Top 6 Investment Innovations in Recent Decades

These are my top picks for innovations that most benefit personal investors.

#6:  Decimal pricing.    Do you remember when stocks were priced in fractions?  Like 23 and 3/8?  This was not cool.  Not only was it clunky, but it meant that bid/ask spreads were usually stuck at 1/8 of a dollar per share, or 12.5 cents per share.  Luckily, today most investments are priced in decimals.  Some exceptions include bonds and the interest rates on most mortgages.  How archaic!

#5: Free online investment info.   Information used to largely come in paper form, and cost money.  Or you could pay tons of money for Quotron… really not practical.

#4: Discount online brokers.   My Dad used to pay $50-$100 per stock trade — over the phone with a broker.  Today some of my ETF trades are free, many of my trades average about $1, and my most expensive trades cost $8.

#3: Exchange-Traded Funds (ETFs).  ETFs fix most of the problems with mutual funds such as high(er) expenses and lack of intra-day trading.  ETFs also open up a wide variety of investment options including access to commodities, leveraged funds, and precious metals.

#2: Index investing.  Index investing brings two huge advantages.  First, incredibly low costs.  Second, maximum diversification.  Index investing has, and continues to revolutionize the investing playing field.

#1: 401(k)s (and IRAs).   Named after a once-obscure IRS code, 401(k)s, or 401Ks, offer investors decades of tax-deferred growth opportunity.  IRAs offer a similar advantage.  Finally Roth IRAs offer similar tax-deferral opportunities where the tax benefit is back-loaded.

Bitcoin: The Inflation-proof E-Currency of the Future, or Not

Bitcoin LogoIf I were to design a new currency I would design something very much like BitCoin.  It is a digital currency with about 6.5 million units in circulation. BitCoin will never have more than 21 million units of currency in circulation…. ever.  Bitcoin is divisible into tiny fractions of a unit down to millionths of a BitCoin and smaller.

BitCoin is digital money.  Imagine PayPal but without the hassle, or the commissions.  Image digital gold.  Gold which is mined (by computers), but has a known maximum supply of 21 Million ounces.

Gold’s value is largely related to its relative rareness.  Gold’s usefulness is pretty limited except as jewelry and a form of currency.  Industrial uses of gold consume only a small fraction of gold’s supply.  And gold can be mined faster than it is consumed.

Gold cannot be as easily traded or exchanged as BitCoins.  Yes gold ETFs can be exchanged for cash which in turn can be used for web transactions, but this is a multi-step process.  BitCoins, however, can be easily exchanged from person-to-person or person-to-business with ease.

Today each BitCoin is worth more than $13.  BitCoin valuations have fluctuated rapidly.  One person, according to Forbes, turned $20,000 into $3 million by buying Bitcoins early then selling them for a killing.

BitCoins may one day be worthless relics on discarded hard drives.  Or BitCoins may become the E-commerce alternative replacing PayPal.  Right now BitCoins seem to be priced about what the current mining cost will bear.  The cost of mining is measured in 1) electricity (energy) and 2) depreciation of the graphics cards used to mine new BitCoins.  This tends to put a short-term ceiling on BitCoin prices.  However, the BitCoin system makes the cost of BitCoin mining escalate geometrically.  Eventually, if all goes optimally, the mining cost will be come prohibitively expensive.

If BitCoins gain wider and wider acceptance I anticipate they will hold or increase in value.  However if either of the following happen they will end up virtually worthless: 1)  BitCoins simply don’t gain wide acceptance, and lose acceptance over time.  2) The algorithmic infrastructure underlying BitCoin is found to be flawed.  There is yet another alternative:  That a BitCoin-like system is created the competes with the original BitCoin.  Finally one more possibility:  various governments outlaw BitCoins.

In closing, BitCoin is a brilliant idea and a risky “investment”.  It is riskier than gold, silver, or index ETFs.  It is similar in risk to buying options, because the value can rapidly go to zero.  However, it is an interesting speculative play that is potentially inflation-proof.  Inflation-proof because, unlike government currencies, the printing presses (BitCoin mines), are held in check.  Buying 1500 dollars worth of BitCoins is no sillier to me than buying a $1500 gold coin. Just make sure you guard your BitCoins like you would your expensive gold coin… security, security, security.   Because BitCoins can be stolen, just like gold.  And they can be stolen without the thief even setting foot in your house.

401k Plan Redux (Coming Soon to Your Company?)

Poker Chips (financial asset allocation)My current employer is radically revamping its 401K plan.  I have noticed that companies tweak their 401K plans about annually, and dramatically change them every 5-7 years.  This time it’s big. One of the choices allows for both ETF and mutual funds purchases.  The EFT option has me excited.

