Month: February 2018

Asset Class IIIA: BONDS

Never forget these two axioms:

 

Money frees us, but its pursuit may enslave us.

It’s not about how much you have at the end; it’s how much you could have made.

 

Asset Class IIIA

 

Bonds

James Bonds…

Sorry, I couldn’t resist.

What exactly are bonds?

Your whole life is based on being a debtor—college loans, med school loans, car loans, home loans, etc., etc.

For once in your life—and likely for the first time—you can be the lender (i.e., the creditor).

By far the most common types of bonds are either corporate or municipal (usually cities or states, but obviously the federal government issues bonds as well).

This is how it works.

A bond is a simply a security of debt—an IOU—where the one issuing the bond not only owes the value of the bond to the person (or institution/mutual fund, etc.) who bought the bond, but also some interest that is agreed upon.

Congrats! You’re the bank…for once.

First some terminology…

Creditor: the person who bought the bond AKA the bond holder AKA the lender

Debtor: the issuer of the bond AKA the borrower

Face Value or Par Value: the original value of the bond alone AKA the principal

Yield or Coupon: the interest that the issuer of the bond/the borrower owes to the bond holder (not like 25 cents off Little Debbie’s coupons)

Default Risk: the likelihood that the debt won’t be paid back to the bond holder

Default risk influences yield/coupon. The higher the default risk (i.e., the more likely the bond issuer/debtor cannot pay back the creditor/bond holder/lender (you)—i.e., the more risky the investment), the higher the yield (interest) will likely be to attract people to buy such bonds. The lower the default risk, the lower the coupon/yield.

(In the good old days [for some of you that’s the 1960′s; for others, that’s sadly the 1990’s], each bond was represented by a physical certificate where the paper document had actual coupons that were cut out for which interest was paid.)

Not all bonds have coupons. These so-called “zero coupon bonds” are bought at a discount and then redeemed at a known higher value on their maturity date (see below for this terminology explanation).

Bonds allow companies or even governments to borrow millions (or hundreds of millions) for long-term expansion or research and development on the corporate side and current projects (usually listed as exactly which construction project for example) on the government side.

The amount of money needed for such projects is usually way beyond what a bank would ever lend and would also make the bank (even the few that would be big enough and brave enough to lend such a large amount of money) put such stringent requirements on the borrowers that it wouldn’t be feasible for the borrower to accept such terms.

As a stock holder, you own (probably a tiny piece) a part of that company. When you’re a holder of a corporate bond, you’re a creditor/lender to that company including all the shareholders. (If you owe both shares and bonds of and from the same company, in a sense then you owe yourself money…and interest.)

News flash: Bond holders take priority over shareholders.

In other words, if a company is going bankrupt, bond holders are paid before shareholders.

So if you think you’re a big deal hot shot because you own stocks…you’re not.

Also, bonds have a defined term AKA maturity after which the total payout (value of the bond originally AKA the principal plus all the interest owed) is given to the bond holder. (There are securities known as irredeemable bonds which is known as a perpetuity—i.e., a bond with no maturity.)

Interest is usually payable at fixed intervals (annual, semiannual, or quarterly; less often monthly).

Bonds are known as fixed income securities since the lender can accurately predict how much money he or she will make by a fixed time (i.e., the maturity date).

Another feature of bonds are their negotiability (not true of all bonds—the issuer will tell you if it’s not) meaning that the ownership of the bond can be bought and sold on the secondary market.

Dr. Unwise: Uh…what now?

Dr. Scared: This is it! This is how they screw you!! Money under the mattress is the only way to go!

PWT: Steady, guys…and settle down.

Once your bond is stamped (i.e., the physical certificate used to gets its stamp of ownership), you can sell it for a nice tidy little profit if it’s desirable enough among those seeking bonds, sometimes even years after the bond was originally issued.

Buying it from the issuer is done on what is known as the primary bond market.

Buying bonds from bond holders is done on what is known as the secondary market.

Here’s how bonds work.

Imagine you buy a $10,000 bond with a 5% coupon (or yield) with a ten year maturity date.

You’d get $500 a year as the bond holder. How that is paid depends on the issuer, but corporate bonds typically pay semiannually.

You get $500/year for ten years or $5,000 for the entire decade.

Then, you get back your principal—$10,000—on the maturity date ten years after you bought the bond.

So, all told, you get $15,000 total (over ten years) for buying a bond for $10,000 a decade ago—just like a bank.

Now you can see how banks make their money. 

So, you got a 50% return on your money over ten years. And it was as safe as any security.

Pretty great right?

Yeah…maybe.

Dr. Scared: See! See!! This is it! This is the path to true wealth!! It’s the only way to go!!

Dr. Know It All: How the hell do we shut this idiot up?

PWT: Fellas, calm down. And Dr. KIA, I know it’s hard, but stop being such a jerk. 

Anyway…

Depending on when your bond is being held/its maturity date is, you may do well and better than the stock market. But usually, bonds perform worse than the broad stock market over time generally speaking.

Don’t get me wrong. 50% return over a decade with no effort and not worrying about the gyrations of the market over that ten years is pretty grand.

Only you (and your spouse) know what returns you want, how much risk you’re willing to take, and how easily you sleep with what you’ve invested in and where your money is. (Much more on this in a later post.)

But, realize this, with few exceptions, you are trading solid returns for peace of mind.

Bonds=Securities with security.

Also, realize this:

This example only highlights the bond with a fixed interest rate (the majority) whereas a sizable number of bonds have variable interest rates where they can fluctuate as often as daily.

