals pick some of the riskiest investments offered in the product.  The philosophy was that by going into the riskiest funds you had unlimited upside potential but the downside risk is a guaranteed minimum return by the company of 6-7 percent. 

So why would I not recommend this product to investors?  Number one is you have to read the fine print in all of these annuities and there is a lot of it.  None that I know of would actually let you take the entire balance out of the fund.  Most allow you to collect income off the accumulation.  Two, with most of them you have to hold them for a ten to fifteen year period.  If you held a well diversified portfolio of stocks, bonds and other assets for the same period of time there a few periods in history that the annuity guarantee would be needed.  So you paid for the guarantee in the form of higher fees for no reason most of the time.  Lastly, the guarantee is backed by the insurance company who may not be able to keep its promise. 

It turns out that my last reason should be the biggest concern for those who own these annuities.  A recent Wall Street Journal article, “Investing in Funds: A Quarterly Analysis-Brokers Fear Many Insurers Ignorant of Annuity Risk” points out that the rating agencies are downgrading the ratings of many of the insurance companies who sold these annuities. 

I do not want to spread fear and panic like Jim Cramer or Suze Orman last October, but you should be concerned.  There is little chance you will lose all of your money in one of these annuities.  The more likely scenario is that you do not get the guaranteed rate of return, but will get the balance in your account with the market losses.  This would mean that you paid higher fees for investing than you would of in just mutual funds without the annuity rapper.

Hopefully everyone is learning from this downturn.  There is no guy (Madoff and others) out there that can defy the laws of investing with above average returns without volatility. There will be no product out there (performance guaranteed variable annuities) that can give you the upside potential of riskier investment without the downside risk. 

In hindsight I stand by my recommendation to those individuals who I told to stay away from those annuities. 

Wednesday, March 11, 2009

Finding the bottom with Behavioral Finance

I was having a debate of sorts with an individual on an online forum about actively managing your portfolio verses passively managing your portfolio. During the discussion I explained that I use Behavioral Finance to decide when to change my allocation.

Below is an explanation of behavioral finance from

"Behavioral economics and behavioral finance are closely related fields that have evolved to be a separate branch of economic and financial analysis which applies scientific research on human and social, cognitive and emotional factors to better understand economic decisions by consumers, borrowers, investors, and how they affect market prices, returns and the allocation of resources.

The field is primarily concerned with the bounds of rationality (selfishness, self-control) of economic agents. Behavioral models typically integrate insights from psychology with neo-classical economic theory. Behavioral Finance has become the theoretical basis for technical analysis. [1]

Behavioral analysts are mostly concerned with the effects of market decisions, but also those of public choice, another source of economic decisions with some similar biases towards promoting self-interest."

I use behavioral finance along with other information to help me find the top and bottom of the market. I can do this because I talk to many individuals a week about there investments. I start to see patterns in the questions and behaviors of investors and get an idea if we are near the top, bottom or still have further to go in either direction.

Let me give you some examples. In late 2004 and early 2005 many of the people I talked to who sold there stocks back in the bear market of 2000-02 were telling me that they did not want to get back into stocks until the market started doing better. The S&P returned 28.7% in 2003 and 10.87% in 2004. The market recover was well on its way, yet I was meeting people who did not realize it. At the time I was thinking about reducing my equity position but from talking to individuals and realizing that the turnaround did not hit the average American I held on to my stocks.

In 2006 everyone I talked to wanted to buy and sell real estate. That is one signal we could be near the top. Think of gold right now. Then I started to hear people talk irrational, which is when I start to think about taking action. Several people I talked to made the same statement, “you can never lose money in real estate”. So in 2006 I put one of my investment properties up for sale and realized that the slow down had all ready begun.

So the question is, using behavioral finance are we at the bottom. It is harder for me to tell this time around because no strategy will work if the financial system is broken. I do have some signs that make me optimistic that we are nearing a turnaround. One sign is the local news cashing in on the crisis with stories like, “Recession Sex” brought to you by Fox news of course. I have not met with an investor in weeks who wanted to sell their stocks. All I need now is some people making irrational statements. Then there is a more fundamental sign, a record amount of money going into treasury securities. Some people are calling it a treasury bubble and I have to agree.

It is important to point out that I only make slight changes to my allocation like going from 80% equities to 60%. I just take some off the table. This way if I am wrong I do not get hurt that bad. I also want to point out that I  moved all my retirement money into equities when the Dow dipped below 8000 the first time. I did not use behavioral finance but I got anxious.  If I was using behavioral finance I would not of bought.  

As somebody who advises people on investing I still think the vast majority of individuals are best served with a buy and hold strategy with the occasional rebalancing of their portfolio.  Your average worker in a 401K plan just does not want to sell when they see their investments making money and do not want to buy the investments losing money.  

Are you a buy and hold investor or do you actively management your portfolio?

Friday, February 20, 2009

America’s Lost Confidence

I try not to let the current state of our economy get me down or the losses in my retirement portfolio. For the most part they have not. What has got me down and angry is the failed leadership of both our corporate and political leaders. First the tax issues of President Obama’s picks. If our political leaders cheat on their taxes, what do they expect the average American to do? Our system works because millions of Americans line up every year to pay their fair share of taxes to keep the country running.

