Making Money

On August 4, 2012, in bond funds, diversification, finance blog, Investing, by Dave

When I last updated my “play money” (Crazy Ivan) account info it was worth $25,953.  As of market close yesterday it is worth $28,174.  Equity and ETF positions have changed slightly. Then now include DTN, INTC, IVV, JNK, PBP, SPLV and XLE.   I like all of these positions, however XLE has been a short-term disappointment.  I hold XLE as only a hedge against rising gas prices.

All in all not bad performance for an account valued at $15,784 in October 2005.  (There have been no deposits or withdrawals  during the whole time.)  This is about 11.2% annualized performance.

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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.

The rule of 72 is an easy way to make fast financial calculations in your head (or on a sheet of paper)… no calculator is necessary.  The idea is that you can determine how fast money will double based on an interest rate or rate of return.  Divide 72 by the interest rate and that is the number of years it will take for the investment to double.

For example if a CD (Certificate of Deposit) is paying 6% it will double in 12 years because 72/6 = 12.

The rule of 72 can be used for decreases in value, such as inflation.  If inflation is 4%, money under a mattress loses 4% per year in value.  Because 72/4 = 18, that money’s value will be cut in half in 18 years.   So positive returns divided into 72 tell how long it will take your investment to double and negative returns how long to lose half its value.

The rule of 72 provides convenient illustration of how fees can effect an investment.  Let’s say you are considering two investments in your IRA managed by your brother-in-law Sam.  Option A is to buy and hold SPY, an index fund that has an expense ratio of virtually 0% (0.09% actually) or option B tracking the same index  but managed by the Sam’s company with a 2% expense ratio.  Sam says “Hey buy my index and I get a commission and a chance to win a boat.” Using the rule of 72 you see that 72/2 is 36, meaning Sam’s index will only be worth half of SPY in 36 years.  If you are 29 years old and want to retire at 65 (in 36 years) that’s half of your retirement money!  Tell Sam to find some other sucker to win his stupid boat.

Rule of 72

Cost of 2% based on the Rule of 72

Finally you can use the rule of 72 together with inflation and expected return to plan your financial future.  If you expect a 7% (nominal) return on your retirement portfolio and 3% inflation, that’s a 4% annual return, so your money will double — in inflation-adjusted terms — in 18 years.  Now if inflation is 4% your real return is 3% and your real investment value will double in 24 years; that’s a whole 6 years longer.  Possibly 6 more years until you retire.  Add a 1% management fee and your real return drops to 2% and doubling time is now a whopping 36 years.  Yes, even a 1% fee can cost you 12 more years until you retire!

The example above shows the destructive power of inflation and why even a 1% annual inflation underestimation can be a big deal.  For tax payers that means tax brackets (based on the government’s CPI-U) gradually form an increasingly tight straight-jacket around your take-home pay.  For Social Security recipients this means cost of living adjustments that simply don’t keep up with real world expenses.

The rule of 72 is a powerful tool for financial estimation.  The rule of 72 is not perfectly accurate, but it is generally pretty close to the target.  It is, however, easy to use and can be used to explain financial concepts to people that aren’t that “mathy”.  It is a great way to start explaining finance to kids; while being a tool powerful enough that is also used by Wall Street pros.

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.

Jim Cramer, Suze Orman. Warren Buffett, Peter Lynch, Bill Gross, John Bogle. The first two are the closest to household investing celebrities and arguably have the biggest media presence. The latter four are perhaps the biggest names in investing when it comes to mutual funds.

While I occasionally enjoy Cramer’s style, I generally dislike his advice. I believe that his high-energy style encourages high turnover, higher trading costs, reduced tax efficiency, and decreased diversification. Suze’s style is more focused on emotion, spending habits, relationships. I believe she offers a kind of emotional support and tough love that can help folks get out of debt and overcome financial life challenges. Suze’s style is particularly well-suited towards women investors (I’ve heard this from several of my female friends). She has a good grasp of mortgages, credit, foreclosures, and debt management. However, when it comes to stocks, bonds, mutual funds, ETFs, 401Ks, and the like, I find her advice spotty, inconsistent, and occasionally wrong.

