Category Archives: Long-term investing

Is My Portfolio at the Right Risk Level?

This is the fifth installment in our series on how individual investors can assess their financial health.

RiskAt every stage of investing, you should periodically ask yourself how much risk you can realistically tolerate. The primary way to measure the risk level of your portfolio is to look at its allocation of stocks vs. bonds.  Although some stock and bond ETFs  are riskier than others, your first decision has to be how much of your investments to put in stocks and how much in bonds.

One standard rule of thumb that’s a good place to start is the “age in bonds” axiom. According to this guideline, you invest a percentage of assets equal to your age in a broad bond index, and the balance of your portfolio in a diversified stock portfolio.  The idea here is that your portfolio should become more conservative as you get older. This makes sense for two reasons:

  1. You tend to get wealthier as you age, so any given percentage loss from your portfolio represents an increasingly larger dollar value.
  2. You are gradually converting your human capital (your ability to work and earn money) into financial capital (investments) as you age. And as you get older, your financial assets represent a larger and larger fraction of your lifetime wealth potential.

For these reasons, it makes sense  to manage this pool of assets more conservatively as time goes by.

Beyond “Age in Bonds” – Choosing Your Allocation of Stocks and Bonds

The past decade provides a powerful example of the tradeoffs between risk and return.  The table below shows the year-by-year returns for portfolios comprising different mixes of an S&P 500 ETF (IVV) and a broad bond ETF (AGG).  The returns include the expense ratios of the ETFs, but no adjustment is made for brokerage fees.

2004-2013 Allocation Performance

Source: Author’s calculations and Morningstar

Over the 10-year period from 2004 through 2013, a portfolio that is entirely allocated to the S&P 500 ETF has an average annual return of 9.2%.  In its worst year over this period, 2008, this portfolio lost almost 37% of its value.  As the percentage of the portfolio allocated to stocks declines, the average return goes down. But the worst 12-month loss also becomes markedly less severe.

We cannot say, with any certainty, that these statistics for the past ten years are representative of what we can expect in the future, but they do provide a reasonable basis for thinking about how much risk might be appropriate.

Ask yourself: If these figures are what you could expect, what allocation of stocks vs. bonds would you choose?  Would you be willing to lose 37% in a really bad year to make an average of 9.2% per year?  Or would you prefer to sacrifice 1.5% per year to reduce the potential worst-case loss by one third?  If so, the 70% stock / 30% bond portfolio provides this tradeoff.

Planning around Improbable Events

One might object that 2008 was an extreme case, and that such a bad year is unlikely to recur with any meaningful probability.  One way to correct for this potential bias towards extreme events is to assume that returns from stocks and bonds follow a bell curve distribution, a common way to estimate investment risk.  Using the data over the last ten years to estimate the properties of the bell curve (also known as the “normal” or Gaussian distribution), I have estimated the probabilities of various levels of loss over a 12-month period.

9-30-2014b

Estimated 12-month loss percentiles for a ‘normal’ distribution (Source: author’s calculations)

When you look at the figures for the 5th percentile loss, you can see what might be expected in the worst 5% of 12-month periods for each of the five portfolio types. For example, the 100% stock portfolio has a 1-in-20 chance of returning -21% or worse over the next twelve months. Note that a loss of 35% for stocks, similar to 2008, is estimated to have a probability of 1-in-100.

It’s important to point out that the ability to calculate the probability of very rare events is very poor.  Perhaps 2008 really was a 1-in-100 probability event, but we don’t know that with any certainty.  The most catastrophic events (what Nassim Taleb has famously dubbed “Black Swans”) are so severe and outside our normal range of experience that they tend to catch us totally off guard.

Moshe Milevsky, a well-known retirement planning expert, suggests that rather than thinking in terms of probabilities, it’s sensible to set your portfolio’s risk to a level that ensures that the worst case outcomes are survivable. Based on that, it’s prudent to choose a portfolio risk level that won’t ruin you if there’s another year like 2008. If you can survive a 12-month loss of 23% (the average of the worst loss for this allocation over the past ten years and the estimated worst-case 1st percentile return), for example, you can afford to hold a 70% equity portfolio.

Final Thoughts

If your investments in stocks don’t approximate the S&P 500, the stock portion of your portfolio may be considerably riskier than the table above implies.  Allocations to emerging markets, small companies, and technology stocks can be very volatile. The examples shown here provide a starting point in determining risk.  Combining a wider range of asset classes can provide important diversification benefits beyond their individual risk levels, but this topic is beyond my scope here.