Back to our example though:

If you had the above bond (50% return over a decade), then you would have come out way ahead from 2001-2010* (S&P 500 total return with dividends: 11.971% or 1.147%/year for the decade) compared to the stock market.

(*January 2001-December 2010)

However, if you had the same above bond again (50% return over a decade), then you would have come out way behind from 2008-2017* (S&P 500 total return with dividends: 136.909% or 9.087%/year for the decade) compared to the stock market.

(*January 2008-December 2017)

(On purpose, I didn’t index this to inflation. Also, I didn’t take fees out of the stock investor’s return because the fee depends on how you invested in the stock market—by yourself, financial advisor, mutual fund, ETF, etc. But, if you invested in the broad stock market by a low fee mutual fund like Vanguard, the expense ratio [remember that?] ranges from 0.04%-0.14% [i.e., $4 charge for every $10,000 invested-$14 charge for every $10,000 invested]. So, in this example, the dent fees would make is quite low though I never want to discount fees or say they are negligible.)

The biggest problem with bonds is the generally low return you get from them. Five percent is great if you can get it, but you’re often not likely to do so with bonds.

The average yield on corporate bonds is 3.83% as of December 2017.

The average yield on municipal bonds is hovering in the 3.6-3.65% range as of December 2017.

And, finally, the US Treasury bonds, the safest and worst paying of them all, is ranging from 1.29% (1 month) to 2.81% (30 years) depending on the maturity dates (noted in parentheses). (These rates are as of January 2, 2018. Believe it or not, these rates fluctuate daily.)

Now factor in these possibly (likely) much lower returns and bonds clearly take a backseat to stocks and funds, especially if the latter two are kept in a low fee environment.

Investing…not easy stuff, huh?

Moody’s       S&P/ Fitch        Grade                        Risk 

Aaa                  AAA               Investment             Highest Quality

Aa                     AA                 Investment             High Quality

A                       A                    Investment             Strong

Baa                BBB                Investment             Medium Grade

Ba, B              BB, B                Junk                        Speculative

Caa/Ca/C      CCC/CC/C       Junk                        Highly Speculative

C                        D                      Junk                         In Default

 

Dr. Unwise: What in the name of all that is holy is this abomination?

 

Dr. Scared: This it! This how they screw you!!

 

PWT: This is a bond rating table. 

 

For corporate bonds, there is a standardized bond rating system, based on the analysis of the three major US credit rating agencies (Moody’s, Standard and Poor’s (Hi again!), and Fitch Ratings) to help potential bond buyers determine a company’s default risk. This is essentially the company’s credit rating. Like the letters in the above table, this is the report card for a company (more specifically, the credit rating of that company).

You may have heard of junk bonds. These are instruments of debt (that’s all bonds are, after all) that are put out by companies in financial trouble. The companies in question are banking on raising money to start a new venture, expand business, etc. that will right the ship for the company. These bonds have a high yield to attract potential investors. This is precisely the scenario in which bonds can be riskier than any other security, even stocks.

I think we’re at a good stopping point for now before we finish our discussion on bonds in the next post.

I’d love to hear from any and all of you about your thoughts, so we can all learn from one another.

Talk to you soon.

Indexes

Never forget these two axioms:

 

Money frees us, but its pursuit may enslave us.

It’s not about how much you have at the end; it’s how much you could have made.

 

We’re going to take a break from asset classes for one post to talk about what indexes actually are.

 

Indexes

 

Let’s start with the biggies.

 

There’s the S&P 500, the Dow Jones Industrial Average (usually referred to as the “Dow Jones”), and the NASDAQ.

 

You hear these terms thrown around on the news, articles, etc. all the time with everyone expecting you to know and understand what all of this means.  You may know exactly what this all means; you may only know that these words are vaguely related to investing, but you’re not sure what any of these terms actually mean.

 

What’s what what? What? Huh?

 

Market Index

 

The S&P 500, NASDAQ, Dow Jones, Russell 2000, and Wilshire 5000 are all examples of a “market index.” An index provides a summary of an overall collection of stocks by tracking some of the top stocks within that market. They provide (or try to provide) a representative picture that shows the direction (up or down) of where the overall market is going.

 

Consider them like polls for an election—just taking a representative sample to demonstrate what a larger group is or will be doing.

 

Indexes definitely don’t track every single stock. Some indexes represent small, medium, and large companies while other indexes represent only the largest companies or only small companies.

 

Some indexes tend to track companies within a certain sector, like technology, but most are broader.

 

So what are the most popular market indexes?

 

The S&P 500

 

This index tracks 500 large U.S. companies across a wide span of industries and sectors.

 

The stocks in the S&P 500 represent roughly 70 percent of all the value of all the stocks that are publicly traded (i.e., market capitalization) even though there are over 17,000 traded stocks in the US alone (which tells you how massive and valuable these 500 companies—the ones most everyone has heard of; the Apples, Googles, Facebooks, Fords, and Microsofts of the world— and how tiny and cheap the other 17,000 companies are). (By the way, “S&P” stands for “Standard and Poor’s,” the name of a stock market research firm.)

 

Companies CAN be (and often are) listed in more than one index. Some of the largest companies within the S&P 500 are also in the Dow Jones Industrial Average.

 

When people talk about “the market”, as in “How did the market do today?” or “The market is on fire!“, they’re virtually always taking about/referring to the S&P 500 and its performance. The only other possibility is coming up next.

 

When trying to figure out how your stock, portfolio, or mutual fund/ETF is doing, you’ll be most often using the S&P 500 as your benchmark of comparison.

