R-squared, the linearity of investment returns.

December 24, 2016

[updated 12/25/2016: R2 is a useful measure of indexing]

The R-squared (R2) statistic describes a pattern of plotted data with respect to a straight line. R-squared is called the coefficient of determination (ref 1,2).

random

The black dots in figure 1 represent investment returns that are poorly related to market returns. There is a random distribution of investment returns with respect to market returns. The blue line is an inadequate representation of the relationship simply because there is no relationship. The R2 score for this distribution is 0.03. Conversely, the black dots in figure 2 show the ‘herding’ of data around a straight line.

ordered

Figure 2’s investment returns are highly related to market returns with an R2 of 0.997.

Significance

The R2 score represents the degree of alignment of data to a best-fit line as determined by regression analysis. The lowest possible score of 0 indicates a random pattern of data with absolutely no alignment. The highest possible score of 1 represents complete alignment.

The product of R2 X 100 represents the percent of variation in investment returns that are related to market returns (ref 1,2). In other words, R2 measures the relavance of the best-fit line to a set of data. Relavance increases as the R2 score varies from 0 to 1.

The lowest score of 0 defies any financial analyst to draw a meaningful line for investment returns as they relate to market returns. In figure 1, the incline (β) and Y-intercept (⍺) of the blue line are unreliable measurements of investment performance.

The highest R2 score of 1.00 identifies a straight line of near-perfect predictions of returns. Any R2 above 0.75 identifies a straight line for making predictions of returns. Lower scores represent increasingly random events. In figure 2, the incline (β) and Y-intercept (⍺) are reliable measurements of investment performance.

R-squared is an excellent measure of index fund performance.  Websites for index mutual funds and ETFs publish R2 as a measure of alignment between fund returns and the market index.   Funds that have an R2 score of nearly 1.00 track the index very closely.

References

1.  Lain Pardoe, Laura Simon, and Derek Young. STAT 501, Regression Methods. 1.5- The coefficient of determination, r-squared. Pennsylvania State University, Eberly College of Science, Online courses. https://onlinecourses.science.psu.edu/stat501
2.  R-squared. 2016, Investopedia http://www.investopedia.com/terms/r/r-squared.asp?lgl=no-infinite


Alpha is a point on a straight line, plus more.

December 22, 2016

{update on 12/23/2016: the significance of technical and operational alpha}

Alpha (⍺) is the cherished -but overrated- measurement of superior investment. Here are several interpretations:

  • A measurement of how well an investment outperforms its market index (ref 1).
  • The observed characteristic of a mutual fund that predicts higher fund performance (ref 2).
  • A portfolio’s return that’s independent of market returns (ref 3).
  • The excess (or deficit) return compared to the market’s return. Used this way, ⍺ is called Jensen’s Alpha.

Alpha represents a unique risk of outperforming the market’s returns. It is classically calculated as the “Y intercept” of a straight line attributed to the CAPM model (see appendix). In the last century, famous investors outperformed the market either by choosing exceptional investments or by investing in exceptional market sectors. The investment could be a single security (e.g., a stock) or a portfolio of capital assets (e.g., a mutual fund) (footnote 1, refs 1, 2). Now in this century, those alledged ‘alpha’ strategies are increasingly difficult to achieve. There’s an emerging sentiment among investors to avoid wasting time and money on attempting to outperform the market, the so called “loser’s game”. The current “winner’s game” is to seek ‘beta’ (refs 1, 2, 4, 5).

‘Beta’ is the portfolio’s return generated by market returns. Therefore, beta represents the risk of earning the market’s returns. The beta statistic, β, is currently calculated and reported by financial research firms as a coefficient for the incline of a straight line attributed to the CAPM model (see appendix).

Straight line of imaginary returns

(refs 5-8)

A straight line of imaginary returns presumably offers the best possible comparison of investment returns to a market index (footnote 2). ‘Returns’ and ‘performance’ are interchangeable terms that indicate the direction and movement of prices over time. An investment’s rate of return is calculated as the percentage change in price at regular intervals of time [likewise, the market’s rate of return is a percentage change in value of the market’s index at regular intervals of time]. Any rate of return is easily converted to a risk premium by subtracting the guaranteed interest rate for a Treasury bill (“T bill”). The risk premium is an investor’s potential reward for purchasing a security other than the T bill.