The past ten years have provided examples of very high returns and very low returns from stocks. This period gives us a useful basis for testing our tolerance for volatility.  Many readers, I imagine, will find that their risk tolerance—self-diagnosed from looking at the tables above—corresponds reasonably well to the “age in bonds” rule. If your choice of risk levels is too far from these levels, a closer look is needed—and perhaps a talk with an investment advisor.

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Am I Better Off Investing or Paying Down Debt?

Emergency Fund vs. Paying Off Debt - Which should you contribute to first?This is the fourth installment in our series on how individual investors can assess their financial health.

A common dilemma in personal finance is whether to use funds to pay down debt faster or to invest more. The question crops up in various forms:

 

  • Should I pay off all credit card debt or make smaller payments while saving more for retirement?
  • Should I pay extra on my mortgage or invest in securities?
  • Should I pay down my student loans faster or invest more?

Financial health requires both savings and control over debt. But when these two goals seem to be in conflict, what’s the best way to balance them? Consider these six ways to prioritize.

  1. Make sure you get your employer match. If you’re lucky enough to have an employer that matches your contributions to the workplace 401(k) plan, your first priority is to maximize the employer match. It’s too good to pass up. Contribute any less than what’s matched, and you’re refusing the offer of free money.
  2. Tackle costly credit card debt. Once you are saving enough to secure your entire employer match, you can focus on paying down debts faster. The goal is to pay off all credit card debt as quickly as possible. The interest rates on credit card debt are typically so high that nothing else you do with your money is likely to be as profitable.
  3. Beef up your emergency fund. When you’re beyond the hurdle of credit card debt, consider building out your emergency fund.  If you don’t have sufficient emergency savings to cover a serious car repair, a trip to the emergency room or other not-so-infrequent disasters, this is the next focus.
  4. Save enough in retirement accounts. Assuming you have no credit card debt and decent emergency savings, you can move on to the next set of priorities. If you are saving less than 10% of your pretax income in retirement accounts, ramping up your contributions is probably a better bet than paying extra on your student or auto loans or mortgage. Contributions to retirement accounts are tax advantaged, and it is almost impossible to catch up if you delay retirement savings.
  5. Decide whether to save more or pay down your mortgage. Only when you have no credit card debt, a healthy emergency fund, and you’re saving at least 10% of your pretax income should you consider making additional investments or speeding up your mortgage payments.

But when you compare the cost of having a mortgage to the possible returns from investing elsewhere, don’t forget the tax deduction on mortgage interest. Because of that deduction, your effective (after-tax) interest rate on your mortgage is lower than your actual mortgage rate. There are handy online calculators that can quickly calculate the effective interest rate on your mortgage, accounting for tax benefits.

If you are confident that you can invest at a rate of return that’s at least as high as your effective mortgage rate, you may want to hang on to the mortgage and invest more.  Over the past few years, many consumers have taken out mortgages with effective interest rates of 3% or less.  At this level of interest, there are investment alternatives that make more sense.

Also remember that extra principle payments come with liquidity risk. That is, if you need a source of cash, it may be easier to sell a security investment. To take cash out on your mortgage, you will have to refinance or open a line of credit.  Either of these may come with a higher cost than your current mortgage, not to mention origination fees.

  1. Decide whether to save more or pay down college debts. If your income is below $75,000 per year ($155,000 for a couple filing jointly), some or all of the interest that you pay on college loans may be tax deductible. So the effective rate of interest on your college loans may be lower than the actual rate. Take that into account when you compare your loan interest with potential investment earnings.

An additional consideration may be whether a parent or grandparent cosigned your student loans.  If you become disabled or die—or you’re simply unemployed for a long period of time, your consignors may have to pay your college loans.  That risk may make it worthwhile to pay off college loans faster.

Accounting for Uncertainty

If you could be sure that you’ll never lose your job and that you’ll always be able to open a low-cost line of credit, the decision to pay off debts would be much easier.  But you have to look beyond comparing interest rates on debt to the expected returns from investments. You have to consider that credit may not always be available at today’s rates.

With mortgage rates as low as they are now, paying down a mortgage does not look like the most attractive choice. Once you’ve paid off all high-cost revolving credit (e.g. credit cards), have a solid emergency fund, and you’re saving 10% of your income in retirement accounts, however, it’s worth considering paying down college debts.