 

 

The Dow Jones Industrial Average (DJIA)

 

Cool (my idea of cool is probably waay different than yours) fact:

 

Charles Dow, the editor of the Wall Street Journal actually, created the first index more than a century ago. (The Jones in question is Edward Jones, a statistician and fellow journalist of Dow’s.) In 1896, Dow averaged the stock prices of the top 12 publicly traded companies in the US. (All he did was add their stock prices of the top 12 publicly traded companies in the US together and divided that total by 12, the number of stocks.)

By doing this, he found that he could trace the movement of the overall market, including the average movement of stocks that weren’t included in his index. Sure, some stocks move opposite of the index, but not by much (usually) and they were the exception. (You have to be spectacularly talented (and not in a great way) to lose money when the index in question is up and you have to be spectacularly talented (in a great way!) to make money when the index in question is down.

That’s far from how it’s done now.

The “Industrial” in the Dow Jones Industrial Average is largely historical referring back to the heavy industries of the early 20th century. Many of the modern 30 component companies (It’s now 30 companies in the Dow rather than the original 12 which is why you’ll hear about the “Dow 30” occasionally) have little or nothing to do with true industry or traditional manufacturing. It is also not only the largest (however that is defined) companies in the US on it necessarily any more. For example, Google and Facebook aren’t on the DJIA…at least for now.

Also, the average is what is known as price-weighted, and to compensate for the effects of stock splits and other adjustments, it is currently done as a scaled average.

Dr. Unwise: Um, what now?

Price weighted is easy to explain.

PWT: 30 companies=100% of the DJIA, right?

Dr. Scared: Yes!

PWT: Therefore, each company~3.3% of the DJIA, right?

Dr. Scared: Yes!

PWT: Wrong. 

Dr. Scared: Oh God, kill me now!

PWT: Relax. The DJIA just takes into account the stock price of each company. Therefore, a $100 stock will have ten times the influence on the DJIA as a $10 stock and 100 times more influence than a $1 stock. 

Dr. Unwise: Makes sense. That’s great. Easy to understand too. That’s it, right?

PWT: No, sadly, like they used to tell us in med school and training, that was the easy part. 

Dr. Scared: Oh God, kill me now!

Scaled average is a statistical method to even out disparate entities that are all under one umbrella.

In other words, the value of the Dow (i.e., the number that people are saying on the news when they say “The Dow closed at…. today” or “Today, the Dow reached an all time high of ….”) is no longer the actual average of the prices of its component stocks like when it first began, but rather the sum of the component prices divided by a divisor, which changes whenever one of the component stocks has a stock split or stock dividend, so as to generate a consistent value for the index.

Whether one stock is spitting out quarterly dividends, another is splitting, and yet another is doing neither, the DJIA’s value reflects the sum of all these disparate company’s stocks. Otherwise, without the Dow divisor, dividends and, especially stock splits (remember, for example, if having 100 shares of a $100 stock for a total value of $10,000 is split 2:1, then you have 200 shares at $50 still valued at $10,000), would markedly alter the Dow’s reported number without actually changing its true value.

Currently the divisor is less than one, therefore the value of the DJIA is actually larger than the sum of the component prices.

SR: Hmm, sounds fishy. Like some real Wall street flim flam there. 

PWT: Not really. Not this time. But don’t worry. There’s plenty of flim flam going on in Wall

        Street and Washington—often one because of the other. This just isn’t it though. 

The Dow divisor has fluctuated significantly over the years. In 1928, it was 16.67. Since most big company actions (e.g., stock splits, spin offs, etc.) push the Dow divisor lower, it should be no surprise that the divisor is now microscopic compared to its 1928 value which it is.

Drum roll please…

The Dow divisor as of 12/18/17 (the day I’m writing this) is 0.14523396877348.

Unlike mathematicians, the Dow Jones clearly doesn’t believe in the rule of significant digits given it has a divisor that is currently 14 digits beyond the decimal point.

SR: Jones! Pffft…Some statistician he is!

The Dow Jones Industrial Average (DJIA or the Dow Jones or just “the Dow”) was comprised of the 30 largest U.S. companies. (This isn’t true per se now depending on how you define company size—number of employees, sales, revenue, market capitalization, etc.)

This means the DJIA is constantly shuffling companies in and out as their values rise and fall. They drop and add new companies every so often (every 2-3 years as of late). The components of the DJIA have changed 51 times since its beginning in May 26, 1896.

Only one company on the original Dow Jones list of companies in 1896 still exists on today’s Dow Jones. Any guesses?*

Just for kicks, here are the current Dow 30 (another name used for the DJIA) companies:

3M Company

Caterpillar Inc.

Nike, Inc.

American Express Company

The Goldman Sachs Group, Inc.

Pfizer Inc.

Apple Inc. (added in March 2015 replacing AT&T which was dropped then)

The Home Depot, Inc.

The Procter & Gamble Company

The Boeing Company

Intel Corporation

The Travelers Companies, Inc.

General Electric Company

International Business Machines Corporation AKA IBM

UnitedHealth Group Incorporated

Chevron Corporation

Johnson & Johnson

United Technologies Corporation

Cisco Systems, Inc.

JPMorgan Chase & Co.

Verizon Communications Inc.

The Coca-Cola Company

McDonald’s Corporation

Visa Inc.

E.I. du Pont de Nemours & Company  AKA Dupont

Merck & Co., Inc.

Wal-Mart Stores, Inc.

Exxon Mobil Corporation

Microsoft Corporation

The Walt Disney Company

 

The DJIA along with the S&P 500 are widely accepted as the leading indicators of the health of the stock market. If someone is talking about “the market”, the DJIA or S&P 500 is what they’re likely using as their measuring stick to make any remarks or generalizations about “the market.”

