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Personal Finance

5 flaws of black-box investing

September 19, 2016

By Richard Barrington | MoneyRates.com Senior Financial Analyst, CFA

Quantitative investment formulas, often referred to as black-box investing, have been around for a long time. However, advances in data gathering and artificial intelligence are pushing some of these techniques to new heights of complexity. The question is, does that added complexity bring greater effectiveness?

There are arguments to be made for and against black-box investing. It can play a useful role in your portfolio, but you should understand its limitations. After all, no degree of mathematical precision can guarantee that a strategy will add value.

Why investors choose black-box investing

Here are some of the points that black-box investing has in its favor:

1. Investment discipline

An automated investment approach is one way to take human error and emotion out of investing. Human money managers are prone to straying away from their disciplines. Fear and greed influence decisions. In particular, professional money managers start to rationalize making exceptions when they are under the gun for poor performance. Following an automated formula should remove the problems that result from human nature.

2. A degree of predictability

A quantitative approach will tend to be very pure in terms of investment style. It might have a particular bias, such as towards growth or value investing. But, an analysis of the formula or the principles behind it should make it fairly clear what that bias is. Style purity brings some predictability to the results, and this in turn helps an investor construct an investment program in which different managers play clear, complementary roles.

3. Low management costs

Having a computer picking stocks is much cheaper than a team of analysts researching companies one by one. Additionally, the money management firm should be able to pass this cost savings on to its clients.

4. A high-speed way of identifying inefficiencies

Some strategies work by exploiting arbitrage opportunities created by small market inefficiencies - pricing anomalies in which market valuations become temporarily out of step with those of the same or similar securities.

These anomalies are small and generally short-lived, so the only way to reliably make money by exploiting this kind of thing is to spot them quickly and trade in high volume. Computers are much better suited than human investors to identifying these opportunities and executing decisions quickly enough.

5 ways black-box investing is flawed

Of course, if successful investing could be reduced to a formula, everybody would be following it by now. In actual fact, trying to invest this way does have its complications:

1. Back-fitting data can be deceiving

Promoters of black-box investing often test their formulas with historical data to see how they would have performed. This type of backward-looking test is called a back fit, and the results can be somewhat deceiving. With hindsight, it is not too difficult to devise a formula which would have been successful in the past, but that track record is no guarantee of how the strategy will perform once it is up and running in real time.

2. Conditions change

One of the reasons why back fits do not always carry over to the future is that conditions change. Artificial intelligence techniques are being used to create approaches that can adapt to changing conditions, but those adaptations are still akin to human experience. No matter how much experience is accumulated, the combination of conditions shaping markets is always going to be a little different from what was observed in the past.

3. Investors flock to successful approaches

Another reason formulaic investing has a hard time duplicating past success is that investors tend to jump on the bandwagon of any successful approach. This popularity starts to remove the opportunity from markets by making valuations less attractive.

4. Lack of transparency

Black-box investment managers have a dilemma: They need to describe their approaches without providing so much detail that their clients could simply replicate the approach for themselves. This means that those clients may not know everything about how their money is invested, and the unknown sometimes contains unpleasant surprises.

5. Blind obedience may be dangerous

Long-Term Capital Management was a high-flying hedge fund that went bust quickly and spectacularly in the late 1990s. Its proprietors had so much faith in its investment approach that they applied a high degree of leverage to it. That level of blind faith leaves little room for error.

There is certainly a place for quantitative methods in investing. How heavily to rely on those methods, though, is a tricky question. Taking the possibility of human error out of investing is a tempting proposition. But don't forget that ultimately even black box investors rely on human judgement to devise the right investment formula.

More from MoneyRates.com:

Protect your portfolio: 3 big factors of investment risk

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7 things everyone should know about credit cards

September 16, 2016

By Richard Barrington | MoneyRates.com Senior Financial Analyst, CFA

Credit cards are a convenient financial tool. They are also a huge money maker for credit card companies. Whether or not you or the credit card issuer comes out on top can depend on how much you know about how credit cards work.

Credit cards generate billions in revenues in the United States, but you can minimize your contribution to those revenues if you know the following seven things about credit cards:

1. Competitive interest rates are out there

Credit card commercials are a staple of television broadcasts. Your mailbox may be full of credit card offers. It's also hard to visit the bank or go shopping without being offered a credit card.

One thing most of these pitches have in common: they don't mention the interest rate you will be charged. Legally, this has to be disclosed when you sign up for a card, but often that disclosure is treated like an afterthought. By that point, you have probably already started the process of applying for the card.

