Thoughts on Current Market Events

So, you might have seen the headline last week: “Markets Soar to New Highs.” Or, “Job Gains Calm Slump Worries.”

The Dow Jones Industrial Average, the index that tracks the 30 largest companies in the US, hit an all-time high, above 15,000, on Friday, as did the S&P 500, which flew to over 1,600 points. (Think of “points” as the price per share of this exact index, which is very different from that of a fund or ETF that reflects the index.)

Ordinarily, this would be time for great rejoicing. If you have an index fund, it is likely performing extraordinarily well and you have no complaints at all. Companies’ earnings reports have been generally positive, although many companies are missing analysts’ estimates. 

So what’s the big deal? 

A) The big deal is the big picture: although unemployment has been falling, it is still 7.6%, which is higher than the targeted 6.5% and much higher than the historical average of 5.8% (the historical average is only this high because it is taking the past five years into account, when the rate reached over 10%). 

U.S. Treasury yields are still at near-historical lows, with the 30-year bond – traditionally the highest yielding – at 2.98%. Some blame quantitative easing for keeping these yields so low. Quantitative easing involves the Federal Reserve buying U.S. Treasuries, with the purpose of keeping yields low so it is cheaper for companies (and individuals) to borrow money to buy houses, cars, etc. The central bank began QE in 2009 and has said that it would stop when the unemployment rate reached6.5%. 

As a result, investors who would typically rely on Treasuries for yield have not been able to make the money they sought to with yields as low as they are. So, they began buying stocks. And more stocks. And more stocks. And even more stocks, pushing the price up to 15,000 and 1,600 for the DJIA and S&P, respectively. 

Some investors are now nervous because they think the market is overbought and overvalued. Well, the S&P 500’s historical price-earnings ratio is about 15. Right now, it’s nearly 19. So, yes, the market may be a little overvalued. 

B)      Another explanation for the recent surge is that investors are anticipating stronger growth in the U.S. economy quite soon. One way that stock prices are determined is by calculating the present value of a company’s future earnings. One could say that the U.S. economy’s future earnings look so great right now that the high market price is deserved. Optimism!

I’m inclined to go with option A, based on my education. Although I am very optimistic about the outlook of the U.S. economy, I think sending the market to new highs on an uncertain foundation is not sound. I would advise my friends to hold off on stock purchases until the market cools down. However, I’m no Miss Cleo and I could be wrong (actually, that would makeme a Miss Cleo, haha!).

401K/403B Mutual Fun(d) Decisions: Part 2, Fund Allocations

*My apologies for the brevity of this post. I’m feeling terribly under the weather (thanks, DC, for being 80 degrees one day and 40 the next). More on this topic to come.

Now that we’ve gotten what fees and expenses to look for out of the way, it’s time to talk actual funds. Please note again that I am not an investment professional (yet!) and can only educate on the types of funds out there. I’m not selling funds until I get some commission. ;)

For starters, you already know about equity (or, stock) funds and bond funds. (More on bonds in a future post.) Depending on the financial advisor, advice will range from “go 100% equity” for young people to “keep it 50/50 stocks/bonds.” As stated in previous posts, your choice depends on your risk tolerance, but know that risk aversion, or a very high allocations to bonds, can lower your returns potential over time.

That said, look for stock funds that have the broadest range of stocks possible, like an index fund that reflects the S&P 500 or Wilshire 5000. If you find an index fund that has every stock available (more than 5,000), go for it, for maximum equity diversification.

Next, throw in a good mix of U.S. Treasury, and maybe corporate, bonds. The longer the maturity, or length of time until you get the principal amount back, the higher the yield, to compensate you for the risk you’ve taken of giving your money to the government for such a long time (the longest maturity available for U.S. Treasury bonds is 30 years). 

Don’t forget international stocks and bonds! They provide great diversification to a U.S. investor’s portfolio. 

I recommend finding index funds for all of these asset classes. If you have to go with an actively managed fund (as you would have to do for bond funds), go with one with low fees and high ratings on Morningstar.com, a well-respected finance research website.

401K/403B Mutual Fun(d) Decisions: Part 1, Expenses

Anyone my age or younger will probably never know what a corporate pension looks like. And, sadly, Social Security will have likely run out by the time we retire. So, saving for retirement is a burden we bare all to ourselves. Employers try to help by offering 401Ks or 403Bs, but this gets overwhelming when there are typically approximately 80,000,000,000 mutual funds and ETFs to choose from.

How do you know a good fund from a bad one?
What the hell is the difference between a "core value" fund and a "large cap blend" fund, anyway?
Should you go for gold, just because a metals and mining fund is available?