So far in my career I have worked for three Fortune 500 technology companies.  Long story short, I have two 401Ks and a couple IRAs.  Between them I have about 8% invested in ETFs and the rest in mutual funds.  After the 401K redux, I’ll likely have about 30/70 ETF to mutual fund mix.  I’ll keep my asset allocation largely the same, but I’ll work out a bit of math here and there to do so.  Some mutual funds stay, some funds go, some switch to higher expense-ratio versions, and some are frozen from new money after a certain date.  Over time my retirement assets may approach a 50/50 ETF-to-mutual-fund ratio.

A similar 401K change may be coming your way soon.  The booming ETF trend is continuing unabated with over $1 trillion dollars in assets under management in 2010; some predict that doubling by 2015.  Why?  1) Institutional investors like ETFs, 2) retail investors like ETFs, 3) exchanges like ETFs, 4) brokerages like ETFs.  Generally for the same reason: lower costs.

The upside of more options is access to better options and greater potential for diversification.  The downside is trading fees for ETFs… $7.95 under the new 401K paradigm.  Wise, infrequent purchases can mitigate trading costs.  This requires a bit of financial planning, but is not really a big deal for serious investors.  And there are ~25 ETFs that trade for free.  One can invest in them every paycheck (like buying EEM for free) then periodically, every 6 months or one year, bite the bullet to sell EEM (for free) and buy the better ETF VEU.  Brilliant — low fees and true dollar-cost averaging.  [Not my idea, but a good one.]

In summary, fear not the change to more ETF-centric investing.  Your particular company may pull a fast one on you… but in many cases not.   Read ALL the fine print before determining the case.  I’m glad I did, and I sense greater investing opportunity.

Wired in High Finance

Stock Tickers BlueThere are two economies, the real economy and the financial economy (the financial markets). The two economies are linked, but sometimes the linkage is almost imperceptible.

Take for instance the recent run up in stocks, up ~20% in the last year, and up a total of ~40% in the last two years. This stock run up in the financial economy is in spite of the dismal real economy which was (still is?) in the midst of the Great Recession. The classic explanation for this jump in stock prices is anticipation of strong economic growth that many were guessing was just around the next fiscal quarter or two.

But continued lackluster economic growth, high unemployment, and inflation fears have the stock markets retreating 4% in the last month. QE and QE2 have driven commodity, gold, silver, and oil prices up (and the dollar down to a degree). Low interest rates have also helped fuel the commodity boom. I don’t say commodity bubble, I say boom, because I don’t believe it is a bubble… merely a precursor to higher inflation.

Further the prospects of Congressional legislation past and present loom as large economy and business-dampening prospects.

  1. Dodd-Frank Act regulating all sorts of financial and non-financial items.
  2. Obama Care.
  3. The real possibility of tax increases as part of debt ceiling deal.

The danger of Dodd-Frank, which deals primarily with the financial economy, is that it may spill over into the real economy as well — a form of fiscal contagion.   Obama Care hits right in the solar plexus of the real economy soon.  Potential tax increases are a kidney shot to the real economy.

Also on the horizon is the debt crisis in Europe, currently centered around Greece, but with dominoes in Portugal, Spain, Italy and Ireland ready to fall.

So, why on earth would I be neutral to mildly bearish (long term) on US equities?  The title “Wired on High Finance” sums it up.

  1. Wired, as is in connected, by wire, cable, fiber optics, or wireless.  The continuing computational and connectivity revolution is only accelerating.  This helps business productivity, which helps business (the real economy) and inevitably the financial economy (the stock market).
  2. High Finance.  High finance in the US eventually finds a way.  Take for instance GE which managed to pay zero income tax last year.  Big money always finds a way.   Call it industriousness, creativity, or greed… it gets things done.

Without all of the governmental fiscal and regulatory “headwinds” (as Bernanke has called them), my outlook would be bullish.  Despite them, I believe that the power of a wired world of high finance will find ways to resist the government onslaught.  Either through back-room deals (the new and no-so-new crony capitalism) or the ballot box (voters tired of 9% unemployment), these “headwinds” will be reduced, skirted, or avoided.

And while CPI stands for Consumer Price Index, most commonly, it also stands for Cycles Per Instruction — one measure of computer processing speed.  So while the mainstream CPI may understate prices, the other CPI is very favorable to computation power.  (In both cases keeping true CPI down is desirable.)

Notice I am neutral to mildly bullish on the US (and global) economy.  That is why I, personally, am increasingly invested in investments that reflect that believe — namely covered-call market-index strategies.  That is why I have switches some of my ETF investments from SPY (an S&P500 index EFT) to PBP (an S&P500 covered-call ETF).  Inflation fears and low interest rates have continued to cause me to shy away from most bonds and bond fund… with the exception of high-yield (junk) bonds.