But remember the credit card market is very competitive, with plenty of opportunities to save money by finding a lower rate. Don't choose a credit card just because an ad got your attention or someone happened to offer it at the right time. The only way to be sure of getting a good deal is to shop around and compare rates.

2. The advertised rate may not be the rate you get

Credit card companies have different interest rate tiers. The lowest rate tiers are available to customers with the best credit, while those with lower incomes or weaker credit histories are assigned a higher rate tier.

So if you have less-than-perfect credit, pay attention to the higher end of the rate range rather than the lower end, and get a quote on which rate would apply to you before you sign up for a card.

3. Watch out for credit card fees

A tricky thing about comparing credit cards is that besides having different rates, some have fees and some don't. The fees can be significant enough that a low interest rate that comes with a fee may not be as good a deal as a slightly higher rate with no fee.

To figure this out, you have to estimate how much of a monthly balance you are likely to keep on your credit card. Then you can project how interest rate expense will compare with the fees. As a rule of thumb, if you tend to keep high balances, you should focus on finding a card with a low interest rate. If you keep little or no balance, then interest rates are less relevant and you should focus on avoiding fees.

4. Rewards may come at a price

Rewards credit cards typically charge higher interest rates than non-rewards cards, so if you keep high balances on your card the extra interest cost could outweigh the value of the rewards.

On the other hand, if you pay your card balance off in full every month, you can reap credit card rewards without ever paying the extra interest - and that really is rewarding.

5. When it comes to rewards, cash is king

Rewards are offered in many different forms, from travel miles to merchandise to cash back. In most cases, when you calculate the economic value of rewards programs, they work out to be pretty much the same. All things being equal, cash back is the best form of reward. It gives you the flexibility to spend your rewards however you like - or even take the radical approach of saving the money.

6. Minimum payments maximize credit card company profits

Minimum monthly payments seem very reasonable because they are generally quite low compared to the balance owed, but they are so low because they are designed to make you pay interest over the longest time possible. Make more than the minimum payments, or else you will be maximizing the interest you pay.

7. Zero-percent balance transfer does not always mean free

These are attractive deals to people who carry long-term balances and want to reduce the interest they are paying, but watch out. The zero-percent interest rate is usually temporary. There is often a fee for transfers that can outweigh the money you would save while the zero-percent rate was in effect.

Knowledge is power. Using your knowledge to shop for and use credit cards can give you the power to stop your hard-earned dollars from contributing to the already-huge credit card industry earnings.

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6 mistakes that can knock out your finances

September 14, 2016

By Richard Barrington | MoneyRates.com Senior Financial Analyst, CFA

During the historic Floyd Mayweather-Manny Pacquiao fight there was no knockout, but your finances may not be able to take a punch quite as well. It is always a good idea to be aware of what could knock out your finances and drain savings accounts because boxers who know where the punch is coming from have better chances of keeping their defenses up.

Here are six common problems that can deal a knockout punch to your finances:

1. Credit card dependency

Americans owed a total of $729 billion on their credit cards in the second quarter of 2016, according to the Federal Reserve Bank of New York's Quarterly Report on Household Debt and Credit. This also means billions in annual interest sucked out of the bank accounts of credit card customers, all because they got in the habit of charging more than they could readily pay off. Mounting debt burdens and interest charges have knocked out many a household's finances.

2. Student loan debt

A by-product of the weak job market resulting from the Great Recession was a doubling in student loan debt outstanding over the past seven years. Going back to school simply because it is easier than facing a tough job market can put your finances up against the ropes before your career even starts.

3. Overpriced investments

The past 15 years have seen extreme peaks and valleys in tech stocks, real estate, oil and gold, among other investments. Trying to chase these trends can lead you into overpriced assets just when they are poised to collapse - the investment equivalent of walking into a punch.

4. Big mortgages

People like to think big when they buy a house, leading them to sign on to mortgage payments that are a stretch to afford. This is like getting into a fight and expecting not to be hit. If your finances cannot take a little adversity, they'll never go the distance.

5. Career complacency

It happens time and time again in boxing - a fighter gets to the top and loses the edge it took to get there. For more mainstream careers, the equivalent is taking your job and your career for granted. People get to a comfortable income level, and they ease back a bit. The problem begins if you don't keep your skills up to date or put forward a consistently competitive effort. Keep your eye on how well your company is holding up in its markets. Or you might find that your comfortable job gets taken by a hungrier and more aggressive competitor, either from inside or outside your own organization.