The straight line is drawn on a graph that shows actual measurements of investment returns plotted against market returns. The returns may either be measured as the rate of return or the risk premium depending on the goal of analysis. In the following chart, black dots represent a series of investment returns plotted against corresponding market returns.

alpha2

The blue line of imaginary returns is the best possible comparison of investment returns to market returns. The position of the line on the graph is governed by its incline (β) and intersection (⍺+ε) with the vertical axis.

⍺, the intersection

(refs 1-3, 5-8)

Alpha resides at the intersection of the theoretical line with the vertical axis for investment returns (chart). Since the vertical axis crosses the horizontal axis at 0% market returns, ⍺ is the theoretical investment return at 0% market returns. A positive value for ⍺ implies that the investment tends to outperform its market index. Likewise, ⍺ = 0 implies no inherent advantage of the investment and a negative value for ⍺ implies that the investment tends to move less than the market index.

There’s a degree of error (ε) involved in drawing the line of imaginary returns, which means that its intersection is defined by the term ⍺+ε. The ε declines when a series of returns lie close to the line. The chart shows plots for 2 different series of returns; one series of black dots and another series of white circles. Both series have an equally small ε as illustrated by the close alignment of data to each straight line. Alpha of the blue line is 0% return and ⍺ of the orange line is 5% return, both occuring when the market return is 0. The series of open-circle returns outperformed the series of black-dot returns by 5%.

Significance

(refs 1, 2, 4, 5)

Alpha measures how well an investment outperforms the market. Yesterday’s ‘technical’ ⍺, shown in the preceding chart, applied to measuring superior stock-picking skills.  Today, the technical ⍺ of stocks is not reported by the most popular financial websites.

Today’s ‘operational’ alpha is really a beta loading factor of multi-factor models (see appendix).  Operational alpha is more relevant to measuring the performance of actively managed mutual funds and investment portfolios. The investment goal of an actively managed mutual fund is to outperform its market index. Active management may be the “loser’s game” of paying excessive fees in contrast to passive management, which may be the “winner’s game” of paying minimal fees.

Footnotes

1. Capital assets are securities and other forms of property that potentially earn a long term capital gain(loss) for the owner.

2. The straight line has other names that precede my use of the term ‘imaginary returns’. The straight line is also called a regression line or security characteristic line (ref 6).

References

1. Larry E. Swedroe and Andrew L. Berkin. Is outperforming the market alpha or beta? AAII Journal, July 2015. pages 11-15.

2. Yakov Amihud and Rusian Goyenko. How to the measure the skills of your fund manager. AAII Journal, April 2015. pages 27-31.

3. Daniel McNulty. Bettering your portfolio with alpha and beta. Investopedia. http://www.investopedia.com/articles/07/alphabeta.asp#ixzz4SYJ0rN9q

4. John C. Bogle. The little book of common sense investing. John Wiley & Sons Inc., Hoboken, 2007.

5. Investing Answers. Alpha Definition & Example. 2016. http://www.investinganswers.com/financial-dictionary/stock-valuation/alpha-43

6. Professor Lasse H. Pederson. The capital asset pricing model (CAPM). New York University Stern School of Finance. undated. http://www.stern.nyu.edu/~lpederse/courses/c150002/11CAPM.pdf

7. MoneyChimp. Regression, Alpha, R-Squared. 2016. http://www.moneychimp.com/articles/risk/regression.htm

8. Invest Excel. Calculate Jensen’s Alpha with Excel. undated. http://investexcel.net/jensens-alpha-excel/

APPENDIX: models for pricing assets and managing portfolios

(refs 1-3, 5-8)

The original one-factor model was called the Capital Assets Pricing Model (CAPM). The single factor is market returns (M).  The investment returns (I) are predicted by a best-fit line with incline (βm) and intersection with the vertical axis (⍺ + ε) (equation 1).

I = ⍺ + ε+ βmM,     equation 1, CAPM

Subsequent series of three-factor and four-factor models were sequential upgrades of CAPM. Equation 2 is an example of a four-factor model for the risk premium of an investment fund (F) comprised of separate portfolios for the broad market (M), asset size (S), asset value (V), and asset momentum (U).

