Three Basic Principles of Money Management

Transcription

1 Three Basic Principles of Money Management 1. Live within your means - Total expenditures must be lower than total income - Your basic cost of living must be below (not at) your level of income - The golden rule of finance ; the first commandment 2. Master your credit - Although the Scriptures do not prohibit borrowing, every reference to it (from the point of view of the borrower) is negative. - In our society, consuming and borrowing are both too easy, so aspire to having low or zero debt. 3. Establish your priorities - If you follow Rules 1 & 2, you will have a surplus, hence you will need to make financial plans for your savings and to establish priorities for spending - Here is a suggested sequence of priorities - First, start with the 4 Basic Essentials Taxes & Debts (Automatic responsibilities; this income is not yours yet) Basic Giving/Tithing (An expression of gratitude) Basic Family Needs (Food, housing, education, medical) Saving for a Margin (Insurance is a partial option) Increased giving Increases giving Increased giving Increased giving Secondary family needs (clothing, transportation, recreation) Saving for capital Family amenities (Convenience & comfort) Personal amenities (Travel, luxuries, etc.) - Beyond these four essentials are two basic tracks. Balance must be achieved between the two tracks as a matter of personal discretion for each family. Page 1

2 Personal Investment 101 Motivation - Individual investors are now expected to know more about personal investing - Retirement, College & Missions: All require funding - Most people lack expertise & sound advice not always readily available - Listed below are some basic knowledge/plans for personal investing Additional Resources o The ETF Book: All you need to know about exchange-traded funds, by Richard A. Ferri (2011) o The ETF Analyzer: o The Yahoo ETF Finder: Three types of investment decisions Each of us will experience different risks and returns because of three types of decisions that we all need to make: 1. Asset Allocation Deciding what proportion of your total investment to allocate to each major asset class for the long-run (for example, how much in: Stocks, Bonds, Real Estate, Cash, or Commodities). 2. Market Timing Deciding when to move funds from one asset class to another asset class (e.g. when to sell stocks and buy bonds). 3. Securities Selection Deciding which specific security to buy within each asset class (for example, which company s stock or bond), after you have decided how much to invest in each asset class. Which of these decisions do you think is most important in determining your risk and returns? Which decisions do most people spend the most time on? The Bottom Line: Page 2

3 Asset Allocation Basic Rules: - Diversification (Choose multiple asset classes; Pick funds, not stocks) Prices within the same asset class move together; but much less so across asset classes. Thus investing in multiple asset classes reduces overall risk. - Tax Efficiency (Invest in tax-deferred or tax-sheltered vehicles first) For example, IRAs, 401(K)s, Municipal Bonds, Deferred Profit Sharing Plans. Also, for self-employed individuals, consider setting up a SEP. - Costs & Fees (When in doubt, always choose the fund with the lowest fees) A fund s performance is hard to predict, but its costs (fees etc.) are certain. Factors in deciding on your allocation %age: Look at each major asset class in terms of: 1. Expected Returns (average annual return over a long period of time) 2. Risk (average volatility; how much prices move on average each year) 3. Correlation (how much it moves together with the stock market) 4. Liquidity (how easy it would be to convert this asset to cash if needed) 5. Cash flow (how much cash income it will provide each year) Typical Core Asset Classes: Expected Returns Risk (Volatility) Correlation Liquidity Cash Flow Stocks U.S. Domestic H H H H L Stocks Int l Emerging Mkts H+ H+ H M/H L Commodities Energy, metals etc. M/H M/H M M L Real Estate M M M M/L M Bonds L/T (10+ year to maturity) M/L M/L L M/L M/H Bonds S/T (5 or less yrs to maturity) L L L M/H M/L Cash (bank deposits or CDs) L L L H L Page 3

4 Use Exchange-Traded Funds (ETF s) to build your own portfolio - An ETF is bought and sold like a stock (by setting up an online brokerage account). - Each ETF has its own ticker symbol, but actually represents a basket of stocks. For example, buying VOO is buying the entire S&P500 index of stocks. Buying VTI is buying a portfolio of the biggest 3000 U.S. stocks. VTI s Expense Ratio is 0.05%, meaning on a $10,000 investment, you pay fees & costs of only $5 per year. - There are over 3,000 ETFs, but most do not have enough volume, so are too costly to buy or sell. Only buy low cost (expense ratio < 0.50%) & large (>$500m) ETFs. - Useful websites for ETFs: and - Key is to ensure you hold both Monetary assets and Real assets Examples of how to build your portfolio using ETF s Ticker Expense Ratio Plan A ( Risk) Plan B Plan C Plan D ( Risk) Equity-US Large Cap VOO 0.05% Total Market VTI 0.05% Small Cap VB 0.08% Nasdaq QQQ 0.20% Equity- F. Dev. Van Ex US VXUS 0.13% Equity- F. Emg Schwab Emg. SCHE % Nat Resources Materials VAW 0.10% Energy VDE 0.10% Real Estate 7.7% Yield -> ish Global REIT REET 0.10% % Yield -> Van REIT VNQ 0.12% Infl-protected VTIP 0.10% Bonds 2.4% Yield -> Van. Total BND 0.10% % yield -> CA Muni CMF 0.20% % yield -> ish Nat Muni MUB 0.20% % yield -> Hi-yield JNK 0.40% % yield -> S/T Van. BSV 0.11% 5 5 %age in Stocks & Commodities (inflation + growth) 60% 45% 35% 30% %age in Real Estate & VTIP (more inflation hedge) 15% 20% 20% 25% %age in Bonds & Cash (monetary assets) 25% 35% 45% 45% Real Assets 1 A reasonable alternative to SCHE would be VWO, which is the Vanguard version. Its expense ratio is 0.15%. Page 4

