“Real gross domestic product — the output of goods and services produced by labor and property located in the United States”. This is mainly used as a measure of economic output. You look for GDP going negative to signal a recession. The GDP itself is a huge economic indicator, but it pays to find out what goes into the GDP and look at the components.
The components of GDP are private consumption, investment, government spending, and exports minus imports or as an equation GDP = C + I + G + (X – M). Next time I will explore each of these components.
I am not going to write a book review for Pioneering Portfolio Management, because many other qualified individuals have already done so, and this book is clearly a worthwhile read. What I am going to do is highlight the main points of the book that would be most applicable to average individual investors.
David Swensen is Yale’s chief investment officer and manages their endowment fund. An individual investor is not too different from an institutional investor, except that he works on a much smaller scale, isn’t sheltered from taxes, and has a finite lifespan. Both types of investors use the same three tools when making financial decisions: asset allocation, market timing, and security selection.
In allocating assets, diversification is key. Diversification is only meant to control risk, not increase return. Investing in multiple uncorrelated asset classes, each with the same risk factor and expected return, will decrease the collective risk factor while maintaining the same expected return.
This is Swensen’s basic formula for an individual investment portfolio:
- Domestic Equity 30%
- Emerging Market Equity 5%
- Foreign Developed Equity 15%
- Real Estate Investment Trusts 20%
- U.S. Treasury Notes and Bonds 15%
- U.S. Treasury Inflation-Protection Securities 15%
After choosing asset allocations, it is important to constantly rebalance your portfolio to maintain these allocations. Swensen recommends rebalancing more frequently with higher volatility assets. For stocks, rebalance daily (but remember that Swensen does not have to worry about tax liabilities). This emphasizes the contrarian approach to investing. Swensen strongly discourages momentum investing.
Where the market is efficient, there are no mispricings for active managers to exploit. Swensen asserts that in such markets, “Good results stem from luck, not skill.” Index funds historically offer better returns than mutual funds simply because they don’t have the active management costs.
Swensen does advocate some allocation into real estate and private and foreign equity. This is more difficult for an individual to directly access, but there are ETFs that track alternative investments.
Finally, trying to time the market is futile.
Recently the limits on insured amounts has changed from $100,000 to $250,000, but what is the FDIC and what does it mean to me?
After the stock market crash of 1929, people pulled their money out of the banks, because they had fears that their deposits would disappear along with the banks. The very act of pulling out the deposits puts the banks in jeopardy. In order to avoid this chicken and the egg dilemma, the government decided to insure bank deposits, so people would have faith that their money would not disappear if the banks disappeared.
- $250,000 in single accounts
- $250,000 in joint accounts
- $250,000 in retirement accounts
The insurance covers savings, checking, CDs and money market deposit accounts. It does not cover any risky investments like stocks, mutual funds and bonds.
Coverage is limited to $250,000 per depositor per bank. If you have less than $250,000 in combined your insured accounts at a bank, then you’re covered. If you have more than $250,000 in one bank, you might want to consider opening an account at another bank. If you have $500,000, you can put $250,000 in one bank and $250,000 in another and be fully insured. Married people have a bonus, because joint accounts are separately insured. A couple could have $1,000,000 insured at a single bank. $250,000 for each of their individual accounts and $250,000 each for a joint account. Certain retirement accounts are FDIC insured and they are also considered separate from individual and joint accounts, adding even more that could be possibly insured at a single bank.
I’ve heard if your bank disappears, you can recover the principal from the FDIC pretty quickly, but the interest takes longer to get. The best case scenario is to avoid a bank that is in danger of going under. Just like stocks, you need to diversify your banks.
Lately, with the economy moving forward like a tipsy drunkard, it seems best to try and eek out every little gain that you can. For those fortunate enough to have a little bit in a company sponsored retirement account like a 401(K), there are still quite a few ways to make sure you’re getting the most out of your money.
Most managed 401(K)’s tend to offer a small selection of different types of funds to choose from. While you might also be able to make a few investment choices within your specific plan, I’ll be limiting my topic to how best to select from the limited options presented to most people with a 401(K). Given the option between a few types of funds, what metrics can be used to determine how to best proportion your money between them. While you’ll have to decide for yourself between large cap, small cap, or some other exotic index of funds, there is one item that can be used to compare similar funds. This useful metric is the expense ratio of the fund.
Since most mutual funds historically tend to underperform the broader markets over the long-term, some of the less risky options are the Index Funds, or mutual funds that emulate the stock market indices. Because they merely attempt to stay within a narrow parameter set by the market index, there is far less management involved in the fund and consequentially less expenses. This leads to most Index Funds having expense ratios well below 1%. Comparatively, most actively managed mutual funds have expense ratios of around 2% with some even higher than 5%. Over the long run, these expense ratios will eat into your potential gains. Now why would you want to pay more for likely less gains?
So, while you may agonize over which mutual funds had the best return over the past three or five years, be aware of the nickel-and-diming that goes on with some of these funds. Past performance is only an indicator of future returns if you’re a politician. Index funds may not be the best option for everyone’s 401(K) plans, but it does offer some of the smallest risk relative to other stock funds. Granted you still need to decide how to balance your contributions relative to which indexes, but if you’re a passive investor keeping down the costs is one of the easiest things to do.