F = ⍺ + ε + βmM + βsS + βvV + βuU,     equation 2, four-factor model

⍺ is the excess risk premium attributable to skillful management of the Fund.
ε is the model’s error
βm, βs, βv, and βu are portfolio loading factors assigned by the Fund’s manager

The four-factor model offers a spectrum of possibilities.

  • During 1927-2014, the average annual returns of indices for the the four-factor model were 8.4% for the broad stock market, 3.4% for stock size, 5% for stock value, and 9.5% for stock momentum.  The sum of average annual returns, 26.3%, represented the alpha-threshold for superior fund returns (ref 1).
  • Passive management could be predicted by setting βm to 1.00, measuring the market index return, and setting the remaining loading factors to 0.  A market index fund would  be expected to generate a risk premium that matches the market index risk premium with an ⍺ of 0 and slight ε for tracking error.
  • Active management involves designing loading factors and portfolio assets to outperform the fund’s predicted returns.

Copyright © 2014 Douglas R. Knight


Beta is the incline of a straight line

December 10, 2016

Beta (which is symbolized as β) is the incline of a straight line. Mathematicians would say the same thing another way, that beta is the slope of a regression line. Either way, β describes the tendency of investment returns to move with market returns. The investment is a security (e.g., stock, bond, mutual fund) that has a unit price. The market is a trading place for a large group of securities. The combined value of all securities is measured by a market index.

Returns

Trading causes security prices to change during the passage of time, a process called price movement. Calculations of β require price movements to be measured as percentage returns. In table 1, the daily closing prices of a security and its market index are listed under the column heading “close”. Percentage daily changes in closing price are listed under the column heading “Return %”.   Equation 1 is the formula used to calculate a return:

Return % = 100 x (current price – past price) / past price  (equation 1)

Notice in table 1 that all prices are a positive number and that the market’s close is bigger than the investment’s close. However, the calculated returns are positive and negative numbers of similar size. The positive and negative returns represent up and down movements of prices. Table 1 has 3 pairs of investment and market returns with corresponding dates.

table-1

Beta (β)

β may be calculated directly from a table of returns, but it’s more meaningful to analyze a scatter plot of returns. The scatter plot in figure 1 has a solid blue line derived from 5 years of daily returns represented by more than a thousand black dots. Each dot has a pair of corresponding returns on each axis.

fig-1
The blue line offers the single-best comparison of investment returns to market returns. The incline of the blue line is β, which is calculated as a ratio of the lengths AC and BC of the dashed lines. Since AC and BC have equal point spreads of 5%, β is 1.00, which means that the investment and its market TENDED to move together at the same rate of return.

Notice that the black dots are closely aligned to the blue line, therefore excluding the random movement of returns. Consequently, the blue line is highly predictive of this particular investment’s past performance.

Significance

β is a measurement that literally means for every percent of market return, the percent investment return TENDED to change by the factor of β.  This is illustrated in figure 2.

fig-2
The colored performance lines in figure 2 represent different investments. Each line offers the single-best comparison of investment returns to market returns. For the sake of graphic clarity, a large cluster of paired returns was not plotted as data points.

At β = 1.00 (black dashed line) the investment and market TENDED to move together at the same rate. At β >1.00 (yellow line), the investment performance was amplified by trading activity in the market. The yellow line’s β infers that the investment’s return was 1.72 times the market’s return. At β <1.00 (green line), the investment performance was diminished by market activity. The green line infers that the investment’s return was 0.86 times the market’s return. At β <0 (red line), the investment performance was reversed by market activity. The red line infers that the investment’s return was -3.86 times the market’s return.

Thus, β is a ‘pretend’ multiplier of market performance. Higher β ‘amplified’ the market performance, lower β ‘diminished’ the market performance, and negative β ‘reversed’ the market performance.

Risk

Risk is the chance for a capital gain and capital loss. Betas greater than 1.00 tend to be riskier investments and those lower than 1.00 tend to be safer investments compared to performance of the market. Negative β infers a reversal of investment outcomes compared to market outcomes.

Summary and advice

β is a statistic for past performance that describes the tendency of investment returns to move with market returns. When comparing the β of different investments, be sure to verify the time periods and market index used by the analyst. β is typically measured with weekly or monthly returns for the past 3-5 years.