I have a better overall opinion of the advice of Lynch, Buffett, Gross, and especially Bogle. I’ve found Lynch’s books useful and I’ve liked his advice about almost everything except bonds. And the performance of the Fidelity Magellan Fund under his management was exceptional. Gross balances out Lynch, because Gross has an impressive track record of bond investing with PIMCO. Buffett also boasts an impressive investing and management record. Finally, Bogle popularized and perfected index investing through Vanguard Funds.

It’s a shame that there is no investing superstar celebrity that provides solid, clear, and broadly applicable investing advice. Perhaps that is because prudent investing advice is somewhat boring. So generating excitement is done through either stock-picking mania (which I consider imprudent) or human interest stories (which tend to be getting out of debt, or get-rich-quick). Another challenge is appealing to a wide range of investing situations and widely different levels of financial literacy.

I’m frequently looking for ways to make this finance blog appeal to a wider audience. That’s why I’m looking at investing celebrities today for clues to make this blog’s message more powerful. As of now, my biggest takeaway is that if I focus more on the emotional and relationship aspects of investing and spending, I may be able to more effectively connect with women investors.

I can’t say enough about index investing.  The best, perhaps only, free lunch in investing is diversification.  And index funds are superb instruments with which to achieve diversification.  There is, however, a potential dark side.   Don’t worry, this dark side won’t effect you much… not really.  At least not directly.

What has me a bit worried is “giving up the vote.”   Yup, when you buy shares of an EFT, mutual fund, other fund you forfeit your voting rights to the underlying shares.  Say you own 1000 shares of SPY.  Cool.  That means you own a couple shares of Apple and a handful of XOM shares.  But, guess what?  You can’t vote them!

Do I care that I am giving up my votes to iShares?  Not enough not to buy ETFs.  But I care a little bit.  Enough to mention it in my finance blog.

The term “indirect investment” is not precise because saying “direct investment in stock” is perhaps not technically correct.  Nonetheless, I am slightly annoyed at institutions voting my shares.  I’d rather these shares not get voted… so that direct shareholders would not get overridden by institutional votes.  Better yet, I’d like to be able to set some parameters for how my shares should get voted.  Difficult to implement… but I’d like it.

So while index ETFs are the best thing since sliced bread, finding a solution to shareholder disenfranchisement would be a welcome improvement.

Options Investing

On December 25, 2010, in finance blog, Index Investing, Investing, options, by Dave

Some readers have expressed interest in options investing blog topics.  So I’ll pontificate a bit about options investing.

I view options as generally “zero-sum” hedging tools.   When I buy and sell (mostly sell) options my first thought is not making money on the options trades.  My main goal is transforming and reshaping my portfolio.

In my IRA portfolio option trades cost me about $8.00 each.  Since IRA accounts generally cannot be margin accounts, I have only 4 basic ways to play options: 1) write covered calls, 2) write cash-covered puts, 3) buy calls, 4) buy puts.

The tactic I’ve applied in my IRA is a basic covered-call approach applied primarily to SPY.  In a nutshell, I started by buying 100 shares of SPY and selling a single at-the-money call 2 or 3 months out.  That call option either expires worthless or I buy it back just before it gets exercised.  I then repeat every couple months; selling 4-5 option contracts a year.

The primary advantage of this approach is that it provides extra return during sideways markets and softens market dips.  The trade off is missing out much of the upside return during bull markets.  Setting the option strike price near the stock price eats into portfolio upside, but gives larger option premiums.  Choosing a higher strike price, more out-of-the-money, allows you to retain a larger share of market upside but provide you a smaller premium.

The other factor to keep an eye on is implied volatility.  The most common way to track implied volatility is via the VIX.  When the VIX is higher, you can expect to get more money for the calls you “write” (create and sell a call option).  I prefer to sell call options when the VIX is 18 or higher.

So if you are interested in dabbling with options I recommend starting with selling covered calls on a highly-liquid ETF like SPY.  Real time bid/offer quotes are almost essential and allow you to make limit order trades.  I recommend starting near the option midprice when selling a covered call.  For example if the Jan 2011 SPY 125 call has an ask/offer of 2.16/2.20, you can started by offering your call at 2.18. [Depending on the exchange, your brokerage account, and the price you may only be able to bid in $0.05 increments; in other cases you can price options in penny increments.]