The Wilshire 5000

A lesser known, but still important, index represents up to 5,000 companies of all shapes and sizes, from gigantic corporations to the smallest of small companies. (In industry terminology, these are known as “large cap,” “mid-cap” and “small-cap.”)

The Wilshire 5000 is often called the “total market index.” Despite how representative this index is of the entire stock market, it oddly isn’t nearly as popular or as followed as the DJIA and S&P 500 which I’ve never quite understood. 

 

The Russell 2000

The Dow Jones focuses on large companies, but the Russell 2000 does the opposite: it follows only the tiniest companies. This index tracks 2,000 of the smallest corporations in the stock market.

If you’re either brain addled or a statistician obsessed with number needed to treat and you think that 2,000 companies is too small of a sample size, and you’re seeking for a larger, more representative snapshot of how small-cap companies are faring, you’re in luck. You can gaze upon the Russell 3000, the sister index to the Russell 2000.

The NASDAQ (the acronym for the National Association of Securities Dealers Automated Quotations)

This is one of the three big indexes, but I saved it for last as it can get a little confusing.

“NASDAQ” refers to both an index and a trading exchange.

Dr. Unwise: Uh…What now?

Dr. Scared: Oh God, kill me now!

OK, let’s back up and get a little back story here.

There’s a marketplace where people go to buy stocks just like you (or people you know because I’ve actually never done this even once in my life) buy produce at a farmer’s market.  This marketplace is called an “exchange.” The most famous one in the world that all the movies and news programs show is the New York Stock Exchange (NYSE). There’s another famous one also in New York City (they’re actually only 7 minutes apart and represent over $30 trillion—that’s Trillion with a capital T or $30,000 billion or $30 million million if that is even comprehensible) called the Nasdaq Exchange.

Stocks that are traded on the Nasdaq Exchange tend to be tech companies, like Apple Amazon, Facebook, and Google, but you don’t have to be a tech company to be on it (Starbucks is traded in the Nasdaq as is Steve Madden, the shoe company, for example) nor all tech companies traded in the Nasdaq exchange. Twitter, for example, is traded on the NYSE.

SR: Ha! Twitter is a terrible example. It may not even be around by the time you post this to the World Wide Web!

Of course, companies on the Nasdaq or NYSE don’t have to be as huge as Apple, Facebook, or Google.  In fact, most of the companies listed in either exchange are much, much smaller.

You’ve likely never heard as many sell only to other businesses and not consumers like you and me.

The Nasdaq is just disproportionately heavy in tech stocks and will surge up or bounce down when something (good or bad) happens in the tech world.

The Nasdaq market index, which is known as the “Nasdaq Composite” or just the “Nasdaq”, tracks the roughly 3,000 companies that are traded on the Nasdaq Exchange by having 100 companies (mostly, but not all tech) in it to mimic what all of them are doing on any given hour of any trading day. (Very, very clever, stock people.)

This is peculiarly unique because no other exchange has its own popular index. The news doesn’t reel off closing highs or lows of the day from the “New York Stock Exchange Composite” mostly because it doesn’t exist. #fakenews

(Of note, this is a market capitalization weight based index which means that 100 companies aren’t each 1% of the index, but rather the bigger they are, the more percent of the index they are. These massive (almost always) tech companies have an outsized influence on the Nasdaq Composite. For example, if Google, Facebook, Apple, Amazon, and Netflix zoom up one day while most of the other 100 companies in the Nasdaq Composite edge down, then guess what? The index still moves up because the big boys have spoken. As companies decrease or increase in value, their share of the index and influence on it will fluctuate accordingly.)

The Nasdaq Composite has grown popular because it’s commonly accepted as a shortcut to understanding how the biggest tech-sector and some other innovative companies – both big and small – are performing financially. And since tech is the tail that wags the dog, everyone wants to hear what the NASDAQ is up to.

Much more on stock exchanges in a future post.

I think we’ve all had enough for one post.

Sorry for going suuuper long on this one, but there was a lot of super important stuff that was all interrelated here that I thought was best to go over all at once.

Sorry if you disagree.

Read it again or as many times as you need to or in bits and pieces. You’re all smart. You know how you best learn, so go and ahead and do it your way at your pace.

I’d love to hear from any and all of you about your thoughts, so we can all learn from one another.

Talk to you soon.

*General Electric is the only company that survived all 121 years on the DJIA list.

Well, not exactly.

GE was removed from the DJIA in September 1897 and came back in November 1907. It’s been on the DJIA since then.

And for you history buffs out there, below are the original dozen companies in the 1896 Dow Jones Industrial Average.

 

1.) American Cotton Oil Company, a predecessor company to Bestfoods which is now part of Unilever.

2.) American Sugar Company which became Domino Sugar in 1900 which is now Domino Foods, Inc.

3.) American Tobacco Company which is now broken up in a 1911 antitrust action.

4.) Chicago Gas Company which was bought by Peoples Gas Light in 1897 which has since become a subsidiary of Integrys Energy Group.

5.) Distilling & Cattle Feeding Company is now Millennium Chemicals

6.) Laclede Gas Company is still in operation as Spire Inc., but was the first company permanently removed from the Dow Jones Industrial Average all the way back in 1899

7.) National Lead Company, now NL Industries, which was removed from the Dow Jones Industrial Average twenty years after its inception in 1916.

8.) North American Company (boffo marketing division, guys), a holding company for electric utilities, was broken up by the U.S. Securities and Exchange Commission (SEC) in 1946.