Don't pull your hair out over your 401K. Remember that it's there to help you. Over the next couple of posts, we'll talk through some high-level details to consider when selecting funds for your portfolio.

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One of the biggest things to keep in mind are fees and expenses. These dollars can set the best of funds apart from the worst because of simple math: the more you pay in fees, the more your investment has to return to make up for those fees. God only knows that you don't want to just go around giving your money away for free. So, here are some brief explanations of the fees you'd typically see from mutual funds.

Mutual funds will typically have 4 types of expenses: operating expenses, a front-end load, a back-end load, and a 12b-1 fee.

Operating Expenses
Operating expenses are costs necessary to run the fund. Fund managers have to pay electricity bills like the rest of us, plus employee salaries. Operating expenses are generally hard to get around because they're just a part of doing business.

These fees can be as low as .06% (also known as 6 basis points) of invested assets and as high as 1.5% or greater. Index funds generally have the lower fees, as it doesn't take as much work on the part of the fund manager to run the fund, since it is supposed to just be a reflection of an existing stock or bond index. You might also see this style of investing called passive management. It's sister, active management, is much more expensive. Actively managed funds are typically trying to outperform the overall market or a certain index by investing in specific stocks. In order to do that, fund managers are much more involved in the fund, handpicking stocks or bonds. As a result, these funds wind up being much more expensive; unfortunately, they don't always meet their goal of beating the market, either, meaning that investors are charged more for worse performance, potentially. 

My advice to you is to go for a passive index fund that will reflect an index like the S&P 500, or even better, every stock in the market (more on that next week) for lower expenses.

Loads
Now, the front- and/or back-end loads, on the other hand, are not so necessary. A "load" is basically a sales fee charged to you when you first buy the mutual fund ("front-end" load) or when you sell, or redeem it ("back-end" load). Then there are no-load funds, mostly from a company called Vanguard, which is extremely well respected in the finance community.

These expenses can run from 0% to 8.5%. The load is especially important to note because it can be total robbery of your investment. When you pay a load, especially a front-end load, you really are just giving your money to a fund manager and not asking for it back. You do expect for the return on your investment to be greater than the load, but you've put yourself farther in the hole from the start.

Example from my own life (glad I learned these things the hard way, so you don't have to!). When I switched jobs to my last job before business school, I rolled over my previous 401K into an IRA (we'll talk about those later, too). I was curious about active management, so my retirement advisor at my bank recommended that I go with a Goldman Sachs fund that had a 5.25% load. I started with about $4,000. After the load, I was only investing $3,800. I needed the fund to return me my $200 (AT LEAST), plus the 1.25% annual expense.

Let's just say, after the market spun itself around in 2010 and 2011, I was lucky to finish right back where I "started," with $3,800. I could have lost much more. But had I invested in an index fund that reflected the S&P 500 with a no-load fund, I would have gained about 15% over that same time period. You live and learn.

12b-1 Fees
12b-1 fees are optional fees the fund can charge so investors pay for part of the fund's advertising costs. Funds do charge them, but again, if there's no need to just give your money away and dig yourself further into a hole, don't do it.

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So, now you know some the key expenses to look for when selecting a mutual fund. (Remember to go cheap!) Next week, we'll look at some of the types of funds that will help you diversify and grow your retirement savings.

Can you risk it?

My great aunt had a way with words. Among her best quotes are, "Love is good, but money's better," "Love don't pay the rent," and "Don't marry a man if he don't have a key to something." (Great advice on all fronts.) Once, my sister told her about a guy she'd started dating, and my aunt wanted know if the guy was trustworthy. Instead of asking, "Do you trust him?," she said, "Can you risk him?"

She wasn't all wrong in correlating risk and trust. It's hard to trust the market, since you know it flucurates so much, so it all comes down to how much you stomach.

The first thing to know and remember like your own name is that there is no such thing as a risk-free investment. (Although U.S. Treasuries are called "risk-free" because they are backed by the government, their value is still at risk of being eaten away by inflation. And, it doesn't seem all that possible, but the government could default one day.)

So, if anyone ever offers you an investment opportunity that has "no risk," RUN AWAY because it is a scam.

That said, the amount of flucuation you can stomach is known as your risk tolerance. To help determine your level of tolerance, there are a ton of quizzes you can take. A couple of ones that I found legitimate were from Merrill Lynch and Rutgers University. The one from Merrill focuses solely on investment decisions, while the Rutgers one -- since it is actually a study on risk behavior -- is more broad and user-friendly, in my opinion.

Quizzes like these present you with questions that try to get at how much you are willing to lose for the chance of making gains. It may surprise you how much the magnitude of the potential gain matters versus the magnitude of potential loss. (I won't give it away; I'll let you take the quiz and find out for yourself!)