Disclaimer: These are my personal investing thoughts, opinions, and choices as of today.  No one can reliably predict the markets (stock, bond, futures, options) or interest rates, certainly not me.

Modern Marvels of Finance

Much rhetoric today is focused against “Wall Street”, bankers, hedge funds, and speculators.  People are upset about the effects of the Great Recession, but are often misguided about the causes.  I submit the idea that the foremost cause of the Great Recession was the business cycle (or economic cycle).    If we are to blame the people and institutions behind the business cycle for the Great Recession we must also applaud them for the periods of growth between recessions.  To one degree or another we are all participants in the business cycle.

Of course, there have been behaviors ranging from ethical violations to fraud, particularly in the arena of mortgages and mortgage-backed securities, and (MBS) credit default swaps.

While there are flaws and imperfections in the US financial system, the accomplishments of the system deserve some attention.  The United States represents an economic marvel of the 20th century and 21st century financial achievements of the American financial system.  Like Rome, the United States incorporates the best of other systems.  The stock exchange did not originate in the United States, but the US and Europe improved upon it.  To the best of my knowledge, the index fund and the ETF both originated in the US.

Right now, today, US investors have access to:

  1. Low cost online brokerage accounts.   It is easy to find brokerage accounts that charge less than $8 per trade and have a list of commission-free ETF trades.  With effort, it is possible to find accounts with trades costing less than $5, or even lower.
  2. Free stock and ETF market data. (For example Yahoo! Finance and Google Finance).
  3. Superb ETF offerings. (SPY, VTI, SCHB, BND, VEA, VEU…)
  4. Excellent order fulfillment and pricing (with most brokers).

Just imagine a world without stock exchanges.  Could you imagine placing a classified ad or holding a garage sale to trade stock certificates?  Ludicrous, right?

The current US financial system is indeed a modern marvel.   English, Canadian, and  European exchanges have been similarly efficient and successful.  Other exchanges around the world are playing catch up, and doing so quickly.

The global world of finance is constantly evolving, but as of today the options available to US investors are quite spectacular.  We are wise to take advantage.

Thinking about Asset Allocation

In my blog post Financial Toolkit: Indexing the World I discussed 5 ETF building blocks for diversified investment portfolio construction.  In this financial blog post I’m going discuss a hypothetical investing situation:

Deborah is a 40-year-old woman with a $100,000 401K who just changed jobs.  She transferred her 401K to an IRA, and has $100,000 now sitting in cash.  Deborah’s new job pays $60K/year and she plans to contribute $10K/year to her new 401K.  How might she invest her IRA funds?

As a proponent of diversified index investing, I suggest the following category questions… What percent  1) Domestic vs. foreign?  2) Stock versus bond?

I put forward the suggestion that Deborah’s choices in regard to these two questions will predict 80-90% of the performance of her chosen portfolio.  (Don’t believe it, then read this asset allocation paper sometime when you are afflicted with insomnia.)

Let’s say Deborah decides that a 80/20 domestic versus foreign allocation, and 60/40 stock versus bond allocation are right for her.  Working out the math that’s $80,000 for US investments and $20,000 for foreign investments.  Applying the second stock vs bond ratio to each yields the following: $64,000 for US equities, $16,000 for US bonds, $12,000 for foreign equities, and $8,000 for foreign bonds.

The US part is pretty easy to achieve.  Plunk $64,000 in a low-cost, broad-market ETF (or mutual fund) like SCHB, and $16,000 into a total (aka aggregate) bond ETF like BND.  The foreign stock component is easy too; but $12,000 into VXUS.  Only the foreign bonds require two ETFs because there are no foreign total bond ETFs (to my knowledge); thus I suggest $4000 in a foreign government-bond ETF like IGOV and $4000 in a foreign corporate-bond ETF like IBND.

There you have it.  A simple example of asset allocation.

My personal opinion is that an initial asset allocation process can be very simple and effective.  Notice that I was able to avoid several secondary asset allocation measures such:

  • Value vs Growth (stocks)
  • Large-cap vs Small-cap (stocks)
  • Sector allocation (stocks)
  • Developed vs Emerging markets (stocks and bonds)
  • Short-term vs Long-term (bonds)
  • Average Maturity or Duration (bonds)
  • Government vs Corporate (bonds)
  • Investment-grade vs non-investment grade (bonds)
  • Average credit rating (bonds)

All of these “secondary asset allocation factors” can be side-stepped by purchasing “total” stock and bond funds as outlined above.  Such total (or aggregate) ETFs seek to own a slice of the total, investable, market-cap-weighted investing universe.  Essentially, a total US stock fund seeks to own a piece of the whole US stock market.  Similarly with a total US bond fund, etc.

