July 29, 2016
What's so great about being passive, including in investing?
Charles Ellis, an investor with over 50 years of experience, wrote in the Financial Analysts Journal about the ongoing debate between proponents of active investment strategies and advocates of passive strategies. Whether you are setting asset allocation guidelines or choosing specific investment products, understanding some of the arguments in this debate might be important to your decision making - especially since real-world investment approaches often include elements of both active and passive investing.
In a nutshell, active investors believe that with careful analysis, it is possible to find better-than-average investments. Passive investing advocates make the point that not every investment manager can be above average, and that the higher cost of active management fees results in below-average results overall.
Ellis points out that the distinction is not really that simple. What follows are some perspectives on why active investing can be important and how you can avoid some of the pitfalls common to active investing.
5 reasons for active investing strategies
So why fight it? Wouldn't it be easier just to invest in an index fund and go along for the ride?
Here are five reasons why active management might still be worth considering:
1. Benchmark investing does not serve an investor's true goals
Passive investing typically is designed to mimic the performance of a given market benchmark, but is that really why you are investing? Real-world investors are typically trying to fund some future need, and various benchmarks will serve that goal better at some times than at others.
2. Many active managers are too passive
Ellis makes the argument that the flaw of many active managers is not their active decision-making but that they are too passive. Ellis estimates that in an attempt not to stray to far from the pack, managers devote 60 to 80 percent of their portfolios to mimicking a benchmark, leaving active decisions in a minority of the portfolio with the burden of trying to add enough value to surpass the manager's fees for the entire portfolio.
3. Passive investing involves some active decisions
Sure, you can pick an index fund, but which index? There are dozens of choices, each representing a different market or type of security, so each will have its unique investment characteristics. Therefore, even the choice of passive investments requires active decision making.
4. Active analysis encourages market efficiency
Another point Ellis makes is that active managers essentially keep companies honest by directing money towards successful ones and away from unsuccessful ones. Passive investing removes that accountability by investing in a company simply because it is in a market index.
5. Consumer behavior is part of the problem
In many cases, the failure of active investing is the fault of consumers rather than the managers because consumers tend to make too many short-term moves from one fund or manager to another in an attempt to chase hot performance.
5 ways to avoid active investing mistakes
The above points mean that to some extent, active investing has gotten a bum rap. However, some criticisms of it are legitimate and if you choose an active approach, you had better do so in a way that acknowledges the pitfalls so you can attempt to avoid them.
1. Keep fees reasonable
Fees for active management are higher than for index funds and the like. If you pay more than 1 percent, you are really creating a high obstacle to overcome.
2. Distinguish luck from skill
Any manager can get hot over a short period of time. Don't be too impressed with short-term performance numbers. Instead, look for success over full market cycles.
3. Distinguish style from skill
If a manager has a given style bias (e.g. value, growth, small-cap, etc.) check performance index specific to that style. Make sure a good run of performance was not attributable more to a given style having a strong period than the manager's individual decisions.
4. Watch for organizational changes
If a manager has done well for you, keep abreast of changes in key personnel that could jeopardize the ability to continue that success.
5. Be aware of the impact of size
As successful managers attract more business, they often find it tougher to continue to execute their strategies with more assets under management, especially if their success was based on small-cap stocks or relatively illiquid securities.
Even the most die-hard passive investing advocate has to make active decisions: about asset allocation policy, which index fund to choose, how to handle inflows of cash and where to turn for liquidity. Since every investment approach has some active elements, it is better to try to understand active investing rather than summarily rejecting it.
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July 26, 2016
When it comes to credit scores, the news isn't good for many Americans. An analysis of scores by the credit bureau Experian found a third of people have what could be considered bad credit.
Having a bad credit score can affect everything from a person's ability to get a job to the loan rates they're offered at the bank. But could it also make it impossible to open a checking account?
The myth of bad credit and bank accounts
While it is commonly believed bad credit will prevent people from opening a checking account, some banking representatives say that simply is not true.
"Bad credit doesn't affect a person's ability to open a savings or checking account at Citizens," says John Rosenfeld, head of Everyday Banking for Citizens Bank. "We have checking and savings accounts available to anyone as long as they meet the minimum amount needed to open the account."
That minimum amount can be as low as $1, Rosenfeld adds.
Steve Novak, senior vice president and director of retail banking at Bryn Mawr Trust, agrees a low credit score usually can't be blamed for a bank denying a request for a checking or saving account.
"Any kid you open an account with has zero credit," he notes.