9.) Tennessee Coal, Iron and Railroad Company was bought by U.S. Steel in 1907 which was removed from the Dow Jones Industrial Average in 1991—pretty great run!

10.) U.S. Leather Company was dissolved in 1952 because of jerks like you with your faux leather belts and whatnot (especially the whatnot)

11.) United States Rubber Company which changed its name to Uniroyal in 1961, then merged with B.F. Goodrich (a privately held company—i.e., a company that you can’t buy stock in) in 1986 which was then bought out by Michelin in 1990.

12.) Good ol’ GE as previously mentioned

Asset Classes, Part IIC: Mutual Funds/ETFs: Index Funds vs. Actively Managed Funds

Never forget these two axioms:

Money frees us, but its pursuit may enslave us.
It’s not about how much you have at the end; it’s how much you could have made.

Asset Classes, Part IIC

Mutual Funds/ETFs: Index Funds vs. Actively Managed Funds

You’ll hear actively managed funds or index funds in relation to usually only mutual funds, but in reality, it can be true for ETFs as well.

An actively managed fund is one in which a “fund manager” or an entire management team makes decisions about how to invest the fund’s money—stocks, bonds, how much, which ones, and when to buy/when to sell.

An index fund, by contrast, is passively managed and follows a market index. It does not have a manager or management team making any investment decisions. Whatever index it follows (e.g., Dow Jones, S&P 500, NASDAQ, etc.), it will mimic those exact same stocks in the exact same proportions exactly (I know, I know; redundant and repetitive) and precisely nothing else. (If you want to know about stock indexes/exchanges, slow your roll, as the kids say,…creepers…that’s the very next post…no peeking!).

Actively managed funds carry far more expense with it than index funds because the manager needs to be paid (a murky number, but the average when last checked out is just over $436,000/year with some over $20 million/year based on performance bonuses, but, hey, you know all about the Krebs cycle, so you’ve got that going for you), research staff/analysts, data analytic software which require updates, etc., etc.

For that reason, how much index funds charge you (the expense ratio, remember? Come on people. This is only going to get harder as we go and impossible if you can’t remember the simple stuff. You can do this. You went to med school and forced yourself way less important stuff than this. Other than the really important things in your life and your professional career, this is the most important thing you need to know and understand) is usually way less than an actively managed fund.
Actively managed funds often carry an expense ratio of 1% or greater whereas index funds are often less than 0.5%, even below 0.1%. When dealing with such small percentages, it may seem like there’s not much difference, but when dealing with many thousands of dollars over many years as you undoubtedly will in the future eventually, it makes a massive difference which will only be overcome by your actively managed fund doing much better than an index fund every year year after year. (Much more on this in a later post.)

Actively managed funds make it possible to beat the market especially in down years. As soon as the conversation on actively managed funds vs. index funds comes up, the actively managed fund groupies always invoke the name: Peter Lynch.

Ah, yes.

Peter.

Lynch.

The sainted Peter Lynch, the fund manager of all managers, ran Fidelity’s Magellan Fund, the world’s most famous actively managed fund (mostly because of Lynch), from 1977-1990. Under his management, the Magellan Fund outperformed the S&P 500 in 11 out of 13 years and had the best performance record of any mutual fund in the world over that time.

Not bad, huh?

At a time where the S&P 500 was at an absolutely sizzling 14.43% per year, the Magellan Fund from 1977-1990 averaged just over 29%/year.

In other words, if you do the math using the Rule of 72 and the Rule of 144, in those heady days of the 1980’s, you doubled your money in just five years by broadly investing in the S&P 500.

Pretty awesome!

But, if you had your money parked with Peter Lynch and the Fidelity Magellan Fund, you quadrupled your money just under five years.

Even more awesomer!!

Fidelity couldn’t have been more thrilled because when Lynch took over the Magellan Fund in 1977, the mutual fund had $18 million in total assets under management and by 1990, assets in the fund had increased 1,286 times to over $14 Billion!

(To be fair, Lynch didn’t post the best returns ever or not in the history of the Magellan Fund even. The best return for the Magellan Fund for one year was 116.08% (!) in 1965, and the best three year record was 68.32% annualized between 1965 and 1967.)

Lynch retired at the top of the financial world in 1990 at age 46 and never re-entered with a net worth reportedly hovering around $350 million in this past decade.

Also, not bad.

SR: “OK, Lynch did great for himself. Fidelity crushed it. What about the average guy like me who invested in the Magellan Fund?”
Physician, Wealth Thyself AKA PWT: If you invested only $10,000 in the Magellan Fund the day Peter Lynch took over and then sold the day he retired and not even more dime the whole time, you made $280,000 before taxes.
SR: Oh. Well, yeah, but who’s that lucky to go in and out with only Lynch?
PWT: 1.) It’s not Lynch’s fault what you do or don’t do. You asked about him; I gave you what you asked for. ***Never ask a question unless you want the answer.*** 2.) When you notice your exceptional fund manager that has beaten the market for over a decade is exiting the place, you should walk out too. It’s like defying gravity. Sooner or later, you have to start dropping. Get out while you can.
If you don’t know who your fund manager is and when they leave, then you’re
doing actively managed fund investing wrong.
WHETHER YOU REALIZE IT OR NOT, ONCE YOU INVEST IN AN
ACTIVELY MANAGED FUND, YOU HAVE DECIDED TO BECOME
AN ACTIVE, INVOLVED INVESTOR. SO DEAL WITH IT.
3.) Even if you fell completely asleep and were under a rock for the decade after
Lynch retired, you did well if you stayed in the Magellan Fund.