Copyright © 2016 Douglas R. Knight


Why we need stocks and bonds

October 20, 2016

Believe it or not, Society is coming to the point where all capable people need to invest in stocks or bonds. So what are stocks and bonds, and why do we need them?

They are valuable certificates purchased from businesses by investors. Businesses need investors’ money to build and sell products to customers for a profit. Investors need the certificate to retrieve their money with a bonus payment. That bonus payment is an enticement to invest in businesses.

Stock and Bonds are different from each other. Stocks represent part ownership in a business. The stock owner hopes to collect portions of business profits called dividends and to eventually sell the stock certificate for a bonus amount. Bonds are written promises to refund investors’ money with an extra amount called interest. Both potentially offer individuals an extra source of money.

Markets for stocks and bonds will grow and endure for future generations.  More individuals will become investors out of necessity.  The details of investing are interesting and challenging.

Copyright © 2016 Douglas R. Knight


Choosing an ETF

August 16, 2016

Investing in an exchange-traded fund (ETF) begins with screening many funds to identify a few candidates, then rating the candidates. My preferred open-source screeners are XTF.com and ETF.com, both of which have inclusion criteria for selecting desirable ETFs and exclusion criteria for rejecting undesirable ETFs.  Aim to find a reputable low-cost ETF that best matches the performance of its category.

Asset class

Assets are potential sources of income to investors.  Consequently, an asset class is a group of assets that earn income the same way.  The ETF portfolio holds assets consistent with the fund’s investment strategy, which is either to copy a market index by process of passive management or compete with a market index by process of active management. The index measures the performance of an asset market.

Competing ETFs are typically grouped in one of the following asset classes:

  1. EQUITY is a share of ownership claimed through the purchase of a company’s stock. Equity ETFs earn capital gains and dividends from stocks.
  2. REIT.  The real estate investment trust (REIT) is a company that owns and manages income-producing real estate. The REIT earns money from rent, mortgage interest, or other real estate investments. At least 90% of the REIT’s taxable income must be given to shareholders in the form of dividends. REIT ETFs earn capital gains and dividends from REITs.
  3. FIXED INCOME securities pay an expected amount of interest (e.g., bonds) or dividends (e.g., preferred stock).
  4. COMMODITIES are raw materials sold in markets for use in making finished products. Commodities are sold for cash or traded in futures contracts.
  5. CURRENCY is a system of money in the form of cash or notes. The currency market trades different currencies to profit from trading fees and differences in interest rates.

Inclusions

The following inclusion criteria direct the search for reputable candidate funds desired by most individual investors:

  1. Passively managed ETFs typically charge lower fees than actively managed ETFs and likely outperform actively managed funds over long time-periods.
  2. U.S. listed ETFs comply with SEC regulations, U.S. stock exchange rules, and the U.S. tax code.
  3. One of these Asset classes: Equity (stocks), REIT (real estate), or Fixed Income (bonds).

Refine your inclusion criteria by selecting reputable indices and desired market categories.

Exclusions

The following criteria should be excluded by all but the most adventurous investors!

  1. Exchange-traded notes (ETNs) are not ETFs.
  2. Closed-end funds (CEFs) are not ETFs.
  3. Leverage and inverse ETFs are very tricky investments.
  4. Actively managed ETFs charge higher fees in order to create porfolios that outperform or underperform a market index.
  5. These asset classes:
    Alternatives (imitation hedge funds)
    Asset Allocation (actively managed mix of assets)
    Multi-Asset/Hybrid (diversified asset classes)
    Volatility (exposure to volatile market)
    Commodities (potential tax burdens)
    Currency (potential tax burdens)

Reputable index

All ETFs compete on the basis of an Index they use to design an investment portfolio. Some Indices make better measurements of market performance than others. Beware that some Indices measure untested markets. Generally speaking, the best-in-class ETFs use reputable market indices. One way of choosing a reputable index is by selecting a long-standing, oft-quoted Index provider or Index name.

Index providers are companies that specialize in measuring market performance and selling the information to financial institutions. Table 1 provides a sample of reputable Index providers.

