Jan 14, 2016

My Investment Philosophy

Slow and steady wins the race.

Last week I wrote about how the lottery is for suckers. As it turns out, almost every ‘get rich quick’ scheme is like playing the lottery. Sure, if you buy the ticket, your numbers might come up and you might get rich, but for the most part you’re going to lose some or all of your initial investment.

Investing in stocks is no different. In stocks, the lottery tickets might be small companies or bargain value buys that on their surface have the potential to be more lucrative than the Apples, Exxons and Wal-Marts of the world — but in reality, you’re gambling that your number — your stock picks — are going to be called in the next drawing (or the next trading day, week, quarter, year or decade).

I am going to be writing a lot more about personal finance in this blog as I undo many of my past mistakes and put myself on better footing. It’s not a ‘get-yourself-out-of-debt-and-get-rich’ plan, it’s a measured process of paying down debts, saving in cash and investments, and planning for a better future. Hand-in-hand with those strategies goes my investment philosophy, which in general is best described by the moral to the age-old fable of “The Tortoise and the Hare.”

Keep in mind that I’m a 35-year-old journalist, not a financial advisor, and that the universe of possibilities when it comes to investments is huge. I am also married with no kids. There is no one-size-fits-all solution for my financial situation, or for anyone else’s. This is a matter of personal preference.

If you read my previous post about my poor financial planning and debt, you already know the core holdings of my retirement portfolio – index funds based on the S&P 500. I consider the S&P 500 my portfolio’s benchmark, too, and there’s a good reason: I believe the S&P 500 is the most accurate index of overall U.S. stock market performance. In the past, economists and investors have looked to the Dow Jones Industrial Average, or as we transitioned to the high-tech information economy, the Nasdaq – but these indices are smaller and less comprehensive than the S&P 500.

I am a passive investor. My balances are still too low to start picking stocks, even if I felt like I had enough knowledge and skill to beat the market. While my risk tolerance is extremely high, I’m not at the point where I can take any chances with my money.

I am seeking beta – to match the growth and performance of the market. Until 2015, the S&P 500 was growing at an average rate of around 10.5 percent per year. I would be incredibly happy to match that performance, as my assumptions for retirement are only 7 or 8 percent a year of asset growth depending on which scenario I’m using.

Why, with all my investment knowledge, my access to advanced financial products and my ability to call some of the greatest living financial minds from my desk at work, would I settle for matching a stock index? Because I don’t really believe in active strategies. Because in general, I subscribe to the efficient markets theory.

The efficient markets theory holds that stock markets, where thousands or millions of trades can occur at the blink of an eye, already price in information about their constituent investment products. That’s important because believers in active management must have faith that they or their investment managers have some kind of knowledge about an investment, a class of investments, or a sector of investments that the market as a whole has not anticipated and factored into its pricing of investments.

For example, a good active investor may feel like the market is underestimating the volume of retail sales or the price of oil in the coming year, and therefore they would buy retail sale stocks, energy companies or oil on the commodities market, believing that their fellow traders are paying too low a price for the investments and that they could turn it around for a profit in the future.

Some of the most successful investors, including Warren Buffet, Vanguard founder Jack Bogle and Princeton University economics professor Burton Malkiel, argue that the market is now moving faster than these active managers can, making it impossible for them to time the optimal moments to buy an investment when it is undervalued or at a low and to sell when it is high. The markets, in other words, know more about the price of an investment as a unified entity than any of the experts could possibly know as individuals or firms.

Furthermore, in the rare cases where an active fund manager or investment advisor is beating the markets, their investment fees tend to diminish or destroy their ability to outperform. In investment lingo, outperformance, or beating the market, is often referred to as ‘alpha.’ Alpha happens, but whether it can occur consistently due to an investors intention is still a raging debate among those in academic finance. I personally believe that on a long enough timeline, even the best educated and best informed active manager's chances of beating the market will approach zero. Slow and steady, folks.

My belief is that by investing in broad indexes, even though I might experience down years or flat years (2015 was a flat year – the S&P ended in pretty much the same place it began), I can pick up that 8 to 10 percent per year average gain in the market, and by averaging into the market at a steady rate, I don’t risk buying mass quantities of stocks when the market is at a peak and about to decline 20-40 percent.

Despite my passive, long-term tack, I also prefer exchange traded funds, or ETFs, to mutual funds for a few reasons. One, ETFs are traded in real time on stock exchanges with prices that are allowed to fluctuate throughout the day. If I’m trying to buy a fund off its bottom, its lowest level, the ETF format is superior to mutual funds. Because they’re traded on exchanges during the day, ETFs are more liquid – meaning if I ever wanted to convert my investments to cash, I would have an easier time doing so with most ETFs than I would with most mutual funds. Furthermore, ETF shares can be 'built' by buying the constituent investments and trading them for their equivalent in fund shares - which contributes to their liquidity. Finally, ETFs are very transparent. While most mutual funds are also transparent – meaning that information about their management, fees and underlying components are widely available – they often aren’t transparent in real time. With ETFs, if I was to start making more active moves in the markets, I could easily compare the value of a fund’s underlying components with its share price and trade accordingly. Not so simple with mutual funds.

Keep in mind that I self-describe as an aggressive investor with a high risk tolerance. I consider myself 30 to 35 years out from retirement – I’m targeting 2051 as my retirement year, I’ll be turning 70. I’m willing to experience severe market fluctuations this far out from my retirement date. Furthermore, when I figure in some of my personal information – fair health, married, childless, moving up in my career (even though I work in a not-so-stable industry), living in an area with a strong economy – I (mostly) fit the profile of an aggressive investor. Thus, I’m not really worried about investing in bonds at this point in my life, I want to capture the growth potential of the stock market.