Year*   MFR**   S&P 500 Return
1990    (4.51%)          (3.10%)
1991     41.03%            30.47%
1992     7.01%               7.62%
1993   24.66%          10.08%
1994   (1.81%)             1.32%
1995   36.82%          37.58%
1996   11.69%          22.96%
1997   26.59%          33.36%
1998   33.63%          28.58%
1999   24.05%          21.04%

*Duh
**Magellan Fund Return
Any returns in parentheses are negative. (Don’t ask me why. It’s an accounting thing.)
(Keep that in mind when you peruse your statements.)

As far as Lynch retiring in his 40’s with many millions and being celebrated worldwide… not bad work if you can perform for that level for that long…which no one else ever has thus why Lynch is a legend and bringing us to the problem of actively managed funds.

Statistically speaking, the vast majority of actively managed funds tend to “underperform,” or in other words, do worse than the market index.
The Magellan Fund (the example cited above) is bandied about so often because it’s the exception to the rule, not the rule…not even close actually.

Plus precisely no one guessed that the Magellan Fund would have done so well when Peter Lynch began as its manager. (Quite frankly, the Magellan Fund was an obscure fund that only became main stream a few years after it took off year after year.) We only know how well it did looking back.
Realize that every single time an actively managed fund sells a stock, the fund is hit with taxes and fees, which diminish the fund’s performance. Therefore, the more buying and selling (i.e., turnover) in an actively managed fund, the worse it will do unless the performance of the stocks it remains in outdoes the taxes and fees it has accumulated in the process…a chancy proposition.

Remember this also: You’ll pay a flat fee every year regardless of whether your fund does well or does poorly. (That’s true for index funds too though.) If the index offers a 7.25 percent return, and your index fund charges you 0.25%, then you’re at a 7% gain for the year. If your actively managed fund gives you an 8 percent return (Yay!) instead, but charges a 1.5 percent fee, then your gain that year is 6.5% (Booo).

Owning an actively managed fund means you’re dreaming of beating the market consistently or, at least, often enough and high enough that, net of fees (i.e., once you’ve subtracted out how much you’re paying each year as a privilege of owning the fund—you’ll see this phrase used a lot in articles, books, etc., so memorize what this means), you’re coming out ahead of an index fund.

Realize one more thing: If you own an index fund, you can just check in on your index (e.g., S&P 500, NSADAQ, Dow Jones) for the day, week, month, or even year and know exactly how well you did in that fund (minus a small expense ratio).
If you own an actively managed fund, how the market or a certain index or a certain stock or even a group of stocks performs tells you absolutely nothing about how your actively managed fund has done. In fact, believe it or not, the market or index could be up and your actively managed fund could actually be down because your genius fund manager (who only got the job because he’s the fund family’s CEO’s idiot nephew—bitter much, PWT?) is heavy into the only stocks that are actually down in an up market.
The only way to check on how your actively managed fund is doing is to check on the actual fund itself.

I think we’ve all had enough for one post.

I’d love to hear from any and all of you about your thoughts, so we can all learn from one another.

Talk to you soon.

Asset Classes, Part IIB: Mutual Funds vs. ETF’s: The Final Showdown*

Never forget these two axioms:

Money frees us, but its pursuit may enslave us.
It’s not about how much you have at the end; it’s how much you could have made.

Asset Classes, Part IIB

Mutual Funds vs. ETF’s: The Final Showdown*

Think of your investment portfolio as a wardrobe.
It’s many different pieces (shirts, pants, socks, shoes, etc.) that cover all of you. Stocks, mutual funds, ETF’s, bonds, commodities, and many other items (all known as financial instruments) comprise your “financial wardrobe” so to speak.
Funds can be like that great piece of wardrobe that has many functions/pieces just as a fund may have many stocks or bonds or both in any combination.
But they can be structured very differently.

Open End Funds vs. Closed End Funds

Open End Funds=Mutual Funds

There. That’s it.

You’re welcome.

*Crickets*

*Puzzled faces*

OK. Fine. Let’s talk some more (eye roll so severely hard that you can hear it through the Interwebs).

Open end funds (which are typical/normal mutual funds) have no limit or end to the number of shares that it can issue. When someone buys shares of an open end fund (which you are buying from the fund itself), more shares are created (really out of thin air). When someone sells their shares of an open end fund, these shares are “retired” or taken out of circulation.
When a massive load of shares are sold within a short period of time (often within a day), the fund may actually sell/have to sell some part of its investments to pay for the amount of money owed to the seller(s). This is known as a redemption.
Though they’re usually composed of stocks, open end funds don’t trade/fluctuate like them. Open end funds reprice at the end of each weekday based on how many shares are bought or sold. (Simplistically thinking, massive buying of shares ups the price of an open end fund whereas massive selling of shares deflates the price.)
The price of the shares of an open end fund at the end of the day is determined by the total value of the fund based on the buying/selling of the shares throughout the day. This total value of the fund is known as the net asset value (NAV).

NAV=Total assets-Total liabilities/Outstanding shares

Total assets (i.e., all the stocks, bonds, etc. the fund owns)

Total liabilities (i.e., all the debt, borrowed money, etc. it owes)

Outstanding shares (remember this? What do you mean, no? Jerks! It’s all the shares of the [in this case] fund floating out there in the world for anyone to buy)

Realize that not only some stocks will produce dividends quarterly (or much more rarely monthly) which will be taxed, but mutual funds as well. (More on all of this in a later post.)

