Handling Finances

My recent post, Retirement: A Poorly Defined Goal was recently included in the Passion Edition of the Carnival of Personal Finances! There are a huge number of articles included in the carnival at TheDividendGuyBlog.com but my favorite was a post at personalfinancier.blogspot.com about the risks and hidden costs in safe structured investments as well as the times when it might sense to include it in your portfolio.

When tech stocks boomed with three-digit price-to-earnings ratios in the 1990s and the markets produced sustained 30% growth rates, we all thought the market was a wonderful investment. When it turned out that many of those high-priced tech stocks were poorly managed and had no market for their products and services, the ‘irrational exuberance’ faded and the market fell sharply. The government’s reaction to this burst bubble was to try to limit the damage by lowering interest rates to make borrowing cheaper and thereby stimulate the economy. The economic stimulus package of 2001 that was intended to increase slumping consumer spending further limited the damage of the boom/bust cycle.

After peaking at nearly 12,000, the market dropped to almost 7000 before shooting back up to the recent high of 14,000 — well past the booming peak of 2000. Now the market is again flagging, and we’re seeing interest rates drop and stimulus packages passed. Presumably, now as before, the economy will be stimulated and markets will be held up by cheap borrowing and a short-term influx of cash.

What if the economy really needs a recession? I’ve been reading some critiques of our obsession with the stock market as an ever-growing investment tool lately (more on specific sources when I’ve had time to digest it) and while I’m not sure I agree with all the conclusions, there are a number of good points out there worth considering. For one thing, price to earning ratios — the price investors are willing to pay for the amount of money a company makes — are much higher than historic averages. In lay-terms that means that the market isn’t as high as it is because companies are doing that well, but because we’re willing to pay more for the same levels of growth. Of course, long-term, diversified investing reduces the risk of this kind of psychological effect by buying a range of investments — not just the ones that are currently hyped. Still, if the entire stock market is hyped far past what it’s historically worth, it becomes more and more important to diversify into other investments altogether rather than simply diversifying within the markets.

As much as I hate the implications of a recession, including job losses and bankrupt companies, could the implications of ever-accelerating, government-encouraged boom and bust cycles be even worse? I’ll have to look at my portfolio’s diversification and see if I can find ways to diversify outside of the markets. I’m not going to panic and switch 100% to bonds (or even 20% to bonds at this point) but as I plan my long-term investments, I’ll need to investigate the possibility that the entire stock market is highly inflated.

Please don’t hesitate to let me know if this resonates with you or if it’s the stupidest thing you’ve ever heard. I’d appreciate comments — especially those with justification — that could help me direct my investing in the right direction.

In Diversification Part I — Taxes, I discussed how I am using different retirement accounts to allow me some flexibility as to when I pay taxes on my investments. Now, I’m going to tackle the much more important task of diversifying my own portfolio. Why diversify? By investing in many different areas, one can reduce the overall risk of losses. Even if one investment does poorly (and they will from time to time) the rest of the investments will keep the entire portfolio from dropping too much. An example of people who didn’t diversify properly are those who worked at Enron and had the majority of their retirement savings in Enron stock. While it looked like a good investment right up until it fell apart, when the unexpected happened, these people were left with no job and no retirement savings, and it all could have been avoided by diversifying into other companies and market sectors.

At the moment, my long-term savings are very limited since I just started saving in September when I got a new job. That somewhat limits my options so I’ve chosen to open my Roth IRA at T.Rowe Price where the minimum investment in a fund is a relatively low $1000. This low initial investment comes with a price: $10 per year per fund as long as the balance is under $5000, but in order to get started right away, I’ve decided to invest my Roth IRA at T.Rowe Price until I build enough to either hit the $5000 in each fund or move to another company like Vanguard where there are no fees, but the minimum investments are $3000. Similarly, my 401(k) account is limited to a short list of funds so my choice of where to put my money is much less complicated than working on diversification.

My Asset Allocation

For now, I generally want to end up with about 40% US stock, 25% foreign stock, 20% real estate 10% in risky investments and 5% in bonds. How did I make these choices? Well the US stock market is the largest in the world, so it certainly deserves the largest share. To diversify within my US stock holdings, I will purchase a mix of large and small companies as well as a mix of value and growth funds.

With European, Asian and smaller African and Latin American markets increasingly moving separately from the US market, I see opportunity for lower risk with higher gains in foreign markets. Within the 25% foreign stock, I want to split between established markets like Europe and Japan and emerging markets like India and Latin America since although their performance is connected, they tend to perform well in different economic conditions.

Real estate has been falling fast ever since the bubble burst and I’ve actually lost 15% of the first thousand dollars I invested in real estate just a month ago. I honestly couldn’t be happier — I actually hope the prices fall further! This is the very beginning of my retirement investing and while I have very little to lose, if I continue buying real estate funds as the prices fall, I’ll end up with a much lower average cost than if I tried to time the market and purchase only when I was sure I wouldn’t lose anything. I’m sure I’ll continue to take some losses here, but real estate has been just as stable as stocks over very long time frames, and as homes, businesses and the land they’re built on aren’t going anywhere, I am confident that this has a place in my portfolio.

What are risky investments? I don’t actually mean I’m going to look for the riskiest fund I can find — this is my play money. While the rest of my portfolio will be pretty boring and disciplined, I’m taking 10% of my money and putting it where I think I can beat the market. At the moment, I’ve invested in a health care fund as I think it’s inevitable that expenditures on medical and health care services will continue to rise as our population ages. This investment is far from a sure thing — everybody else knows about the aging population so the potential for growth is already priced into these investments to some extent. Further, if the government passes laws that force hospitals to provide more care to uninsured people or makes deals to lower Medicaid drug costs, health care stocks could take a hit. At the same time, as our economy slows, I see health care outperforming many other sectors so I bet this fund will do better than many of my other investments in the next decade. This investment will help me to stay interested in my portfolio and will be a fun way to stay involved with my investments while risking very little since the rest of my portfolio will stay disciplined and diversified.

What about bonds? I actually own a very small share of bonds in a balanced fund (more on my actual portfolio later) but I’m looking to add to a bond index fund in my 401(k). For the next year, I will be holding up to $20,000 in a money-market fund as I save to buy a house so I don’t see a reason to put more than that in bonds that receive lower returns. Further, since I have four decades until my retirement, I can afford the extra risk avoiding safer bonds in exchange for the potential for much higher returns.

How will I get there?

The graph below shows my current asset allocation next to my goal allocation. Where my current allocation is under the goal, I’ll have to add more to the investment. Where the current allocation is far under the goal (in risky investments) I just won’t add any more to that investment this year. The numbers don’t come out to exactly the percentages I figured above, mainly because my planned contributions to the Roth IRA are fixed at $1000. I could get the percentages more precise, but since the values of my investments will change over the year and affect asset allocation anyway, I figure 1-2% is close enough.

The Plan

Finally, I need to know how much to allocate to each catagory. From my post about 2008 goals, I plan to end the year with about 16,000 in retirement savings. To determine what I need to do to reach this goal, I calculated how much I should end up with in each catagory at the planned allocation with 16,000 and calculated how much I need to save in each catagory to reach the goal.

With these graphs in hand, I can easily calculate how much I have to save in each category before the end of the year to reach my investment goals. It doesn’t take into account any market fluctuations so I’ll have to tweak it periodically, but this type of planning is designed to direct contributions, not to directly dictate investment values.