We can split my personal investing into two areas, with two different philosophies and concerns: a portfolio solely for retirement, consisting of my 401(k) accounts and IRAs, and a portfolio for other savings, which does not yet exist (and won’t for some time, as any income it generates would be taxable).

While I count around $12,000 from my wife in a T. Rowe Price large-cap growth mutual fund as part of what I manage, I won’t be discussing it here. I also have around $5,000 in old employer 401(k)s that is allocated to target date funds. That will remain untouched for the time being, and won’t be counted for the purposes of this discussion. What’s left is my current 401(k), a rollover IRA and a Roth IRA.

My Roth IRA account is currently in cash — with less than $100 in it, I haven’t bought an investment with it yet. When the account reaches the minimum price for the Vanguard S&P 500 ETF (VOO), which is around $175 today, I’ll start buying.

My rollover IRA – a traditional IRA – has eight shares, around $1,500, of VOO in it. I will diversify this IRA as a roll over more of my former 401(k)s into it, but for now VOO is my base investment.

Which leaves my workplace 401(k). I have a love-hate relationship with 401(k)s. For one thing, if you  are offered one with an employer match, I don’t think I’m going against the grain telling you to get the free money in your employer match. That’s what I’m doing, my employer will match me up to 3 percent, and will match me half a percent for every percentage point I contribute between 3 and 5 percent. So if I contribute 5 percent, I can get my employer’s maximum match of 4 percent, which as it turns out is what I am currently doing. I love that. I also love that, like a traditional IRA, the money can be deducted right out of my paycheck before taxes, and I won’t pay any taxes on it until I start taking distributions from the account in retirement.

However, like most workplace 401(k)s, my investment options are limited, in this case to some of mutual funds. I would much rather be able to select from an unlimited range of ETFs, but instead I have to chose from 20 or so mutual funds. Luckily, there are some great options in the list.

Out of the gate, I chose to begin contributing to this new account 90 percent stocks, 10 percent bonds. This is still considered a very aggressive portfolio allocation, but when I first set up my contributions I hadn’t considered how aggressive I really am. As a result, I’m now slowly averaging out of contributing to the two bond funds I chose.

Here’s a list of my investments:
91.7% in EQUITY (or stocks)
40.3% in SWPPX – The Schwab S&P 500 Index Fund $560
10.7% in BEGQX – The American Century Equity Growth Fund, Investor Shares $149
10.6% in VIMAX – The Vanguard Mid Cap Index Fund, Admiral Shares $148
10.1 % in GSSIX –The Goldman Sachs Small Cap Value Fund, Institutional Shares $141
10.1% in OIDYX – The Oppenheimer International Diversified Fund $141
9.9% in EKJYX –The Wells Fargo Premier Large Company Growth Fund, Institutional Shares $139

8.3% in FIXED INCOME (or bonds)
5.1% in PHYZX – The Prudential High Yield Z fund $71
3.2% in VSGDX – the Vanguard Short Term Federal Bond Fund, Admiral shares $45

The Schwab S&P 500 fund is a mutual fund similar in composition and goals to the VOO ETF. With an expense ration of 9 basis points, it costs almost twice as much to buy and hold as its Vanugard ETF cousin, but 9 basis points comes out to .09 percent per year. I think we can afford that. The other funds range from 9 basis points for VIMAX to 94 basis points for GSSIX and 101 basis points for OIDYX.

Originally, when the account was opened around four months ago, the portfolio was 40 percent in SWPPX, 10 percent in each of the other equity holdings (for 90 percent equity total) and 5 percent in each of the fixed income holdings (for 10 percent equity total). Since then, equity markets have had a bumpy ride and the value of the fixed income investments has sagged.

Currently, I’ve set my my future contributions to look like this:
94% Equity:

6% Fixed Income:

By the end of 2016, I will average out of contributing to fixed income altogether, and begin averaging out of my other equity contributions and into SWPPX, the lowest cost investment in this portfolio. Eventually, contributions to this account will be 100 percent SWPPX – at which point I will have to decide how I want to diversify. I believe I will start averaging out of contributing to GSSIX and OIDYX first among the equity funds, as they come with a 1 percent sandbag to whatever alpha they might  happen to generate.

And that’s really how I’ve arrived at my current allocation and contribution levels — I’m slowly reducing contribnutions to PHYZX and VSGDX and raising my contributions to whichever equity mutual fund has had the worst year-over-year performance on that particular day.

So why not just sell my bond funds and my non-S&P equity funds and buy into SWPPX? For one thing, a little diversity is a good thing, in investments and in life.

For another, when you’re a passive, long-term investor, you want to avoid selling as much as possible. Selling and buying stocks repeatedly is costly, you being to rack up commission expenses, you risk selling at a trough or buying at a peak, and in general it doesn’t work. Instead, I’m going to balance my portfolio through future contributions – I’m young enough and my account balances are low enough for that to be an effective tactic. Again, slow and steady wins the race.

As it turns out, Mrs. Chris and I are going to be enjoying a slight bump in household income this year, and our expenses for debt, fuel and food are probably going to decline. I strongly believe that I’m best off saving and investing this additional revenue. I’m waiting until the end of the month – just after my 35th birthday – to figure out whether I want to put the bulk of this money towards my growing emergency savings, or either or both of my retirement accounts.

What I do know is that I want to invest aggressively, in index funds, with responsible management at a low expense ratio — and unless a young person sitting on a pile of money, or your blood pressure rises at the thought of a market downturn, that’s probably the ideal way for the millennial generation to invest.

So coming up on the financial side of things, I’ll reveal a little more about how I am budgeting and saving for the future, and I’ll also expand upon the benefits and detriments of adhering to the efficient market theory through index investing.

Also, long live David Bowie and Alan Rickman. I hate cancer.

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