In summary, if you have a diversified, low-cost investment portfolio, the two biggest ratios to know are domestic/foreign and stock/bond.    [If you don’t have a diversified, low-cost investment portfolio you might want to think about changing your strategy and your financial adviser!]

Smart People, Dumb Investments

When I started this financial blog a couple years ago, I wondered if I would run out of ideas to blog about.  Luckily, so far anyhow, I have had a different problem — How to choose amongst all of the ideas that pop into my head.

Thing train of thought takes me to consider what explains the relative success and failure — the investing fates if you will — of various investors.  It would be foolish (and wrong) of me to make the blanket statement that smart people make poor investors.  On the contrary I believe that successful investors are very smart people — John Bogle, Warren Buffett, Carlos Slim, Peter Lynch, Bill Gross.

What is interesting and occasionally baffling to me are the poor choices that I see smart people making.  For whatever reason, people tend to share two things with me:  personal information and personal investing information.  If I had to guess why, it is for two reasons.  1) I am actually interested, fascinated in fact. 2) I am very discrete.  Still this doesn’t quite explain why relative strangers tell me these things.

One thing is for sure.  I listen. And on thing I have learned is that people love to tell of their investing success and are hesitant to share their investing misses.  I feel privileged to hear both types of stories.

For the record there is, perhaps, no such thing as a bad (or good) investment in the present.  The “goodness” or “badness” of a given investment is only truly realized when the position is closed and the gains and/or losses are counted.   There are, however, in my opinion, poor portfolio decisions.

Here is my overall impression of the types of under-performing (aka bad) portfolio decisions that smart people make.  Most notably rationalizations for extreme non-diversification.

1) I work in field X.  I understand field X.  I believe the outlook for field X is tremendous, therefore I’m going to pick my favorite stocks that participate in X.  [I heard this all the time during the tech/dot-com pre-bubble and bubble].  I’m going to focus my portfolio in X…. meaning I’m going to severely underweight all other sectors.

2) I’ve followed fund manager, fund company, or my investment manager Y, and I trust and believe in them.  I’m going to put most/all of my money in their hands.

3) I understand the economy, the markets, and what’s going on.  I’m going to make my own decisions, and cut my losses when appropriate.  I’m going to manage my own money, and I’m not going to sheepishly follow conventional wisdom (things such as time-horizon-based asset allocation and CAPM models).  I’m going to bet big and win big on what I believe in.

Over the years I’ve seen that hubris and pride are subject to positive self-reinforcement.  When bets pay off, bettors place bigger bets.  In most cases though, luck eventually runs out and large losses are realized.  This is soul searching time.  Some respond by becoming hyper-conservative for a while (I will only save money in the bank and in T-Bills), some by becoming moderate for a while (I will own some stocks, but mostly bonds), and some by doubling down.

I understand these impulses.  In fact I see that impulse control is a key factor in rational investing.  I understand that smart people are accustomed to being correct.  It is instinctual to believe that this extends to investment decisions.  I’m saying, “If you believe you are orders of magnitude smarter than ‘the market’, think twice.” Or put another way, it is better to be wise than smart when it comes to investing.

To summarized, I know first hand that smart people sometimes make very dumb portfolio decisions.  They believe that their personal academic and career success will translate directly to investment success.  I also know that many such very smart people have been burned, to the tune of $100,000+ (if not millions) of losses directly attributable to non-diversification.

And finally, as to my personal investments, I happily say that I have been relatively steadfast in my Boglehead-like investing style.  So far it has paid dividends.

Financial Toolkit: Indexing the World

There are many, many U.S. stock indexes.  Naturally there are even more world stock indexes. So I set myself a goal of coming up with a very short list of ETFs that can build a low-cost, globally-diversified portfolio.

I’d start with:

  • VT Vanguard Total World Stock Index (FTSE All-World Index); 0.25% expense ratio; foreign holdings: 58.2%
  • IGOV S&P/Citigroup International Treasury Bond Fund (S&P/Citigroup International Treasury Bond Index Ex US); 0.35% expense ratio
  • IBND SPDR Barclays Capital International Corporate Bond ETF (Barclays Capital Global Aggregate ex-USD > $1B: Corporate Bond Index); 0.55% expense ratio

That’s a good start.  However it underweights US holdings (call it home-country bias).  These ETFs provide counterbalance:

  • BND Total Bond Market ETF (Spliced Barclays USAgg Float Adj Ix); 0.11% expense ratio
  • SCHB Schwab U.S. Broad Market ETF (Dow Jones U.S. Broad Stock Market Index); 0.06% expense ratio

That’s my stab at it.  Five ETFs that provide reasonable building blocks: VT, IGOV,IBND, BND, and SCHB.