6. No financial cushion

It isn't just laziness that dooms some fighters. Others are done in by too much fast living once they become rich and famous. Financially, you don't need to have a drug or alcohol problem to be living on the edge. Any lifestyle that is debt-dependent, makes no room for savings or is just one setback away from defaulting on payments is too close to the edge to be safe.

Notably, Floyd Mayweather has made a huge fortune by being a primarily defensive boxer. You will probably never make Mayweather money, but your finances can be successful if you learn to keep your defenses up.

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Protect your portfolio: 3 big factors of investment risk

September 12, 2016

By Richard Barrington | MoneyRates.com Senior Financial Analyst, CFA

Risk management is a prominent aspect of portfolio analysis, and yet it remains frustratingly difficult to grasp. It's not just a question of differing opinions on the best way to control risk - the very definition of risk varies from one expert to another.

In an issue of the Financial Analysts Journal (FAJ), David M. Blanchett and Philip U. Straehl point out that defining risk according to the composition of an investment portfolio may be too narrow a focus. An investment portfolio exists in a larger context of personal wealth, and you should take that context into account in the construction of your portfolio.

As discussed in the FAJ article "No Portfolio is an Island," the following are three of the bigger picture factors that should inform portfolio construction.

Factors for investment risk

Employment

Income

The size and reliability of your income should be a consideration in how you construct your investment portfolio. A counter-intuitive aspect of this is that even though you are likely to earn less money in the early years of your career, the income of younger people is generally a bigger factor in total wealth than the income of older people. This is simply because younger people have typically not accumulated as much wealth in other assets.

A $35,000 income to a 24-year-old with no assets (beyond $500 in a savings account) is a more significant component of financial well-being than the $75,000 income of a 50-year-old who has built up a $600,000 retirement portfolio. Therefore, the risk profile of your investments typically becomes a more significant consideration as you get older.

Job security

Another way that employment weighs on overall financial risk is how you make your money. Two people may make the same income, but there is a big difference if one is in a very volatile industry while the other is in a highly secure position such as that of a tenured teacher. In that scenario, the person with the more uncertain income might be well served to have a more conservative investment portfolio than the person with the more secure position.

Industry

Your profession also matters in terms of the industry composition of your portfolio. An auto worker might want to be more cautious about a heavy weighting of car company stocks than someone in an unrelated industry. This is because those holdings would essentially represent doubling up on exposure to the auto industry. This is important because employees sometimes tend to be attracted to stock in their own company or industry. However, from a risk-management standpoint, they should be avoiding such holdings.

Homeownership

Owning a home should also be taken into account in portfolio construction because in many cases, that home is a person's single biggest asset.

One aspect to consider is that two people may own homes with similar values, but the weighting of those homes in terms of their total wealth depends on how far along they are in paying off their mortgages. Essentially, as you pay down your mortgage loan, your house becomes a bigger part of your overall wealth. Thus, your portfolio should increasingly be thought of in terms of comprising complementary assets.

The role of home value is also impacted by the volatility of your local housing market. If you live in a market subject to wild price swings, you may want to have a less risky investment portfolio than someone in a more stable market.

Retirement vesting

Finally, vesting towards retirement entitlements should also play a role in how you view risk management. This can be another source of counter-intuitive risk management tactics. One typically thinks of decreasing portfolio risk as one gets older. But, if you view vesting towards Social Security as building up an income-producing asset, other holdings logically can afford to get more rather than less risky.

On a related note, it also depends on whether you are in a retirement plan that entitles you to a specified income, as in the case of a defined benefit plan. Or you have one that is based on the accumulation of assets, as is the case with defined contribution plans such as 401(k) retirement savings. The latter scenario calls for less risk in other investment assets than the former.

As closely as financial risk is studied, there will never be a precise way to measure or even define that risk. Why? Because central to the nature of risk is that it is unpredictable. Still, elusive though an exact mastery of risk may be, examining its characteristics and manifestations can help you prepare for at least some of the possibilities. Additionally, you will be guarding against one of the greatest financial risks of all: complacency.

More from MoneyRates.com:

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7 financial moves to make before your first child

September 7, 2016

By Maryalene LaPonsie | Money Rates Columnist

Having your first child is a welcomed milestone for many parents, but the price tag of parenthood could be overwhelming for some.

Recent figures from the U.S. Department of Agriculture says it will cost more than $245,000 to raise a child until adulthood. This figure includes a lot of items, such as housing, that you'd be paying whether or not you have kids.

However, frugal parents often find ways to bring down child-rearing costs by breastfeeding, cloth diapering and saying "no" to many of the things society insists children should have.

