Personal Investing 101 By Curtis Gary Dean FCAS, CFA, ChFC Distinguished Professor of Actuarial Science, Ball State University You’ve Heard It Before Information is not new. Repeated again and again. Even so, most of you have no strategy or an inferior strategy. You can beat most investors by wide margin by following a very simple plan. Average Annual Returns: 1926-2002 Annual Return Standard Correlation Deviation Stocks Bonds T-Bills Large Company Stocks 10.19% 20.63% 1.000 .193 -.016 Long-Term Corp Bonds 5.88% 8.72% .193 1.000 .205 T-bills 3.79% 3.15% -.016 .205 1.000 Compound Growth Stocks: $10,000 x (1.1019)30 = $183,766 Bonds: $10,000 x (1.0588)30 = $55,516 T-bills: $10,000 x (1.0379)30 = $30,526 Stocks may not be quite as dominant in future, but still best bet for long-term growth. Fundamental Principles Identify goals and select appropriate investments. Diversify. Defer taxes. Keep turnover low. Keep investing expenses low. Make yourself rich, not the brokers. Make a plan and stick to it. Do not chase yesterday’s winners. Identify goals and select appropriate investments Short-term goals: money market, certificates of deposit, short-term bonds Long-term goals: inflation-protected bonds, intermediate-term bonds, real estate, stocks Diversify Across asset classes: money market, bonds, real estate, stocks Within asset classes – Bonds: municipal, U.S. govt, corporate, mortgage-backed, inflation-protected – Stocks: industry, company size, value and growth, domestic and international Defer taxes Selling securities creates taxable events Use 401(k) and Roth IRA (if available) Complications – 15% tax rate on long-term capital gains and dividends – 401(k) and regular IRA distributions taxed at ordinary income tax rates Use $3,000 capital loss to offset ordinary income Investment expenses Mutual fund operating expenses and management fees Loads Commissions * Bid-ask spread * Market impact * *Harder to identify Effect of expenses on returns Average 7% market return for 30 years If .15% eaten annually by expenses $10,000 x (1.0685)30 = $72,985 If 2.00% annual expenses $10,000 x (1.050)30 = $43,219 If 3.00% annual expenses $10,000 x (1.040)30 = $32,434 Selling Magazines Money, Kiplinger’s Personal Finance, Smart Money, Forbes, Fortune, Business Week, etc. Range of methodologies Identifying yesterday’s winners Buy me – “The 10 Best Funds” – “Annual Mutual Fund Edition” – “Best Funds for Today’s Market” List of “best” regularly changes: taxes if you switch! Pretty Efficient Markets Weak correlation between past and future performance But, lousy funds tend to remain bad Trying to beat market -> probably do worse than market because of expenses and chasing trends Fundamental Principles Identify goals and select appropriate investments. Diversify. Defer taxes. Keep turnover low. Keep investing expenses low. Make yourself rich, not the brokers. Make a plan and stick to it. Do not chase yesterday’s winners. The Magic Bullets: Indexing Invest in broad indices – MSCI® US Broad Market Index or Wilshire 5000 – Lehman Brothers Aggregate Bond Index – Morgan Stanley REIT Index Diversified, tax efficient (stocks), and low expenses Consistently beat most actively managed funds and investors Use open-end mutual funds or ETFs Open-end mutual fund vs. ETF ETF = Exchange Traded Fund – Traded on stock exchanges – Arbitrage opportunities keep prices in line with indices – Usually lower expense, but must pay commission Open-end mutual fund – Your deposits used to purchase more stock for fund Examples: Annual Expense Ratios ETFs Vanguard Total Stock Mkt VIPERS: 0.07%* Vanguard REIT VIPERS: 0.12% iShares MSCI EAFE Index: 0.35% Open-end Mutual Funds Vanguard Total Stock Mkt Adm: 0.10% (0.19%) Vanguard REIT Index Adm: 0.16% (0.21%) Vanguard Total Int’l Stock Index: 0.31% *Average stock fund has expenses more than 25 times greater!! Total Stock Market Index General Electric ExxonMobil 2.58% 2.24% Microsoft Citigroup Wal-Mart Stores 1.94% 1.67% 1.51% Pfizer Bank of America Johnson & Johnson 1.36% 1.28% 1.26% AIG IBM 1.14% 1.13% 16.11% Sample Portfolio for 40 year old 47.5% - Vanguard Total Stock Mkt Index 17.5% 5.0% 15.0% 15.0% - Vanguard Total Int’l Stock Index - Vanguard REIT Index - Vanguard Total Bond Mkt Index - Inflation-protected bonds One Stop Shopping Personal Investing 102 “Value stocks” produce higher returns over time – Low: Price/Book Value – Low: Price/Earnings – Reasonable dividends “Value and Growth Investing: Review and Update,” by Louis K.C. Chan and Josef Lakonishok, Financial Analysts Journal, Vol. 60, No. 1 Add Low Cost Value Funds to Mix 30.0% - Vanguard Total Stock Mkt Index 12.5% 5.0% 10.0% 7.5% 5.0% 15.0% 15.0% - Vanguard Value Index - Vanguard Small Cap Value Index - Vanguard Total Int’l Stock Index - Dodge & Cox Int’l Stock (.77%) - Vanguard REIT Index - Vanguard Total Bond Mkt Index - Inflation-protected bonds Tax Efficiency Put REITS and bonds in tax-deferred accounts Consider municipal bonds (funds) outside of tax-deferred accounts Recommended Reading A Random Walk Down Wall Street by Burton Malkiel The Four Pillars of Investing by William J. Bernstein Common Sense on Mutual Funds by John C. Bogle Winning the Loser’s Game by Charles D. Ellis The Future for Investors by Jeremy J. Siegel The Intelligent Asset Allocator by William J. Bernstein Master and use what’s in these books and you will beat most professional money managers Resources Online mutual fund research (free) – www.moneycentral.msn.com Library – Stocks: Value Line Investment Survey ($598) – Funds: Morningstar Mutual Funds ($549) One Last Time: Fundamental Principles Identify goals and select appropriate investments. Diversify. Defer taxes. Keep turnover low. Keep investing expenses low. Make yourself rich, not the brokers. Make a plan and stick to it. Do not chase yesterday’s winners.