To make things a little more confusing, most options are quoted with a 100x multiplier.  So that means that an option quote of $2.18 actually sells for $218.00.  Each option contract transacts 100 shares of the underlying security (the “underlying”).  So exercising one SPY 125 call contract requires paying $12,500 in order to buy 100 shares of SPY at $125 per share.

Just a quick chart, globally-exposed ETF building blocks with VTI, JNK, IGOV, and  EFA.

GRAPH:  Possible portfolio construction pieces

And on the short-side, ETFs: BIL, BWX, IEI, IEF, ISHG, ITE, and TLO.

GRAPH: Possible short-side (deconstruction) pieces

These ETFs are building blocks I’m considering for a long-short portfolio.  As you can see it would be a US-equity-long,  global-equity long, high-yield (junk bond) long, USD (United States Dollar) short portfolio.

I’m also very interested in call option writing to blunt some of the equity exposure, whilst still remaining equity-long.

To Make Finance Interesting

On October 15, 2010, in bonds, finance blog, by Dave

I went to a get together tonight with some friends, and talked about all sorts of topics.  The least popular, by people’s reactions, was personal finance.

People, in my experience, find Madoff somewhat interesting.  They sometimes find a bit of Wall Street bashing a bit entertaining.  And they find John Bogle and ETFs plain boring.

My issue is that I find the details of ETFs, markets, exchanges, and bonds fascinating.  I want to get inside of people’s heads to understand just why is finance boring or even vaguely repulsive?  My first thought is that somehow people feel that making money from investments is less morally redeeming than through work.  Another thought is that “respectable people don’t talk about money.”  Perhaps they find finance and all its jargon overwhelming.  Perhaps they have other more important things to focus on than their portfolio.

My mission with this finance blog is to find ways of helping people make better financial decisions.  A secondary goal is to bolster confidence in these financial decisions; to help people sleep easily at night with their financial strategy.  Finally, if possible, I would like to help people see finance through my enthusiastic eyes… as the minor miracle that it is.

The first two goals seem very achievable, while the third seems ever remote.  Really making sound financial decisions, and feeling secure in those decisions is important.  Perhaps, making finance interesting is not so important.  There are a handful of people, like myself, who find finance intrinsically interesting, while the vast majority of people could care less about money, investing, stocks, commodities, ETFs, options, futures…. hey, you in the back, quit snoring… mutual funds, gold, ETNs, annuities, insurance, loans, equities… oh, crap I think I might have dozed off a bit myself.

Proprietary Trading Group

On September 17, 2010, in bonds, Index Investing, Low-Cost Funds, options, by Dave

It’s official.  Balhiser LLC now contains a proprietary trading group which manages a private fund.   The fund, dubbed Sigma 1 (Σ1), seeks to be a covered-call balanced fund for the benefit of Balhiser LLC shareholders.  Balhiser LLC’s initial investment in the fund is a modest $25,000.  Like the CIA (Crazy Ivan Account) Σ1 is, in part, a test vehicle for trading and investing strategies.  Unlike the CIA, Σ1 is a Balhiser-LLC-owned tool to put my theoretical fund management skills to the test.

As fund manager, I plan to apply more rigor than necessary for an LLC  proprietary trading group.  I plan to draft unaudited quarterly reports.  I have crafted an outline of fund rules and guidelines.

With direct access to markets and exchanges, very low trading costs, and access to futures, options, forex, margin, algorithmic trading, etc.,  Σ1 should allow testing of  trading strategies that were simply not practical before.

Despite the myriad choices available, Σ1′s initial ground rules and objectives will be pretty pedestrian.   Here a some of them for the record:

Conceptual target allocation: 40% bond, 60% stock.

