Fredrickson Financial

Should you go all in on stocks?

October 25th, 2016

I have had a few clients recently ask me about the wisdom of having a retirement portfolio that is 100 percent invested in stocks based on the following two-part article published in the New York Times.

The article makes the point that stocks virtually always outperform bonds by a wide margin over lengthy periods of times so maybe people should have all of their investments in stock.

First of all, while the articles point out that Warren Buffett subscribes to this view, that is hardly a rationale that applies to the rest of us. What may work for one of the richest men in the world could misfire when applied by normal people.

Second, the argument is based on a fallacy. It takes the returns of stocks and bonds and says, hey, look stocks are much better, therefore you should put all of your money in stocks and forget about bonds.

The reality is that the returns of stocks are often inversely related to those of bonds. Bonds will tend to go up when stocks go down and vice versa.

As a result of this tendency for asset classes to behave differently, a blended portfolio is more than the sum of its parts.  Taking the individual parts and comparing their returns is wrongheaded since the blended return in any given year will tend to be higher than the annual average of the asset returns considered individually.

This is the essence of modern portfolio theory. The goal is to maximize your return for a given level of risk.

It’s true that stocks go up more often and further than bonds, so it makes sense for most people to have more stocks than bonds. But a lot of folks can’t handle the volatility of an all-stock portfolio, as the writer points out, and again, you are not giving up as much the article claims by having some bonds in your portfolio, as can be seen from this graphic:

Bottom line, it’s a case-by-case thing, but bonds are not what you should be afraid of this October.

The prudential thing would be to cut fees

February 13th, 2015

I keep seeing a TV commercial in which Daniel Gilbert, a Harvard psychology professor helping to advertise Prudential mutual funds, asks a crowd of people how much money they have in their pocket. People mention small sums of cash and Gilbert asks, “Could it be that something that small can make an impact on something as big as your retirement?”

The prof then knocks over a tiny domino marked $45 that begins a chain reaction of falling dominoes, leading to one that is 30 feet tall crashing to the ground. “… if you let it grow for 20, 30 years, that retirement challenge might not seem so big after all.”

Trouble is that the fees charged by Prudential and many other mutual fund companies, particularly for those funds that are actively managed and/or have 12b-1 fees, could seriously retard that growth.

According to Morningstar, the average fee for Prudential domestic stock funds is 1.34 percent.  This expense ratio is typical of the active fund universe. On the other hand, the Vanguard Total Stock Market Index Fund Admiral Shares has a management fee of 0.05 percent.

If you assume a tax-free investment  of $20,000 in the Vanguard fund earning 7 percent for 30 years, you wind up with about $150,000. At the Prudential fee of 1.34 percent, the same initial investment with an equivalent return becomes a relatively measly $104,000 after three decades. (Note: the assumed return is an example for illustration purposes, not necessarily what  an investor will receive.)

You can see this for yourself using any number of online calculators.

Something tells me that in real life some of those actively managed dominoes might not make it to the end zone.

Muni bonds make April less taxing

April 1st, 2014

As last minute filers square away their tax returns, there may be an opportunity for some investors to make the tax season a bit less painful next year.

For many people, some municipal bonds may offer an advantage as compared with taxable corporate bonds of similar maturity and credit quality.

An interesting comparison can be made between the Vanguard Limited Term Tax Exempt  fund and the Vanguard Short Term Investment Grade fund. The federally tax-exempt fund, in the Admiral share class, recently yielded 1.72 percent, while the taxable (Short Term Investment Grade) fund yielded 1.91 in the Admiral share class, according to Yahoo! Finance.

Both funds are rated as having limited interest-rate sensitivity by Morningstar, the fund-rating company. But the tax-exempt fund is rated as offering high credit quality, whereas the taxable fund is rated as offering only intermediate credit quality.

Despite the higher credit quality, the tax-exempt fund may offer a higher after-tax return for people even at the 15 percent federal marginal tax bracket. On a tax-equivalent basis for investors at that tax rate, the tax-exempt fund is yielding 2.02 percent, vs. the 1.91 percent for the taxable fund. That may not sound like much of a lead  for the municipal fund, but it’s more typical to see an advantage for tax-exempt bonds for people at the 25 percent marginal rate and above, not down to the 15 percent level.

The edge for some short-term municipal bonds compared with short-term corporate bonds could be fleeting. The tax-exempt fund has declined a bit more in the past 30 days than the corporate fund, accounting for much of the advantage. The situation could reverse quickly in this volatile market.

Investors generally are better off considering their long-term situation and not reacting to short-term market opportunities. This commentary is intended to be educational and should not be viewed as specific advice. Consult your financial and tax advisors to see if and how this may commentary may apply to your specific situation.

Jellybeans teach a lesson

October 31st, 2013

What can a jellybean contest tell us about the stock market? A lot, it seems.

I just returned from a regional conference for Dimensional Fund Advisors — a mutual fund company that incorporates index-like strategies in its funds. This story was told by Apollo D. Lepescu, a vice president at DFA. In a previous event that he described, a jar was filled with jellybeans. He asked everyone in the audience to write down their guess of the number of candies in the container. The guesses ranged from 409 on the low side to 5,365 on the high end. The actual number was 1,670. Guess what the average was? 1,653.

This result was not a fluke. Mr. Lepescu has replicated it a number of times. His point in telling the story is that the stock market is like the opinions of the people in that room. People state their opinion of the value of stocks by buying or selling them, and the actual value, the average of those opinions, is generally a correct reflection of their risk-adjusted earning potential. This is why it is often futile to try to time or beat the market.

However, DFA has exploited pockets that seem to give their funds an edge over the market as a whole. These include tilting their index-like exposure toward value stocks – which are stocks that are cheap relative to their peers based on measurements such as their price-to-book value and price-to-earnings ratio – and small-cap stocks.

This doesn’t mean that small-cap and value stocks are mispriced; rather, they are riskier and therefore investors demand a higher price than even their relative market risk measurement, known as “beta,” would indicate.

However, there is also some evidence that investors occasionally become too enamored of growth stocks, which could explain some of the out-performance of value stocks over time. This debate continues, as exemplified by the fact that two of the three honorees of the Nobel prize for economics this year were Eugene Fama, known as the father of the efficient markets theory, and Robert J. Shiller, who has made a career of identifying and studying speculative bubbles.

Professor Fama has been on the board of DFA from “the first day,” as he said recently in the New York Times, and his research underpins DFA’s investment approach. Interestingly, Professor Shiller, even though he is theoretically opposed to the efficient markets theory, recommended in the Times that “people might consider investing in DFA.”

Of 320,000 financial advisors in the United States, only about 2,000 are approved to use DFA funds with clients, according to Scott Bosworth, a DFA vice president. Garrett Investment Advisors, LLC, the Registered Investment Advisor firm of which I am part, is one of those. Contact me to find out if DFA funds are right for you.