Closed end funds

Closed end funds, in contrast, have a fixed number of shares that do not increase or decrease depending on sales and are bought and sold among investors, not the fund itself, on an exchange
(i.e., marketplace). Like stocks, their share prices are determined according to supply and demand. They also are often at a steep discount (Yay!) or at a high premium (Whoa!) to their net asset value. (In all seriousness, realize that there is usually a reason something is really cheap [“it’s a porker”] or expensive [“you want quality, you have to pay”]. You just have to ensure that you’re getting value for the money you spend as you buy anything…anything at all.)
Just over 2/3 of closed end funds use borrowed money (known as “leverage”) to invest to bring about a bigger return to make the fund and, in turn, you money. So, anything that makes it more expensive for the fund to borrow money (e.g., higher interest rates, a fund being downgraded—more on this in a later post) will cost the fund more which will then be passed on to you one way or another thus lowering returns back to you as the investor.
Therefore, you have to watch quite a few things pretty frequently to ensure you’re in the right closed end fund and don’t need to avoid them or bail out of the one you’re already in.

Generally speaking, open end funds are safer and more predictable than closed end funds though their upside can be significantly higher than that of open end funds. Either can have dividends (though they’re more common in closed end funds), but those of the closed end funds are usually higher, but also far more likely to get cut depending on underlying conditions with that fund or the economy in general.

We will discuss investing in funds in a later post, but closed end funds are neither for the novice or faint of the heart.

Exchange-traded funds

Exchange-traded funds (ETFs) are similar to mutual funds because both group together securities (usually stocks or bonds) to offer investors diversified portfolios. Typically anywhere from 100 to 3,000 different securities can be grouped together to comprise an ETF.

SR: Uh, pal…That’s no different than a mutual fund. So what gives?

PWT: So here are the differences between mutual funds and ETFs.

SR: Finally!

ETFs are just like stocks in that they fluctuate throughout the day while, if you remember, mutual funds trade only at the end of the day at the net asset value (NAV) price.
Most (but certainly not all) ETFs track to a particular index and therefore have lower operating expenses than actively invested mutual funds. ETFs have no investment minimums (which mutual funds often do—i.e., you can’t buy any shares of a particular mutual fund unless you fork over what they demand such as $5,000 or $10,000).
Also, some mutual funds charge for the privilege of owning some shares of the fund (sales “loads” as you purchase the shares [front loaded] or as you sell the mutual fund shares [back loaded] vs. ones that don’t charge at all [no load]) whereas ETFs do not. Lastly, once you sell a stock or mutual fund, you are charged capital gains tax on it (much more on this in a later post), but that’s not the case with ETFs necessarily.
As you sell the shares in your ETF, the ETF doesn’t actually sell any shares (stay with me here), but rather creates and then offers to sellers what is known as “in-kind transactions or in-kind redemptions” which are often not taxable. Therefore, ETFs allow you to either significantly reduce or altogether avoid taxes on your way out of the ETF.

Here are the differences summed up in table fashion for all you bottom line chart/table/graphics learners out there. (Yeah, you know who you are. I went to med school too, people.)

ETFs                                                           Mutual Funds

Trade during trading day           Trade at closing NAV
Low operating expenses             Operating expenses vary
No investment minimums        Most have investment minimums
Tax-efficient                                   Less tax-efficient
No sales loads                                 May have sales load

Both open end and closed end funds have been around for decades, even a century. Closed end funds are the oldest type of fund debuting in the late 19th century.
Exchange traded funds, or ETFs, are the Johnny Come Latelys (Latelies? Who really knows how to spell these made up colloquialisms?) of the fund world being introduced just over twenty years ago.

Mutual funds are MASSIVELY popular. And why not? They allow you to invest broadly in the economy (US or global) or any part of it as you desire (e.g., technology, energy, utilities, etc.).
Currently, 7,467 open end funds exist with total net assets of $12.1 trillion (Yes, Trillion with a capital T—that’s $1,000 billion for those of you keeping track at home) as per Morningstar, the most well-known investment firm in the business.
In a relative sense (and only in a relative sense), the ETF market is small: roughly $1.7 trillion placed in 1,550 ETFs.
But closed end funds by far have the smallest amount in terms of both the number of funds and total assets: 568 funds worth about $252.6 billion (not even a measly trillion dollars; wealth just ain’t what it used to be.)

I think we’ve all had enough for one post.

I’d love to hear from any and all of you about your thoughts, so we can all learn from one another.

Talk to you soon.

*My favorite Europe song of all time.** What a hair band!! Too bad they broke up in 1992…and then got back together!! And are now still touring around somewhere…somehow…

**It was actually The Final Countdown, but whatever. Still good fun. Though it was always unclear what they were counting down to as they had already launched off Earth early in the song as per the lyrics. The countdown to their oxygen running out? Maybe. But that’s probably just the Pulmonary/Critical Care guy in me coming out unnecessarily again.

 

Asset Classes, Part IIA: Putting the Fun in Funds

Never forget these two axioms:

 

Money frees us, but its pursuit may enslave us.

It’s not about how much you have at the end; it’s how much you could have made.

 

 

Asset Classes, Part IIA

 

Mutual Funds/ETF’s

 

 

Mutual funds and ETFs (exchange traded funds) are simple to understand in principle, but complicated to follow in practice. Simply put, they are just a collection (or “basket”) of stocks or bonds or a combination of both that collectively will determine if the mutual fund or ETF will increase or decrease in value. Inevitably, some of these stocks will go down as others will go up.

 

Whichever direction the majority goes is the direction the mutual fund/ETF goes…possibly. The “possibly” part comes in that no fund (for the sake of convenience, I’ll just say fund from now on in reference to both mutual funds and ETF’s) is obligated to buy each stock in the exact same proportion as each other stock already held.