About a week and a half ago, I checked out CNN Money before I went to work to find that the S&P 500 index had dropped over 90% to 134.42!!!
Realizing that the Dow and Nasdaq were down 1.64% and 1.73% respectively, I realized that there was no way that the S&P 500 would be down such a scary percentage. Turns out that CNN Money had some kind of error where the price would be fluctuating from the erroneous value of a 90% drop to a more respectable 1-2% drop. While you probably won’t live to see a 90% drop in the S&P 500 or Dow, you will live to see tough times where the markets drop a lot in a very short amount of time. Some people run for the hills, some people don’t even want to check the prices of the stocks they own, and some people see it as a golden opportunity to buy stocks that are oversold. After the dot com crash in 2001 and 2002, a lot of people lost serious amounts of money. On the other hand, people who invested in late 2002 and early 2003 were probably rewarded very nicely as the market escalated consistently for over four years. When investing, keep two things in mind when you have extraordinary declines in the market: cash is a beautiful friend and you don’t need to buy shares all at once.
Keep Cash on the Side
If you invest all your money at once, you handcuff yourself from opportunities when the market has declined. Since investors can’t always predict how the market will act, it is wise to keep uninvested funds available just in case stocks get depressed to prices where you see the stocks as oversold. It’s terrible to see a great buy available only to know that you can’t do anything about because you don’t have the funds to buy.
Buy in Increments Since Trading Fees are Cheap
Most investors don’t deal directly with a brokerage firm and pay exorbitant trading fees of around $100 per trade. Those days are generally over and now you can instead pay $7/trade through Scottrade or $12.99/trade through Etrade. What this allows investors to do is be more conservative with their trades by splitting up purchases of a particular stock. Say you want to buy 100 shares of Monsanto Company (MON) at $107. Instead of buying all 100 shares at $107, you can instead start by buying 50 shares at $107. Then go ahead and put a limit order of $97 to buy another 50 shares. What this does is protect you a bit of any fall in Monsanto when you buy it. If it happens to drop to $97, your average is $102/share and you’re getting it cheaper than by just buying your initial 100 shares at $107. If you like Monsanto so much, then it shouldn’t be a problem if it drops and you buy more shares because you were planning on purchasing 100 shares in the first place anyways. If Monsanto happens to increase in value and rises to $125/share, then you just made yourself a nice 16.8% gain on your 50 shares. Sure, you could have made double by buying all 100 shares in the first place, but this is a good way to protect yourself when there is downside. With this volatile market we are experiencing, buying in increments would be a good strategy to enforce throughout the rest of 2008.
Exchange-Traded Funds (ETFs) are relatively new to the US market, having been introduced only in 1993. ETFs allow investors to follow the performance of key indices and sectors while providing the flexibility and instant liquidity lacking in traditional mutual funds.
There was a time when mutual funds were the most accessible entry to professionally-managed diversification. However, professional management has a price, and after the active managers have collected their paychecks, approximately 80% of mutual funds underperform the average stock market return. (Index funds, which are automated mutual funds that track a stock market index, have lower annual fees – but that is an article for another day.)
ETFs differ from mutual funds in that they can be traded like a stock. ETFs allow intraday trading, unlike mutual funds, which are only traded for the net asset value at the end of the day. The fact that ETFs are traded like stocks also means that they can be shorted, bought on margin, or placed on limit orders. Options are also available.
Finally, ETFs have tax benefits over traditional mutual funds. Actively managed fund shareholders pay taxes on all the capital gains that the fund owns while they hold their shares, as opposed to just paying taxes on their personal capital gains.
Now, onto the ETFs. There are more than 300 of them, and here are some of the most popular ones:
- SPDRs State Street Global Advisors (SPY) – tracks the S&P 500
- PowerShares QQQ (QQQQ) – tracks the NASDAQ-100 index
- iShares Russell 2000 Index Fund (IWM) – tracks the Russell 2000 index
Here are a few that I am partial to:
- streetTRACKS Gold Shares (GLD) – invest in gold without the risk of buying gold futures or the hassle of storing gold bricks in your home
- SPDR S&P Metals & Mining (XME) – tracks the S&P Metals & Mining index
- iPath S&P GSCI Crude Oil Tot Ret Idx ETN (OIL) – tracks the Goldman Sachs Crude Oil Return Index
Lately, it has been easier to target sectors to stay away from than ones to invest in. These bear-market ETFs can do the shorting for you:
- UltraShort Financials ProShares (SKF) – corresponds to the inverse of the Dow Jones US Financials index
- UltraShort Real Estate ProShares (SRS) – corresponds to the inverse of the Dow Jones US Real Estate index
- UltraShort FTSE/Xinhua China 25 Proshare (FXP) – corresponds to the inverse of the FTSE/Xinhua China 25 index
- Rydex Inverse 2x S&P 500 (RSW) – corresponds to the inverse of the S&P 500
All of these can be traded an AMEX, NYSE, or NASDAQ.