Even with these cost-cutting strategies, there is no denying that kids are going to cost a chunk from your paycheck. What's more, they bring with them the possibility of unexpected costs: medical bills, class trips and classes or other interests.

Be sure you're ready to face the cost of a child.

Follow these seven tips to get your family on firm financial ground before welcoming that bundle of joy:

1. Decide if you and your partner are ready for kids

The first step in welcoming a baby into your life is to have a heart-to-heart discussion with the person who will be helping you raise this child. Being a parent is both an emotional and financial commitment, and both parents need to be on board with the decision.

Still, money experts say there is no reason to wait until your finances are perfect before having a child.

"You're really never, ever going to be perfectly ready to have kids because something always comes up," says Keith Klein, Certified Financial Planner and principal of Turning Pointe Wealth Management in Phoenix, Arizona.

2. Determine your life and financial priorities

Instead of waiting for the stars to align or your next big raise, a better strategy is for both parents to commit to having a child and agreeing to work within their current means to meet their family's needs.

To do that, parents need to discuss and agree on a set of financial priorities.

Questions to ask about parenting and finances

The following are some questions to ask during this discussion:

  • Do we plan to enroll our child in a public or private school?
  • Will we pay for a portion of his or her college education?
  • Do we want to take annual vacations or buy a vacation home?
  • Will one parent stay home? If not, who will provide child care?
  • Is our current housing adequate or would we like to move?

Klein suggests future parents ask others what expenses they've encountered with their kids to round out their discussion and identify any items they may have missed.

3. Create a budget based on family goals

A solid household budget is a crucial part of being financially stable in preparation for children.

"Being on firm financial ground isn't necessarily about not being in debt," says Cory Schmelzer, Certified Financial Planner and founder of San Diego Wealth Management. "It comes down to a plan and a budget."

Schmelzer says discussing family priorities in advance of creating a budget is important since a couple's shared vision will shape how they plan to spend and save their money. Fixed expenses, such as housing costs, need to be prioritized. But, once those are covered, a couple can discuss how to pull money from their variable expenses and redirect that toward a family goal.

For instance, a couple may decide to eliminate cable or cancel a gym membership and put that money toward an education or vacation fund. Others may take a more extreme approach and decide to trade in their big house for a smaller one and therefore a less sizable mortgage loan in order to allow one parent to remain home.

4. Set aside an emergency fund

While you don't need to be out of debt to have kids, you should have an emergency savings account in the bank. Klein recommends single income households keep a fund large enough to pay for six months of expenses. However, dual income households can probably get by with a three-month emergency fund.

"Unexpected things happen all the time," Schmelzer says.

A fully funded emergency fund helps you survive a financial storm, whether that's the loss of a job or complications during the baby's delivery.

5. Review your insurance needs

Next, you need to review your insurance coverage, including life insurance.

Health insurance

For the immediate future, you should know how much your health insurance deductibles and co-pays will be for labor and delivery charges. This is the amount you'll have to cover out-of-pocket. Then, you need to add your child to your policy within 30 days of their birth or adoption to ensure they will be covered as well.

Life insurance

For the long-term, consider whether you have enough life insurance. Klein recommends 15-25 times your annual income. While that can be through either a whole life or term life policy, Klein notes term life will get you the most coverage for the least cost.

Disability insurance

Beyond life insurance, parents should consider buying disability insurance.

"Not enough people understand what can happen if they can't earn an income," Klein says.

Disability coverage can bridge a financial gap in case one parent is no longer able to work.

6. Update beneficiaries and discuss guardianship during estate planning

The birth or adoption of a child is a great time to review beneficiary information on insurance policies, bank accounts and retirement funds. Parents should also talk about drawing up a will and who would get guardianship of their child if needed.

"People often forget that the guardians who get the kids don't have to be the people who manage the money," says Klein, reminding parents that they can have a third party oversee money left to their children.

7. Come up with a Plan B for financial setbacks

Finally, Klein says every couple should run through a "fire drill" of what happens in a worst case scenario.

"What happens if we burn through our emergency savings? What if you lose a job?" he says.

This exercise helps couples create a workable Plan B they can put into action in the event of a crisis. Rather than being forced to make difficult decisions during an emotional time, couples should already have already identified how they can lessen the impact of a serious financial setback.

Couples thinking about having a baby should know a child comes with more than the opportunity to post cute pictures to your Facebook timeline. It's also a serious financial commitment, but one that parents can meet head-on by following these seven simple steps.

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