Table1

Category and Index names

Asset Classes have unique categories. Each category may be measured in a variety of indices listed in Tables 2-4.

table2

 

table3

 

table4

Rating the candidates

By now you should have several ETFs that could satisfy your investment goal. Verify that they belong to the same category, then assess their suitability based on the following critera:

  1. Net assets, Total assets, Assets Under Management (AUM), or Market cap AT LEAST $1 BILLION.
  2. Inception date AT LEAST 5 YEARS AGO
  3. Expense ratio BELOW 1%, LOWER IS BETTER AMONG COMPETITORS
  4. Legal structure PREFERABLY “OEIC” OR “UIT” (table 5)
  5. Number of holdings CONSISTENT WITH THE MARKET INDEX.
  6. Tracking error, LOWER IS BETTER AMONG COMPETITORS
  7. Premium (Discount), LOWER IS BETTER AMONG COMPETITORS

The finishing touch

It’s a good idea to review the Annual Report of your selected ETF.  Your potential tax burden is determined by the ETF’s legal structure, its portfolio turnover, and your tax accountant’s hourly fees.

table5

Copyright © 2016 Douglas R. Knight


Empower young investors with savings plans.

May 29, 2016

The purpose of this article is to help young people make long range savings plans.  It’s a three-step process: 1) Set the goal. 2) Adjust for inflation. 3) Make recurring payments. I begin by presenting a retirement savings plan and conclude with a generic process for making other savings plans.

Planning for retirement

QUESTION: How much money should I save to start retirement?

ANALYSIS: I know people save money for future expenses even though inflation increases those expenses. Thank goodness my current budget is designed to pay for emergencies and pay all debt before retirement. If I live within my means and save 25 times my annual salary, I could safely withdraw 4% of those savings in the first year of retirement and keep withdrawing that amount, adjusted for inflation, each year of retirement. Life would be good! [refs 1-3]

GOAL: Save $25 per dollar of annual salary, plus an adjustment for inflation. The goal has 2 parts: 1) The savings account should hold at least $25 for every $1 of gross annual salary. 2) Every saved dollar should be inflated to match the Economy’s inflation rate.

STRATEGY: Start to invest regularly at the beginning of my career.

  1. Starting at approximately age 25 and finishing at approximately age 75 will provide 50 years of opportunity to save for retirement.
  2. At an annual inflation rate of 3%, the average price of everything that costs $1 today will likely be $4.38 fifty years from now (check this estimate with a future value calculator).
  3. My real savings goal is $25 X $4.38, which rounds to $110 for per dollar of salary.  The planning table in Fig. 1 will help me select a regular deposit.

Fig. 1

Fig. 1

For instance, a stock index fund that’s expected to earn a 10% annual rate of return could accumulate $110 when 9 cents per year are deposited into the account for 50 years.

How does this apply to me?  Suppose I start earning $50,000 a year at age 23 and invest in a stock index fund that earns an 8% rate of return. Thanks to the help from my parents, I already have $1,000 to open an investment account. According to the 50-year plan in Fig. 1, I will choose to deposit 18 cents per year for every dollar of salary. That means my annual deposits will be $9,000 from the $50,000 salary. If things go right, my investment account will be worth $5,546,902 after 50 years. Really?!!?

  • The future value of $1,000 is $46,902 based on an annual return of 8% for 50 years {test this calculation with the future value calculator}.
  • The planning table in fig. 1 is designed to earn $110 by making regular deposits for every $1 of salary; $110 X $50,000 = $5,500,000.
  • $46,902+$5,500,00 = $5,546,902.  Happy retirement!

THEN WHAT? Plan on safely withdrawing 4% of your savings at the beginning of retirement in order to match your annual salary before retirement; 4% of $110 is $4.40. Next year withdraw the same amount plus extra cash to adjust for inflation. The adjustment factor is (1+I) for the annual rate of inflation. Assuming that I is a 3% rate of inflation, (1+0.03) X $4.40 = $4.53. Each succeeding year, withdraw the same amount as the previous year plus an adjustment for inflation. In the first 5 years of retirement your annual withdrawals will be $4.40, $4.53, $4.67, $4.81, and $4.95 per $1 of pre-retirement salary and you will have plenty of savings for the rest or retirement [refs 1,2].

Risk management

There’s no guarantee that your plan will work. What could go wrong and how do you avoid failure? Some likely risks are missed deposits, taxes, low rates of return, brief time, and market declines.