Some general rules/thoughts regarding risk are:

• If you're younger, you can take more risks. This is because of precious time your portfolio will have to recover from market losses. For example, if you'd invested $100 in the market on January 7, 2000, by December 27, 2002, you would have lost almost $41 dollars. Let's say you decided to hold on to those shares instead of selling them at a loss.* By December 28, 2007, you would have recovered your losses.* Holding for a brief period (that, in this example, was a terrible time for the market overall) would not have served you well, but over a longer period of time, you actually gain.
• Small-cap stocks tend to be riskier than medium- and large-cap stocks. This is because small-cap stocks are from smaller companies that are not as established, but have a lot of growth potential. Take Rocky Mountain Chocolate Factory, which operates in malls, primarily, in 40 states, Canada, Japan, and the UAE. This company is growing in different geographies, but since chocolate is not a commodity, its business can flucuate in hard economic times, so this investment would certainly be riskier than one in Hershey, for example, since the latter has been around for 100 years or so and has a strong global presence.
• Women tend to take fewer risks when investing. Common thought holds that women tend to be more risk averse when it comes to investing. Which could mean that a woman's retirement savings will likely be much lower than her male counterpart's. However, loss aversion can be useful. Women may be more inclined to make more thoughtful investment choices than men and stay out of overly risky investments. Some say that if more women were on the boards of banks, the financial crisis would never have happened.
• Stocks tend to outperform bonds. Historically, stocks have consistently outperformed bonds over time. From 1928 to 2012, the S&P 500 beat out ten-year Treasuries by more than 3 percentage points, which could be the difference between making $871 or $564 off of a $100 investment. It's good to have a diversified portfolio of stocks and bonds that complement each other, but stocks tend to have greater upside potential. Since bonds are debt, the bondholders, like a credit card company, are ultimately more concerned with getting their money back rather than what can be made on top of it. Equityholders, on the other hand, do not have to be paid back, so upside is all they can hope for; in exchange for taking on this risk, they get a higher reward. Get rewarded for holding stocks!

Don't be afraid to take risks, but if you don't have the funds to spare, do not risk them at all. It's much more important to pay down high-cost credit card debt than to start investing. But once you're free from that bondage, fly higher into stocks for [potentially] added financial security.

*Source: Google Finance S&P 500 chart.

Investing in Emerging Markets: Growth for your portfolio and the world over

Today we're going to talk about investing in emerging markets, what exactly that means, how to do it, and some of the risks involved.

First, let's get out of the way what emerging markets are: developing economies that may still have relatively high rates of poverty, but are growing rapidly. Examples include China, India, Brazil, Mexico, and South Africa. (For the sake of comparison, countries such as the U.S., Canada, U.K., France, Germany, and the like are all considered "developed.")

There are also "frontier markets," which are even riskier than emerging markets because they are generally less economically and politically stable, but still have potential to grow into emerging, or even developed, nations. These include countries such as Argentina, Ghana, Colombia, and Vietnam.

The key thing to note about emerging and frontier markets is their incredible growth potential. In the early part of the past decade, investors were lured by these countries' huge economic growth rates, anywhere from 7% to 10% per year or more. In contrast, the U.S.'s and other developed economies' gross domestic products (GDP) only grow about 3% per year, and that's during a good year. (GDP is typically what people are referring to when they talk about the "economy" more broadly. It's basically the value of all the goods and services made in the country.)

While the global financial crisis slowed almost all countries' economies, some emerging nations proved more resilient. For example, although China's growth has slowed, it is still grew more than 7% in 2012 (compare to the U.S., which grew only about 2%. Final numbers on U.S. GDP growth for 2012 will be out soon).

Because of this outstanding growth potential, investors stand to make a ton of money. Think about it: think about people who invested in U.S. railroads, for example, in the 1800s -- those families are still wealthy today! Emerging and frontier markets investors can take essentially the same stance. Incredible!

However, where there is significant reward, there is significant risk. Note again some of the countries I mentioned: Mexico, Argentina, Vietnam. While they make for great adventure vacation spots, they are not known for being the most politically stable. Democracy and capitalism are working their way around the world, but in many places, governments control (and often inhibit) countries' growth. This adds a lot of risk for investors.

For example, let's say an investor has found a way to fund infrastructure building in Argentina, but new government leadership comes in and decides that alleviating proverty through social programs will be the new priority and all infrastructure building will come to a halt. Panicked, the investor looks to sell her investment, but no one wants to buy it now that everyone knows that infrastructure has gone kaput. During all of this, the value of Argentina's currency declines, so she now owns even more of an investment that no one wants. So, the value of the investment tanks and the investor loses her money. 