 

For example, Fund X (sounds cool and futuristic—who wouldn’t want to get a piece of this???) may hold/own/have (all meaning the same thing, but used by different people thus adding to people’s confusion potentially) 200 stocks in it, but ten of those stocks may comprise 50% of the fund [and not even 5% each necessarily, but in any combination adding up  to 50%] whereas the other 190 remaining stocks make up the other 50% of the fund.

 

If 200 stocks in one fund sounds excessive, it’s not.

 

Sapp and Yan in their splendid paper in Financial Review in 2008   showed that the average mutual fund owned a portfolio of 91 stocks and that the top 20% of most diversified mutual funds hold (on average) 229 stocks. Not much has changed since then.

 

The choices are dizzying.

 

The number of mutual funds in the US alone as of 2016 was 9,511.

The number of ETFs in the US as of 2016 was 1,707.

(To be fair, the two largest stock exchanges—NYSE and NASDAQ—have 3,812 companies listed for anyone to buy their stock. There are over 15,000 more companies offering their stock for sale in lesser exchanges. Thus, the US alone has nearly 20,000 companies you can be a shareholder in. Much more on stock exchanges in a later post.)

 

The expenses associated with stocks are the following three:

1.) when you buy them (obviously)

2.) taxes on any dividends

3.) capital gains taxes when you sell them for higher than when you bought them (hopefully)

 

Funds however have four potential associated expenses as detailed below.

1.) when you buy them (obviously)

2.) taxes on any dividends

3.) capital gains taxes when you sell them for higher than when you bought them (hopefully)

4.) expense ratio

 

Dr. Unwise: Uh…wait…what’s this expense ratio you speak of? What’s that all about?

Dr. Know It All: Pffft. You don’t know that?!? God, how stupid are you? Everybody knows that. 

Dr. Unwise: So…you know?

Dr. Know It All: Of course I do! 

Dr. Unwise: So tell me.

Dr. Know It All: It’s very complicated. I doubt you would understand. 

Dr. Unwise: Well, tell me. I’m pretty smart. I am a doctor after all.

Dr. Know It All: Let this blogger guy tell you. He seems weirdly passionate about all this investing stuff. 

PWT: Sure, super duper smart guy, I’ll let you hide behind your bluster…again. 

 

The expense ratio (or ER) is the annual fee that all funds charge their shareholders. This does not include any charges related to the purchase of the fund itself. Stocks do not have such an expense.

So, unlike stocks, you are charged a fee every year no matter what as long as you hold the fund just for the privilege of owning this fund. How much you’re charged, why that much, etc. is variable between funds.

This fee is what pays all the people at that fund to help run it, manage it, sell stocks (hopefully) that they believe will perform poorly, and (hopefully) buy stocks that they believe will perform well.  (Much much more on expenses, taxes, and their breakdown with all basic investments in a later post.)

So why not then just buy stocks instead of funds?

It’s that dreaded two word phrase no doctor ever wants to even hear about, let alone deal with: risk management.

A fund has many stocks which will protect against the downside in any one company or even sector of the economy (such as oil/gas/energy) undergoing a downturn whereas owning one stock which may get crushed by some new technology destroying its way of business (e.g., music stores were wiped out by MP3 players, downloads, and streaming music services) or your company is destroyed by a civil war in a country you’ve never even heard of where the critical supply of a mineral you’ve never heard of is from and without said mineral the process needed to make their final product which you also never heard of is impossible.(If the latter happens to one of the companies where your money is, you didn’t do your homework. Sorry. This blog holds hard truths. If you want someone to make you feel better, call your mom. Seriously. Call her. She’s probably awesome and loves you unconditionally. So call her and tell her the same. And don’t text her. Call her. And Dad too. You are where you are because of them. Don’t be a jerk.)

Funds can be (let me emphasize the words “can be” here and further emphasize the word “are” was not used) a simple way of still getting upside in your investment as/if the economy hums along with decreasing the potential downside as mentioned above.

Perfect investment, right?

Dr. Know It All: Obviously. Everyone knows that. 

PWT: Eh…not necessarily.

Mutual funds over a five year period of time generally do not beat the S&P 500 and never beat the S&P 500 over a longer time period (10-20 years) and that’s before accounting for the expense ratio (ER) costing you money.

If you’re invested in only funds and nothing else, you’re banking on the gains minus the ER being close to how the S&P 500 performs while ensuring a few under performing stocks don’t sink you.

Whew!

A lot of assumptions are baked into that line of thinking.

As an advocate of the “funds only” approach, you’re assuming that as a stock only holder, you’d have the worst performing stocks thus making your funds only approach look brilliant.

But what if you just held only four stocks in equal 25% proportion each, the so called FANG stocks (Facebook, Amazon, Netflix, and Google [now Alphabet])?

Your returns would be 27.1% as opposed to 7.21% for the S&P 500 by late 2017.

Yes, it’s only one year, but look at those FANG stocks again. You’d have to think the next five years will be very kind to them.

No way, your mutual fund is going up 27.1% (unless the entire market is) even if the FANG stocks are a core holding of your mutual fund because the fund will have dozens (or hundreds) more stocks crowding out the FANG stocks thus dragging down the overall return of the fund. Then subtract out the ER. Then if you have any dividends from your mutual fund, those will be taxed.

So…

Not so easy, this investing thing huh?

I think we have done enough for one day.

Coming up next…the difference between different types of mutual funds and ETFs

I’d love to hear from any and all of you about your thoughts, so we can all learn from one another.

Talk to you soon.