ChexSystems reports: What you need to worry about
Rather than bad credit, what consumers should be concerned about is their ChexSystems report. That's where banks record which consumers bounced checks, had accounts closed due to unpaid overdrafts or who otherwise owe a financial institution money.
"It's banks helping banks," Novak says.
ChexSystems serves largely the same purpose that credit reports do for lenders. It helps banks determine whether a person poses a business risk or if they are likely to be a good customer. If ChexSystems comes back with a negative report, Novak says banks and credit unions typically consider the following when deciding whether to approve or deny a new checking account:
- How long ago the negative account occurred
- How long the account was overdraft
- Whether the bank was paid back
- Consumer reasons for the overdraft
Every bank has its own criteria but generally those who owed a small amount for a short period of time are more likely to be approved for a new checking account compared to someone who owed significantly more for a longer period or who never paid back the bank.
Account options for people with poor bank records and bad credit
In the event you find yourself on the receiving end of a bank account denial, don't despair. You still have options.
Look into a second chance checking account
Some institutions, such as Wells Fargo and PNC, offer what is known as second chance checking accounts. These accounts may come with certain restrictions or strings attached.
"You may be unable to write checks off the account or to use online bill pay," says Peter McVey, vice president and director of treasury services for Lead Bank. "[You] may be limited a debit card only with no overdraft privileges."
Plus, there could be minimum balance requirements or additional maintenance fees to pay.
If there is no bank nearby with a second chance checking option, Novak says consumers may have better luck getting an account at a smaller institution.
"Big banks…are more hard and fast on rules," he says. "Smaller banks may be more lenient."
Is a prepaid card right for you?
Another, increasingly popular option is to use a prepaid card in lieu of a checking account. Cards such as RushCard and Bluebird tout themselves as bank account alternatives, and money can be directly deposited into a card just as you would with a checking account. Some cards even have online billpay services.
While prepaid cards are an option for those who can't open a checking account, they may be an imperfect solution. By some accounts, the average prepaid card charges $300 per year in basic fees. What's more, some cards don't offer FDIC insurance coverage, leaving money unprotected in case an institution fails. Additionally, some consumers have complained about some prepaid companies locking them out of their account for days at a time.
How to get your bank record back on track
Whether you've had negative reports work against you or not, there are steps you can take to improve your chances of being approved for a new checking account.
Pay back any money owed
The first thing to do, Novak says, is to pay back any money you owe a bank. While that does not erase the ChexSystems report, paying back the money can improve your standing in the eyes of some institutions.
Ask for a savings account instead
Another tactic to boost a tarnished bank record is to request a savings account with an ATM card. Banks and credit unions typically don't have anything to lose by allowing a saving account, and many are willing to open one even for those with a poor banking record. Then, by showing a history of regular deposits and good money management, the institution may be willing to reconsider its decision on a checking account.
"If you've had some prior issues and are listed in ChexSystems, it does not mean you cannot open a bank account," McVey says. "It simply means you'll have to be more diligent in finding a bank or credit union willing to look beyond your past and focus on your future."
Comment: How have you bounced back if you've had a negative bank record?
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July 25, 2016
One of the things that determines the yield on bonds is uncertainty. Knowing the relationship between bond yields and uncertainty can help you get a yield that adequately rewards you for the investment risk you are taking.
A bond is essentially a loan - investors give money to an issuer for a set amount of time, and in return, they get a specified rate of interest. However, an important difference between a bond and an ordinary loan is that investors sell bonds to one another on a daily basis, and changing prices reflect changing conditions. Some of those conditions are general to the market as a whole, while some are specific to the bond's issuer.
Bond issuers are evaluated based on the degree of certainty that they will repay. This degree of certainty is referred to as "quality," and quality is an important determinant of bond yields.
Bond yields: What is a spread?
The global standard for high-quality debt instruments is the U.S. Treasury bond. Other bonds, whether issued by corporations, non-U.S. governments or municipalities are considered to have a higher risk of default. In return, investors demand a higher yield. The extra yield is measured relative to the yield on Treasury bonds and is called a "spread." For example, if 10-year Treasuries are yielding 3 percent and a certain corporate bond is yielding 5 percent, it is trading at a spread of 2 percent.
How high that spread is depends on two things:
1. The creditworthiness of the individual issuer
2. The overall level of optimism about financial conditions
Bond quality and ratings
The general principal is that the lower the quality of the bond, the higher the yield will be.
Quality is formally measured by ratings agencies such as Standard & Poors and Moody's, who use a range of quality ratings to assess the ability of issuers to repay. For corporate bonds, these systems usually are some variation of the type used by Standard & Poors.
