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.

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!]

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.

It’s what you keep

On December 4, 2008, in Investing, money, by Dave

I recall something I read several years ago.  I’ll paraphrase…

If you’re going to pay for investment advice, start with good tax advice.

I was listening to an estate planning program on PBS while working in the garage. The speaker charmed his audience with anecdotes and analogies. His advice was decent enough:

  • Pay attention to the beneficiary forms for your investments.  Especially for 401K and IRA accounts.  These trump wills and have important tax advantages upon death.
  • Spouses should consider bequeathing some assets to  non-spouse heirs to benefit from the $2M estate tax exclusion. (Note: I’ve not fact-checked this amount).
  • Consider life insurance and annuities.   Life insurance for tax-free inheritance, annuities for the possibility of living much longer than you expect (say to 100).
  • If you don’t plan, guess who is likely to take most of the estate…. the government and the nursing home.

First, these are valid points.    Second, this type of planning ranks right up with dentist visits, cleaning the bathtub, and proctology exams on the fun scale.

Nonetheless I’ve seen first-hand the impact of helpful decisions (smart IRA beneficiary choices) and unhelpful ones (no will, hard-to-find financial information, social security snafus, nursing home challenges).

If you wish to leave the most to your grandchildren, heirs, charities, then estate planning is a must.  Boring, yes.  Important, yes!

Additionally, tax planning is helpful not just for the deceased, but for the your day-to-day life.  I’ll touch on that in my next blog.

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Angst, action, and a modicum of perspective

On September 23, 2008, in Investing, by Dave

So I must confess this market has me a bit nervous.  My main outlet for financial nerves is my “play money”  (aka mad money) IRA account.  Here are my recent plays:

  • Buying an SPY call to close my covered call.  (realizing ~$300 gain on the call)
  • Selling 100 shares of SPY (about $1100 loss realized over about 1 year, offset by about $700 in call gains and dividends)
  • Buying 2 OCT 123 SPY puts yesterday (~$490 profit on paper in a day and a half).

So far I am happy with these moves.  It frees up cash for future buys and gives me the feeling of security of cash (in a money market).  More importantly it makes feel active rather than feeling passive.  This is helpful as part of me wants to sell sell sell! shares in my broader portfolio.

For me getting out of shares (selling) is emotionally easier than getting back in.  Thus, staying in is important.  I must admit it is feeling harder to resist a bit of selling.  I am certainly discouraged by the lack of gains in the last 10 years in the stock market.

Which gets me to real estate.  My home has been a pretty solid investment.  It has appreciated about 4-5% annually inclusive of the recent slight housing downturn.  This is not bad considering :1) it is a leveraged investment, 2) tax-deductible interest payments, and 3) I enjoy my house and my neighborhood.  So I take some solace in the fact that while stocks have been mediocre, my other investments (house, bonds, money market, options) have provided decent (if not exactly spectacular) returns.

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