This is a very elementary (and likely unrealistic for Argentina) example, but I want to highlight exactly how risky investing in emerging and frontier markets can be. Not only are there the risks we discussed previously about individual companies, but there are also political and currency risks.

Know that investments in other countries will likely be made in that country's currency, not in U.S. dollars, so there may be money gained or lost during the translation. Additionally, one has to pay taxes on these investments as well, which will eat into returns even more. These investments can also be less liquid, or harder to sell, than developed markets equities (stocks).

So why on earth would anyone invest in emerging markets after all that?

Because of faith in the growth stories.

Emerging markets investors get to be a part of helping build roads, factories, and maybe even schools around the world, giving people jobs, educations, and livelihoods. And, as I mentioned earlier, these countries generally grow much more rapidly than the U.S., so investment values go up very quickly. They also tend to go up when U.S. equities go down, and vice versa, so they can add a layer of diversification to a U.S.-based stock portfolio. (This excludes recent times of economic decline around the world. We live in a very unique time that I pray will get much better soon.)

So, if you are not overly risk averse, and if you are young, then you should be investing in emerging and/or frontier markets. As stated in previous posts, time has a way of ironing out wrinkles brought on by volatility.

If you have a 401k or 403b, see if there is a mutual fund that invests specifically in emerging and/or frontier markets and add it to your portfolio. You can also likely find index funds or ETFs from your brokerage to invest in, such as the Schwab Emerging Markets Equity ETF.

Only make these investments if they fit your risk appetite. Next week, we'll talk more about risk and how to determine how much of it you can stomach.

Investing Insights from China

I'm back from the trip of a lifetime in China. While it was an interesting experience for many reasons (primarily because I'm African-American and was quite the spectacle, apparently), I learned ton more about how business is done in China and I know understand much more why investors get so jazzed about sending money to the East.

Upon arrival in Shanghai, I was greeted by this huge Coach ad, right outside my hotel window:

 

It is a country of both extreme wealth and extreme poverty, but investors have jumped on the former as a money-making opportunity. The Chinese middle class is burgeoning and, like Western countries, this means that the population is consuming more luxury goods. I saw an impressive number of Coach, Tiffany, and Louis Vuitton stores in Shanghai alone.

 

But, before you march off to buy shares, note one thing. Many purchases of luxury goods in China were the result of a business and government culture of gifting. Some might call it "bribing," but I think that's too strong a term. Business partners exchange gifts after a deal is closed as a way to thank each other for doing the transaction. Following my team's presentation, we gave our company representatives small tokens of our appreciation, and the they did the same for us. Of course this can lead to many abuses, especially bribing. To that end, the Chinese government is cracking down on this type of corruption. Unfortunately, this may take an unforseen toll on luxury brands in China. A new government was inaugurated only in the last few weeks, so only time will tell what will actually happen. But investors in luxury goods companies who are relying on growth in China should beware.

 

Another thing to note is the major housing boom in the big cities, especially Shanghai, Beijing, and Xi'an. China is the world's most populous country with 1.36 billion people, and all of those people need to live somewhere. However, I was taken aback at the rapid real estate development. It seemed to me that houses (well, apartments, mostly, as result of high population density) were being built long before demand could fill them. This could also play a role in the future on the incomes of the Chinese middle class. If housing values fall, so will their net worths and ability to spend on luxury items. The Communist government can likely keep some damage from occuring if there is a bubble burst like that of the US in 2007. But I would caution investors to be careful of a situation that appears to be growing more precarious.

 

 

 

It's not all bad news, of course! I saw a lot of growth potential in China, particularly in terms of infrastructure. As they continue to build homes, they will need roads, electricity, and public transportation. There is also a bit of a pollution problem that will have to be tackled. Investors can take advantage of these things by putting money toward building out these roads and investing in companies that will put electrical wires underground. Some of my classmates also joked that, once it becomes required to wear a bike helmet, helmet makers will clean up!

 

 

 

Some people say that China is "out," as if it were culottes or harem pants. The world's largest nation definitely has opporunities, but I would shake things up a bit by looking at Brazil or India, or in even riskier frontier markets, such as Mexico. Next week, I'll explore how one would invest in emerging markets.

 

The globe is calling me...

Dearest Readers,
You didn't miss a post from me yesterday -- I was getting ready for a big trip! I'm headed to China tomorrow for my MBA program's Global Residency in Shanghai, where I'll be meeting with bigwigs and making a presentation to the heads of a Chinese financial services company. Wish me luck!

Posts will resume on March 20, after I've returned.

Wishing you rich returns,
Vonetta