The rating system by S&P is as follows:
Highest level of quality: AAA
AAA is the highest level of quality (considered just below Treasury bonds in quality). AA is the next highest, then A, BBB, BB, B and CCC.
Investment grade bonds: BBB and above
Bonds rated BBB or higher are considered "investment grade."
Junk bonds: BB and lower
Those rated BB or lower are considered "junk bonds." As a reflection of the fact that lower-quality bonds trade at higher yields, some people prefer to refer to junk bonds as "high-yield bonds."
Bonds in default: D
Bonds that are currently in default are giving a rating of D.
It should be noted that quality ratings are assessments of an issuer's current financial condition, and not a forecast of its future. Adverse events could cause a downgrade in quality rating, and market prices might anticipate that downgrade before it formally happens.
How bond rating changes can affect yield spreads
Getting downgraded or upgraded in quality rating is one way that yield spreads on a bond can change. Downgrades usually result in wider spreads, which mean lower prices, and the opposite is true of upgrades.
Besides changes in individual issues, the level of optimism in general about lower-quality bonds changes according to economic conditions, resulting in across-the-board changes for yield spreads. For example, due to the Great Recession, high-yield bond spreads went from about 2.5 percent in mid-2007 to over 20 percent by late 2008. This was a particularly extreme swing from high optimism to bleak pessimism. The 2001 recession saw a more moderate rise in spreads, from about 7.5 percent to just over 10 percent.
Low-quality bonds and price changes
A key to understanding the investment characteristics of lower-quality bonds is to remember the relationship between yields and price: when yields rise, prices fall, and vice versa. Because of how quality spreads can widen or narrow so drastically, lower-quality yields tend to be more changeable than higher-quality ones, meaning that lower quality bond prices are subject to more extreme price movements.
From a portfolio standpoint, this means that lower-quality bonds take on some of the characteristics of equities rather than playing the role of sure-and-steady high-quality bonds. Buy a low-quality bond whose outlook improves, and you should be rewarded with a strong price gain in addition to the higher yield that goes with a lower rating. However, if the outlook for a bond you hold worsens, you could be subject to a price decline which could become permanent.
Effectively then, investors need to understand that the lower the quality of a bond, the less it behaves with the certainty of bonds and more with the volatility of stocks. The higher yield being offered should be evaluated in the context of the higher level of risk.
July 22, 2016
The Securities and Exchange Commission on Oct. 30, 2015 opened the door for ordinary investors to put money into crowdfunding opportunities that were previously open only to the wealthy. Now that this door has been opened, should you walk through it?
Investing in small, private companies provides an alternate form of equity to traditional, publicly-traded stocks, and also gives people access to the explosive growth potential of start-ups. In doing so though, it could introduce a whole new element of risk to your investment line-up.
Why the limitations?
Crowdfunding was previously restricted to what are known as "accredited investors," which include individuals making more than $200,000 a year or who have a net worth in excess of a million dollars, not including their primary residence. The SEC has now made it possible for smaller investors to participate in crowdfunding, but only within certain limits.
Why the caution about allowing this form of investment? For one thing, private companies do not have the same level of requirements for audited financial reporting that public companies do, and so there is the potential for unsophisticated investors to fall for a gaudy sales pitch that is not backed up by a sound business model. Also, investing in start-up companies rather than those with a measurable earnings track record carries a much higher risk of failure.
Updated crowdfunding guidelines
While the SEC loosened the restrictions on crowdfunding, it has not eliminated them altogether. Now, people with incomes of less than $100,000 can invest the greater of $2,000 or 5 percent of either income or net worth, which ever is smaller. Those with income and net worth of more than $100,000 can invest up to 10 percent of the lesser of income or net worth, up to a maximum investment of $100,000.
These restrictions apply to all crowdfunding investments in aggregate over any given 12-month period.
Is crowdfunding for you? 7 things to consider
Crowdfunding is trendy, and you could make the argument that it can add both diversification and a new source of growth opportunities to your portfolio. However, you have to ask yourself if you are prepared both financially and emotionally to make the type of investments that might lose most or all of their value.
You also have to ask yourself whether you are prepared to do some detailed analysis of proposed investments, both when you are looking to buy and then regularly thereafter to monitor your investments.
Here are seven things to consider when investing in a private company via crowdfunding:
The SEC investment limits should help make sure crowdfunding investments don't represent too big a portion of your wealth, but given the specific risk of any one of these investments, you should look to spread your money over multiple opportunities rather than depending too heavily on any one.