  1. Missed deposits- Deposits energize the process of compounding interest to accumulate savings [ref 4]. Avoid missing deposits by making automatic payments through an employer sponsored savings plan –e.g., 401(k), 403(b)– or through payroll deposits into an individual retirement account (IRA).
  2. Taxes- Tax-deferred savings plans reduce your taxes. Deposits into employer-sponsored retirement-savings plans and traditional IRAs are not taxed until withdrawals are made after retirement when the withdrawals are taxed as regular income. Deposits into a Roth IRA are taxed at the time of deposit, but never taxed again. If the traditional and Roth IRAs are not affordable for you, the U.S. Government offers an affordable Roth IRA called the MyRA. If you wish to invest in Treasuries and corporate bonds, beware that they ares taxed at a higher rate than the long term capital gains from stocks.  Use a tax-deferred account to invest in bonds [ref 5].
  3. Low rates of return- Stocks reputedly pay higher rates of return than bonds. Investing in individual stocks is a risky and time-consuming effort; joining an investment club may be helpful. Consider buying shares of index funds that invest in market sectors with the understanding that investing in market sectors is riskier than investing in broad markets.
  4. Brief time- Start investing while you’re young. Starting later will require larger payments.
  5. Market declines- Since 1929 the average stock market cycle was 40 months divided into 30 months of price inclines and 10 months of price declines [ref 6]. The net effect was an uptrend in prices over long time periods. Individual investors can protect their investment returns from market declines in two ways: 1) Continue investing during market declines when regular deposits will purchase more securities at lower prices. 2) Diversify by adding bonds to your stock portfolio. This is best done by making supplemental payments for bonds in tax-deferred accounts such as MyRA.

Generic savings plan

Any long range savings plan can be made in 3 steps:

1. Set a goal for how much money you want to save. Your goal becomes the accumulated amount calculated by the compounded interest calculator [Fig. 2].

2. Adjust for inflation by multiplying your goal by the factor (1+I). I is the decimal value of the annual inflation rate. If you choose last century’s average annual inflation rate of 3.2% [ref. 7], the factor is (1+0.032). If 3.2% seems too high, use your internet search engine to discover more recent inflation rates.

3. Determine recurring payments needed per $1 of annual salary.  Display them in a customized planning table similar to Fig. 1.  Here’s how:

  • The columns are values of N for the number of years. Choose at least 2 time periods for the sake of versatility.
  • The rows are values of R for an investment’s annual rate of return. Choose a practical range of stock and bond returns for the sake of versatility.
  • The cells display fractions of $1 for making the minimal recurring deposit (d). Determine the deposits by testing trial values of d in the compounded interest calculator (Fig. 2). For example, start with d = 10 cents at the highest rate of return (R) for the longest time period (N). 10 cents represents the idea of depositing 10% of every dollar in your annual salary [Hint: it’s practically impossible to deposit more than 50 cents per dollar of salary].
  • In Fig. 2, the value of PV can be $0 unless you already have an initial deposit.

Appendix: All-purpose Savings Calculator

Try fig. 2’s all-purpose savings calculator that’s in the open-source publication of PracticalMoneySkills.com [ref. 8].

Fig. 2

CompdInterestCalculator

Note: Fig. 2 can be validated by tests using the compound interest formula for annual additions discussed in ref 4.

References

1. Jane Bryant Quinn. How to make your money last. The Indispensable Retirement Guide. 2106, Simon & Shuster, New York. 366 pages.

2. William P. Bengen. Determining withdrawal rates using historical data. Journal of Financial Planning, pages 171-180, October, 1994.

3. Craig L. Israelsen. The importance of diversification in retirement portfolios. AAII Journal, April, 2015. pages 7-10. American Association of Independent Investors.

4. Miranda Marquit. How does compound interest work for investments? ©️2016 empowering media inc. 2/18/2016.

5. Types of Retirement Plans. IRS.gov, 10/7/2015.

6. Paul A. Merriman. 22 things you should know about bear markets. Aug 24, 2015. MarketWatch.Inc, ©️2016.

7. Tim McMahon. Average annual inflation rates by decade. June 18, 2015.

8. Compound interest calculator. PracticalMoneySkills.com. ©️2010 Visa.

Copyright © 2016 Douglas R. Knight


Book review: The Index Card, by Helaine Olen and Harold Pollack

May 5, 2016

The Index Card. Why Personal Finance Doesn’t Have to Be Complicated. Helaine Olen and Harold Pollack. Penguin Random House, New York, 2016.