Personally I do not see why anyone would need to cheat on their taxes. Individuals like Timothy Geithner should know the system well enough to barely pay taxes. I get my effective tax rate below 15% and some years 10% because I know the system.

On The Journal with Bill Moyers he played a sound bite of a top Morgan Stanly official basically explaining to management about their “retention award” in his own words, “…please don’t call it a bonus…” What a slap in the face to the American people. Not so much the fact that they are paying out a bonus, but that they believe the people are so stupid that we would believe rebranding the word bonus to retention award would have us believe it is any different. I guess the managers were being lured away by Merrill Lynch or Lehman brothers.

On top of this entire financial crisis you have the Madoffs of the world coming out of the woodworks. Guys who work hard, not to make you money, but to rip you off. As someone who works in the industry I want these guys to do hard time in the same prison with criminals who rob us with a gun instead of a pen.

Then the icing on the cake or should I say peanut butter. One of the largest manufacture’s of peanut butter blatantly let a tainted product be consumed by millions, killing about 8 people that we know of. As far as I am concerned this is a capital punishment case.

I know there will be people who say that it is easy to point out what is wrong and we need to focus on what is right. I think we need to point out what is wrong, demand change and do what ever it takes to get it. I am optimistic about America’s future because at the end of the day it is a government by the people and we can change what is wrong.

Sunday, February 15, 2009

Spend More, Save Less

There is a lot of talk among economist that Americans need to spend more and save less to help get the economy moving again.  There is a reason why they are called economist and not financial planners.  It is true that Americans are saving more than they have in the past, but it may not be what you think.  Including in the savings rate are those who are paying down debt.  So if you put an extra $100 a month toward your credit card bill that is counted as savings.  What economist are saving is true, when everyone starts to “save” at the same time it has a negative impact on the economy, but telling people to spend in this environment is poor financial advice.

Americans are doing the right thing by paying down debt and padding their bank accounts.  It is not the role of the individual to get the economy moving in such a crisis.  Let the government borrow and spend.  They have the power to print money and tax the people.  They will not lose their home or go hungry from borrowing. 

In theory government spending should grow the economy and create jobs.  As individuals get a 3-5 year contract to build a bridge or road they will feel confident in their employment and start spending again.  Their spending will ripple through the economy and put more money in the pockets of merchants who may hire help or spend more themselves.  That is the theory, but before you start spending again the advice from the financial planning community is, pay down debt, build your savings and cut expenses. 

If the government stimulus does turn the economy around, then you will be in a better position and can always start spending again.  

Monday, February 9, 2009

Mutual Fund Share Classes

Many investors have no idea what mutual fund share class they are in or why. If you are about to do business with a broker or advisor a little education will go a long way.
There are three main share Classes; A, B, and C. Class Y will represent other share Classes explained later.

Class AClass BClass CClass Y
Managemant Fee.
12b-1 Fee.251.001.000
Total annual Expense Ratio.851.651.70.65

Excluding class Y, you can see from the table above that Class A has the lowest annual expense ratio. The annual expense ratio is the fee taken from the fund each year. It is somewhat of a hidden expense because you never see it come out of your personal account. Instead it is taken from the fund's assets. The net effect to you is a total return minus the expense ratio. So if you own Class A shares and the fund returned 10% the fund company takes .85% and you get 9.15% versus Class B where you would get 8.3%. So why would anybody by Class B or C? Class A carries a 5% or more front end sales load. A front end sales load is taken from the amount you put into the fund. If you contribute $10,000, only $9,500 is invested.

Class B has a back end or contingent deferred sales load. The load is on a declining scale. For example if you sell your shares in the year one or two you pay 5%, year three you pay 4% until the load goes to zero in year 6 or more.

Class C you will only pay the load if you sell the shares within the first year. After the first year the load usually is zero.

Now you are thinking why buy Class A or B. The answer is because of the expense ratio. Class A has the lowest expense ratio and Class C the highest. Over long periods of time Class C becomes the most expensive. The class with the lowest expense ratio will have the highest rate of return. You pay less year after year so you keep more of the return. Eventually the compounding of the higher return makes up for the front end load in Class A. With most companies Class B shares will convert to Class A shares after a number of years and to the lower expense ratio. The Class C shares never get a reduction in expense ratio.

If you are going to hold your shares for 10 or more years more often you are better off with Class A. If you think you are going to hold your shares for 5 years or less, Class C may be your best bet and between 6 and 10 years Class B.

I also put Class Y in the table above. I picked any letter to describe the next set of share classes. Some companies may have one or two more share Classes and other will have several. Most of the other share classes have to do with shares offered in pension plans, 401(k) plans or sold through fee only advisors. They are generally the lowest priced share Class.

The information above is very general including the table. There are many variations to the share Classes by company. For example the spread in the over all expense ratio between the Classes, how long the contingent deferred sales charge is and when and if Class B converts to Class A. The aim here was to give you a general understanding of how share Classes work. I also wanted to point out that what seems like the obvious choice when looking at the sales loads, may not be your best bet when you consider the entire expenses of the fund.

The details about overall expenses can be found in the mutual fund’s prospectus. I encourage everyone at a minimum look at the expense section of the prospectus before you invest.