Bond Portion Parameters:

  • Duration 0-7 years.
  • Max. Foreign Exposure:  50%
  • Max. Corporate Exposure: 50%
  • Munis: 50% max
  • Mortgage-backed : 50% max
  • Treasuries/TIPs/Govt:  25% min
  • Bond ETFs:   Yes

Stock Portion Parameters:

  • Foreign: 40% max
  • Any single stock: 20% max
  • Total single stocks: 50% max
  • Diversified (largely index) ETFs: 50% min

Other parameters:

  • Max Overall Stock Exposure: 80%
  • Max Overall Bond Exposure: 60%

Margin:

  • Never to exceed:
    • 60% of  NPV of holdings
    • 100% of NPV of bond holdings

Stock Options:

  • Covered calls: Yes
  • (Cash/Bond)-Covered puts: Yes
  • Uncovered puts/calls:   only allowed intra-day while closing covered positions.
  • Buying puts/calls:  Yes, not to exceed 5% of NPV of holdings.
  • Paired options (e.g. butterfly):  Yes, VAR not to exceed 5% NPV.

Futures:  TBD

Other Options:

  • interest-rate: TBD  (likely only as bond hedge)
  • currency options: TBD (likely only as foreign-bond hedge)

Stock (ETF) Futures:  TBD

Commodities:

  • Futures:  No
  • Precious metals (ETFs):  Yes,  10% max
    • Covered calls:  Yes
    • Buy puts:  Yes, as hedge
    • Buy calls:  Yes, 2% NPV max.
  • Non-metal:  No

“Uncovered” (value at risk)  Derivative Exposure:

  • Total 5% NPV max (on any trading day).

“Uncovered” Derivative Loss Limits:

  • Not to exceed 10%  in 4 rolling consecutive quarters.  (10% of 4-quarter average starting NPV).
  • How enforced:  If previous 3 (or 2 or 1 or present) quarter(s) uncovered net derivative loss (NDL) is in excess of 5%, max uncovered-derivative VAR cap is lowered to 10%-NDL.

Short-selling:

  • TBD, likely only allowed as a hedging technique.

Futures Options:  TBD

That is a brief outline of Σ1.  I will be providing updates as it moves forward.

Disclaimer:  Σ1 is a private proprietary trading account and is not available to the public.   Balhiser LLC is a privately-held company.

Exchange-Traded Funds (ETFs)

On November 29, 2009, in funds, money, by Dave

There are two very different types of funds that are traded on the stock exchange(s).  The dominant form is the open-ended exchange-traded fund, commonly called an ETF.  The smaller cousin of the ETF is the closed-end fund commonly called the CEF.

According to a recent Forbe’s article ETFs currently contain $725 billion in assets and could top $1 trillion in the next two years.  According to this site CEF assets totaled $335 billion in 2007.

Closed-End Funds

The weakness of the CEF is that its assets are bound up in a closed financial package.  In a way a CEF is a bit like a financial black hole — the investments inside are not reachable by the rest of the financial universe outside the event horizon.  The only way that the money is accessed is indirectly through the current price of the CEF and through cash distributions.   To take the analogy further a CEF is a bit like a “white hole” in that the internal assets can slowly radiate out in the form of cash distributions.

Because there is no effective mechanism to keep CEF price in line with NAV (net asset value) they hold they frequently trade at a premium or discount to their NAV.  This yahoo finance chart shows the ever-changing relationship between price (red) and NAV (blue) for S&P 500 covered call CEF.

The price versus NAV tracking-error in CEF pricing is a big con to CEF investments.    It does also present a couple opportunities.  1) Buying CEFs at a steep discount to their NAV is sometimes possible and 2) shorting CEFs that are at a steep premium is another opportunity.  Generally, however, I don’t advice speculating or investing in CEFs, largely because of the superior alternate — the ETF, or exchange-traded fund.

Exchange-Traded Funds (ETF)

The ETF is a really great financial innovation.  ETFs excel over CEFs because they build in a financial arbitrage mechanism that minimizes price/NAV tracking error.   The underlying components (stocks, bonds, money, etc) can be be redeemed directly from the ETF issuer in large blocks of ETF shares called creation units.  Typically 50,000 shares of an ETF equals a single creation unit.  If the NAV is greater than the price of the ETF a large investor can buy a creation unit worth of shares and resell the constituent investment pieces for a profit.  This arbitrage mechanism helps to keep ETF prices in very close correlation with the underlying NAV.

The beauty of ETFs is that they incorporate many of the best attributes of stocks, closed-end funds, and mutual funds into an efficient financial package.  ETFs, like CEFs, trade like stocks.  Because they do, they can be bought and sold in virtually any brokerage account just like any other stock.  Additionally, ETFs can do essentially anything a mutual fund can do — provide diversification, passive or active management strategies, invest in foreign or domestic securities, etc.