Genesis

The authors converged their experiences from  journalism (Helaine Olen) and academia (Harold Pollack) into the worthy effort of demystifying the world of personal finance for everyone’s benefit. Author Pollack began the process by devising an index card of rules for recovering from financial hardship and staying solvent. Author Olen’s experience with the Personal Finance Industry validated Pollack’s scheme. Together, they explain the index card to readers of this valuable book.

Rules from the Index Card

  1. Strive to save 10-20% of your income.
  2. Pay your credit card balance in full every month.
  3. Max out your 401(k) and other tax-advantaged savings accounts.
  4. Never buy or sell individual stocks.
  5. Buy inexpensive, well-diversified indexed mutual funds and exchange-traded funds.
  6. Make your financial advisor commit to the fiduciary standard.
  7. Buy a home when you are financially ready.
  8. Insurance- make sure you’re protected.
  9. Do what you can to support the social safety net.
  10. Remember the Index Card

Highlights

Rule #1. The household budget is essential for living comfortably. Be sure to save 10-20% of your income for future needs. The most important savings account is an emergency fund; every household should save 3 months of income in an accessible savings account to use for emergency expenses. —An emergency expense is both immediate and necessary; something bad has happened.—

Rule #2. Unpaid debt has top priority in your budget. Credit card debt is a preventable financial illness that must be corrected. Other forms of debt must also be managed within the framework of a budget.  Unfortunately, there may be unpreventable causes of overwhelming debt such as health care bills and other catestrophic events. Overwhelming debt may require seeking legal advice to file for bankruptcy; don’t feel ashamed.

Rule #3. The second most important savings account is your retirement fund and/or educational savings account. Start while you’re young to take advantage of the compound interest (a.k.a. compounding returns) from investments in either account. DON’T REJECT employer-sponsored retirement savings plans and DO participate in them to the full extent. You can also open personal retirement savings accounts. Facilitate your savings plan by making direct deposits into the retirement and educational savings accounts.

Rule #4. The media’s ‘toxic’ message is that playing stocks is easy and fun. But no matter how much research you do, buying stocks is still a matter of speculation. Stocks are a pay-to-play business where only the broker can always win. Forego the dream of a big win by investing in a small selection of index funds.

Rule #5. Index funds are designed to automatically match the performance of a selected stock- or bond market index. Index funds are true buy-and-hold investments. Most exchange-traded funds (ETFs) and a few mutual funds are index funds. They charge lower management fees than the actively managed mutual funds. Actively managed funds charge higher fees in order to pay for the research needed to outperform the stock or bond market. Few actively managed funds succeed in their effort to beat the market on a sustained basis. Annual management fees for index funds (~0.12%) are lower that for actively managed funds (~0.89%). The average household loses $155,000 in potential investment gains due to the unnecessary fees of actively managed mutual funds.

Rule #6. Most financial advisors are salespeople who chase a profit at your expense. They are not your friend. However, you still have to pay for good advice from a fiduciary advisor. A fiduciary advisor is responible for acting in your best interest, hopefully providing the best advice at lowest cost. The fiduciary advisor is usually a certified financial planner (CFP), registered investment advisor (RIA), fee-only advisor, or robo-advisor who is a proven fiduciary. It’s important to seek a fee-only advisor who is paid by you and only you. The advisor may charge a percentage of your assets under management, a flat fee, or an hourly fee.

Rule #7. Spend no more than 30% of your budget on housing. There are risks and advantages to either renting or buying a home. The authors discuss both.

Rule #8. Insurance is complicated but necessary. Don’t be exploited by salespeople. The 6 Golden Rules of Insurance are:

  1. buy term life insurance
  2. buy high-deductible property insurance
  3. buy a health care plan that pays your provider
  4. buy umbrella insurance that is twice your net worth
  5. avoid complicated annuities
  6. keep an emergency fund

Rule #9. We can’t protect ourselves from everything; sometimes we need a little help. The government is our insurance-backer of last resort. 96% of us have used government financial support to improve our financial situation. Isn’t it our fiduciary duty to Society to support the best government insurance programs?

Conclusions

I concur with the authors’ advice. The strength of their advice is supported by pages of references at the end of the book. Read and re-read their book.


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