5 Some Advice for a Young Couple we know: 1. Always put away some savings each year It is hard to do this when you are starting off, particularly with kids and all, but as a rule, after tithing, put some savings away. How much you save is up to you but 10% or more is good to aim for. It allows you to get used to living within your means. I know people with pretty low income, but who still can save every year. You should be able to do this. 2. Take advantage of tax-advantaged savings first 401(k)'s, especially those that trigger matching funds from your employee, are must savings. There is no justification for not putting money away on that basis. Also, if you have a college saving plan that allows you to deduct your savings from current year's income (up to a certain amount each year), that is also a must. It is free money and you will never get that kind of return otherwise. If you have control over the type of asset to put into your tax-sheltered plans, pick taxable bonds and high-income investments. 3. Consider your spending (liquidity) needs first If you plan to spend a larger sum in 2-3 years, you should not be putting the money in highly volatile or illiquid instruments. This is because you have very little choice but to liquidate your position even if the market prices are not favorable. What instruments are volatile? Stocks, in general, and possibly long-duration bonds. So at least for the portion that you expect to spend soon, you need a lower volatility instrument. For your longerterm savings (remember, some of your saving should be for 5+ years), you can buy stocks and long-duration bonds (unless it is tax-sheltered, I buy tax-free muni-bonds). 4. What are your options for low-volatility investing? Short-answer: Not much right now. Most of the shorter-term instruments (such as bank CD's) are yielding extremely low returns. Here is a snapshot of the yields on Government Treasury-Bonds from a recent Google-Finance page: T-Bonds 3 Month 0.25% 6 Month 0.35% 2 Year 0.69% 5 Year 1.11% 10 Year 1.61% 30 Year 2.42% These are approximately what you will get on your bank's CD's. You really do not have much yield until you get out to 10 or more years. That is because people are expecting interest rates to go up (a reasonable assumption). If interest rates go up, the longerduration bonds will go down more sharply in price. Notice these yields are before tax, so after tax yields are even lower. Page 5

6 In short, if you really need liquidity over a 2 or 3 year horizon, your best bet is to buy some CDs at your bank and live with the low yields. Other cash-like instruments include short duration ETFs, for example SHV or BSV. These currently have very low yields. Don't get greedy... ignore the market run-up... you need to be liquid. 5. A Slightly Riskier Strategy If you are willing to bear a bit more risk, there are certain stocks and exchange-traded funds (ETFs) that have high yields and lower volatility. In general, unless you are good at picking stocks (I run a stock screen and monitor it every day as part of my teaching, but most sensible people do not), you should invest in low cost ETFs rather than try to pick stocks. If you are willing to bear the overall market risk, cheap ETFs to look at include VTI (all stocks) and QQQ (which buys the Nasdaq100). For more international exposure, I use VXUS and VWO. Two important web-sites for ETFs: and Another interesting instrument is "EXG". This is a tax-advantaged closed-end fund that focuses on blue-chip high dividend yield stocks. They also write covered call options, which means they have sold some of the upside of their stock positions (meaning this portfolio will lag the market if the market catches fire), but in exchange they will receive a steady income stream, so their dividend yield is extremely good. Other examples of similar funds, all of which I own myself, are ETB, ETV, EOS. You buy these funds primarily for their dividend yield. Every time they pay dividends, the price will drop by about the value of the dividend. But over time, you are getting around a decent yield. What's more, the stock will still go up if the market goes up. Also, look up ETFs that invest in investment grade bonds, especially tax-free munibonds. You can buy and sell these just like a stock, but they hold a portfolio of munibonds. The dividends from these bonds are tax-free at the Federal level. If you pick ones that specialize in your state, they can also be tax-free at the state level. For example, CMF is a fund that specializes in California Muni-bonds. It has yielded around 3% recently. For some people, that is equivalent to 6% pre-tax. 6. Long-term Investing If you have some money that do you not expect to need to spend for a while, then you have even more freedom. I have put a lot of our personal wealth in long-duration munibonds (bonds maturing 25 years or later). Recently longer maturity AA+ California muni-bonds have yielded about 4 percent. All my bonds are tax-free at both the federal and state level. Their market value will go down if interest rates go up (and vice versa), but if you are a long-term investor in a high tax bracket, this is definitely worth investigating. The best website for buying these bonds directly (that I know of) is: This outfit owns their own bonds. You buy the bonds directly from them (you tell them what kinds of bonds you like: the state you live in, the risk level and duration you are Page 6