Often a mutual fund company will offer a particular fund it two different packages– a typical mutual fund or as an ETF.  For example Vanguard offers the Vanguard Total Stock Market fund as a mutual fund under the symbol VTSMX and as an ETF under the ticker VTI.

I have just scratched the surface of the CEF and ETF investment world with this blog article.  Suffice it to say I am a proponent of ETF investing.  Understanding the disadvantages of CEFs helps illustrate the advantages of ETFs.  In fact, I believe ETFs are one the of greatest financial innovations since the index mutual fund.  One passing word of caution.  Please be carefully not to confuse ETFs with the similar-sounding ETN (exchange-traded note).  ETFs are backed by the underlying securities they contain, whereas ETNs are simply senior debt notes that are only as secure the issuer who sells them.  For this reason, I prefer the real McCoy, the EFT.

Investor’s Thanksgiving Thanks

On November 26, 2009, in funds, Investing, money, by Dave

As we reflect on Thanksgiving, here are some personal finance things I am thankful for:

  • Decimal stock pricing. Remember all those pesky fractions?  Decimal pricing is so much easier.  And the spreads are much better too.
  • Online stock trading. I don’t know about you, but I don’t want to talk to a broker.  I want fast quotes and cheap trades without the conversation.
  • Free online financial data. Thank you all you online publishers of stock data.  It’s 2:00 AM and I just have to know the market premium on the BEP closed-end fund — No problem.
  • Index funds. Thanks John Bogle and others for these diversified, tax-efficient, cost-efficient funds.
  • Good financial planning. Thanks, Dad, and others along the way who taught me money management, investing, and financial planning.
  • 401K, IRA, and Roth IRA accounts. These tax advantaged accounts were spectacular ideas, and they work.
  • Good accountants. Thanks for helping me make some sense of the US tax code.
  • Buying opportunities. Every now and again a great investment comes along and a great price.  Doubling my money on PCU comes to mind.  Such opportunities are what make investing fun for me and keep me searching for the next great buy.
  • Dividends. Even when stocks are down, many still pay dividends. A lot of stocks are currently repaying 3% dividend yields. These quarterly dribbles of cash do feel good to receive.

For investors, there is a lot to be thankful for.  Yes, our equity investments are generally down, and our economy is lethargic. Equities have been a wild ride to nowhere in the last decade.  But bonds and, yes, in many places even real estate have fared much better.  And as long-term investor I am excited about the prospects finding buying opportunities.  I wouldn’t say equities are cheap, but I am thankful that they are not all that expensive either.  I am looking forward to the next 10, 20, 30+ years of investing.

Hot Days, Cold Stocks… Cool Logic?

On July 27, 2008, in funds, Investing, money, by Dave

My retirements accounts are down 12.3% and 10.1% YTD (as of 7/11).  The market is down again today so these number are likely to be a shade worse when the YTD return on the website updates later today.

At the same time the weather has been hot.  In the 90′s and flirting with 100 degrees.

Today the S&P closed at 1228. Not much different from where it was 10 years ago at 1177. At less than half a percent appreciation per year plus about 1.5% yield that’s a whooping 2% per year return for a 10-yr investment window.  Taking a look at the chart is unlikely dollar-cost-averaging would have significantly altered the return up or down over that period [hmm... sounds like an analysis for a future blog].

Not exactly a PSA for the merits of stock investing.

So, how’s my personal investment strategy going to change?  Not much.  My “fun” money account has been doing better because I’ve been selling SPY calls high and re-buying to cover low.  This has been a helpful hedge so far and something I may wish to write about further.  My “core” money allocation is unlikely to change… a mix of large/small/international low-cost index funds, some bond funds, and some cash.

Cool logic reflecting on history suggests that over any 20 year period stocks beat bonds… and likely commodities, cash, real-estate, etc.  Perhaps the S&P500 values 1177 and 1228 are some worthwhile data points to start my blog with and to test against over the next ten years.  Maybe these numbers will be part of an unprecedented counter example.  Time will tell — but for now I’m putting much of my money on the bet that stocks will outperform in the end.

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