Very often, these companies won't have an earnings track record yet, which makes valuation difficult. If there are substantial assets involved, you could look at what the investment price represents as a portion of those per-share assets, but more likely you will have to rely on the company management's projection of earnings as a basis for price comparisons.
3. Track record of key people
Since the venture itself is likely to have a limited history when you invest, what you are really buying into is the talent of the key people running the show. Look at their backgrounds for evidence of past success, and also for warning signs such as legal troubles or frequent business failures in their past.
4. Scope of market
Understanding the extent of the market for the company's products or services will help give you a sense of the growth potential.
Look at both the number and relative strengths of competitors to gauge how difficult it might be for a new firm to succeed.
6. Defensible position
If a company has a promising new product or service, think about whether there are patents or other factors which will make it possible for them to defend their market position, or whether it would be easy for competitors to quickly jump in with similar offerings.
Think beyond just what the company is offering, and look at whether they have a viable way of marketing and delivering their wares.
Crowdfunding is no different from other types of investments in this sense: it is not the method of investment that makes something a good or bad idea, but instead the details of what you are buying and how much you pay for that. Don't get too caught up in the growing popularity of crowdfunding to forget to look at the fundamentals.
Comment: Have you considered crowdfunding investments?
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July 18, 2016
Retirement saving is an abstract concept to people who aren't close to retirement age. It's easy to blow off because in the here and now, failing to save does not seem to have any consequences. People need to make it seem more real to get better motivated to save. One way you could do that is by taking a test drive and spend a month on a retirement budget, and see how you like it.
Majority of Americans at risk for saving too little for retirement
Study after study of American retirement savings have shown that the average worker is falling well short of the savings they would need to support their current lifestyles. As a recent example, the Center for Retirement Research (CRR) at Boston College estimated that roughly half (52 percent) of Americans risk not being able to maintain their standard of living in retirement. This is even when taking into account that less income should be needed in retirement than during one's working years.
Why are so many on track to come up short? Just look at the numbers. The CRR found that the average retirement savings of people in their 50s totaled just $110,000. This is disturbing because that age group has most of its saving years behind it, and is rapidly approaching retirement. Using the common rule of thumb that a 4 percent withdrawal rate allows for sustainable retirement assets, these savings would produce just $4,400 a year in retirement income. Even if you doubled this withdrawal rate, which would probably entail drawing the balance down over time, the result wouldn't augment Social Security benefits enough to provide much of a retirement lifestyle.
How to take the retirement budget challenge
To make this more real to you, try to live on the type of retirement budget your current savings would be likely to support. See the step-by-step process below to take the retirement budget challenge:
1. Project your retirement savings amount
Use a retirement savings calculator to project what your current rate of savings plus investment growth would add up to by the time you retire. This will tell you the total retirement savings you are on track for currently.
2. Figure out what yearly spending your savings can support
Again, 4 percent withdrawals are considered sustainable, but since it is not realistic to expect that everybody will be able to afford to live off their retirement savings without drawing them down. So, you might want to use a higher assumption, perhaps something between 4 percent and 8 percent. Applying this percentage to your projected savings tells you what your annual retirement income your nest egg would produce.
3. Be realistic about Social Security income
You can go to the U.S. Social Security Administration website and get a projection of what your retirement benefits will be. In the end, those benefits are based on the 35 highest-earning years of your career, so if you plan to retire early or if your income drops off later in your career, those benefits may not be as high as you think.
4. Make a budget based on your projected annual allowance
Your income from retirement savings and your Social Security benefit is what you would have to live on. Now create a monthly budget based on that amount.
5. Spend a month living on that budget
As an experiment, try living on that budget for a month. Don't take it so far that you fail to pay bills that you already owe, but limit any discretionary spending to what that budget would allow.
6. Figure out a budget you can live with
If your retirement savings rate is as meager as most Americans' rates, chances are you won't find that budget is very doable. So, figure out how much retirement income you would actually need to have a decent lifestyle.
7. Work backward to see what you need to save
Go back to the retirement calculator and see how much you would have to save to get to a workable retirement income. The experience of trying to live on less might just motivate you to ramp up your savings accordingly.
One way to think about this exercise is that it should encourage you to narrow the gap between your lifestyle now and the one you will be able to afford in retirement. If you get a taste of what it would be like trying to get by on a lot less money, you might decide it's better to spend a little less now, in order to afford a retirement budget that is less of a steep drop-off from how you lived during your working career.
Comment: Have you tried the retirement budget challenge? Tell us your experience below.
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