7 interested in, and they will match you up with the bonds in their inventory). You will need to open an account with them. They can hold the bonds for you for safe-keeping (they are insured), or you can ask them to transfer ( sweep ) the bonds to one of your regular brokerage accounts. If you need to sell the bonds, you call them and they find a buyer for you, but this is not a liquid asset class. Therefore it is not a good idea to buy long-duration bonds if you are likely to need the money in the next few years. My contact at FMS Bonds is Mr. Warren Silver ( X2273). I have worked with him for many years and found him to be both helpful and honest. You can also invest in stocks, of course, or other things for the long run. If you do so, buy regularly and do not worry about short-term fluctuations. Just put something away each month into VOO or VTI. To invest in energy stocks or basic material stocks, check out something like VDE or VAW Getting Help from Automated Advisors If you still find asset allocation confusing, a couple of new web-based startups can help. These firms have cropped up just over the past couple of years, and each one is based on an automated process implemented using ETFs (much like what we just went through). and For around 0.25% per year in fees, each firm will ask you a few questions about yourself, and develop an allocation strategy to match. The service will take into account such things as risk preferences, diversification benefits, and even tax efficiency. That s it. Focus on a sensible asset allocation mix, tax-advantaged investing, and don t spend a lot of time worrying about it after you have made your general strategic decision. May the Lord bless the labor of your hands and greatly multiply what you have so cheerfully offered up to Him! One Final Tip Charitable gift funds are very useful vehicles for managing donations, especially if you have uneven income flows. You donate to the gift fund (irrevocable) and get an immediate tax deduction. You then can pay out the gifts to registered charities over time. This ensures that the payments match the needs of the organization while the donations match your income flow. Many of these gift funds will take care of the writing of monthly/quarterly checks etc. to the charitable organizations, for a small annual fee. We have used the Fidelity Charitable Fund for many years now, and it is excellent: 2 Avoid oil ETFs, such as OIL or USO. These involve a contract expiration problem call Contango, which essentially ensures that the price of these funds will not be able to keep up with oil prices. Also I typically do not invest in precious metals, such as GLD or SLV. Page 7

8 A List of Other Useful ETFs: New ETFs are cropping up every week. Some could be a good match for exactly the kind of investing you want. Go to to search for them. In general, focus on large sized ETFs (generally $500m or larger) with low expense ratios (don t pay above 0.25% unless it is an asset class that you really want to own). Note that the yields may have changed since I last updated them. Here are some interesting ones. Although some of these are too expensive or too small at the moment, I think the small ones will get bigger over time (for example, REET). Some of the more expensive ones are here because they have high yields, or are investing in an interesting sector/region/strategy. I have marked the ones I find most interesting to watch this year ( ). Ticker Size (Billions) Exp. Ratio Real Estate Schwab US REIT (2.65% yield) SCHH % SPDR DJ International REIT (4.80% yield) RWX % Bonds ishares S&P CA Muni (2.88% yield) CMF % Powershares Insured Nat Muni (4.0% yld) PZA % Powershares Insured CA Muni (3.9% yld) PWZ % SPDR Hi-Yield Bond (5.8% yield) JNK % S&P National Muni Bond (2.90% yield) MUB % ishares Invest Grade Corp Bond (3.4% yld) LQD % Short Vanguard Short-Term Bond (1.2% yield) BSV % Mid Van. MBS (Mortgage-backed) (1.7% yld) VMBS % Long Vanguard L-T Bond Index (4.0% yield) BLV % Long Van Extended Duration Treasury (3.09%) EDV % Commodities Energy Select Sector SPDR XLE % Materials Select Sector SPDR XLB % SPDR Gold Shares GLD % Van Eck Market Vectors Agribusiness MOO % Stocks Van Europe Pacific ETF (yield 2.9%) VEA % Van European ETF (yield 3.5%) VGK % Van Telecom Services Sector (yield 4.9%) VOX % ** ishares Emg Mkt Min-Volatility Index Fd EEMV % ** ishares MSCI USA Min-Vol Index Fd USMV % ** ishares MSCI EAFE Min-Vol Index Fd EFAV % ** Note: A minimum-volatility fund buys low-volatility stocks. It moves with the overall stock market in that region of the world, but is more heavily weighted towards mature, stable, firms. Prior studies show these stocks tend to outperform the market. MSCI EAFE is simply an international stock index that does not include the U.S. Page 8