Putting non-retirement money into risky investments like stocks before you have accomplished the milestones listed above makes your overall financial situation more risky.  Whether or not this is too much risk depends on you.

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Am I Saving Enough to Reach My Goals?

This is the second installment in our series on how individual investors can assess their financial health.

Am I saving enough to reach my goals?The starting point for any discussion of a household’s financial health is to evaluate current savings and savings rates in the context of financial goals.  The three largest expenses that most families will face are buying a home, paying for college, and providing income in retirement. Setting specific savings targets and timelines is a key step in increasing your ability to meet these goals.

To determine whether you are saving enough to pay for one or more of these goals, consider the following factors:

  • Expected total cost of goal
  • When the money is needed
  • Current amount saved for the goal
  • Expected annual rate of saving towards the goal
  • How much risk to take in investing to meet the goal

Retirement

A good first step for estimating how much you’ll need for retirement—and how you’re doing so far—is to try Morningstar’s Retirement Savings Calculator.  This tool uses a range of sensible assumptions (which you can read about in the study from which it was developed) to estimate whether you are saving enough to retire.  The study accounts for the fact that Social Security represents a different fraction of retirement income for households at different income levels and assumes that investments are consistent with those of target date mutual funds.  The calculator scales income from your current age forward, based on historical average rates of wage growth.

Are you saving enough for retirement?

The calculations assume that you will need 80% of your pre-retirement income after subtracting retirement contributions, and that you will retire at age 65.  The estimated future returns for the asset allocations are provided by Ibbotson, a well-regarded research firm (and wholly owned subsidiary of Morningstar).

The final output of this model is a projected savings rate that is required for you to meet the target amounts of income.  If this is less than you currently save, you are ahead of the game.

College

There are enormous variations in what a college education costs, depending on whether your child goes to a public or private institution and whether those who choose public schools stay in-state.  There is also a trend towards spending two years at a community college before transferring to a larger comprehensive university.    estimates that the average annual all-in cost of attending a public four-year university is $23,000 per year, while the cost of attending a private four-year university averages $45,000 per year.  This includes tuition, room, board, books and other incidentals.  It is worth noting, however, that the all-in cost of private universities are often far above $45,000 per year.  The University of Chicago has an all-in cost of $64,000 per year.  Yale comes in at $58,500.

Every college and university has information on current costs to attend, as well as a calculator that estimates how much financial aid you can expect to be given, based on your income and assets.  There are a variety of ways to reduce the out-of-pocket cost of college including work-study, cooperative education programs, and ROTC.  There are also scholarships, of course.

College tuition and fees have been rising at about 4% per year beyond inflation for the past three decades.  With inflation currently at about 2%, the expected annual increase in college costs is 6%.

To be conservative, assume that money invested today in a moderate mix of stocks and bonds will just keep up with inflation in college costs.  Vanguard’s Moderate Growth 529 plan investment option has returned an average of 6.9% per year since inception in 2002 and 6.4% per year over the past ten years.  In other words, $23,000 invested today will probably pay for a year at a public four-year university in the future.  You can invest more aggressively to achieve higher returns, but taking more risk also introduces an increased exposure to market declines.

Using the simple assumption that money invested today in a moderately risky 529 plan or other account is likely to just keep pace with cost inflation makes it easy to figure out how you are doing in terms of saving.  If you plan to pay the cost of your child’s four-year in-state education and you have $46,000 invested towards this goal, you are halfway there.

Buying a Home

A house is a major financial commitment—one of the most significant that most people make.  Unlike retirement or education, there is an alternative that provides the same key benefits: renting.

For people who decide to buy, a key issue is how much to save for a down payment.  The amount that a lender will require depends on your income, credit score, and other debts.  Zillow.com provides a nice overview, along with an interactive calculator of down payment requirements. This tool can help estimate how all of the factors associated with obtaining a mortgage can vary with the down payment.

In general, the goal is to have a down payment ranging from 5% to 20% of what you plan to spend on a home.  By experimenting with the calculator at Zillow, you can determine how much house you can afford and how much you will need to put down.  A down payment of 20% or more is the most cost-effective route because smaller down payments require that you buy mortgage insurance, which adds to the monthly payment.

There are several alternatives for investing a down payment fund.  The primary consideration, however, is whether you are willing to adjust your timeframe based on how the market performs.  If you are committed to buying a house within one to three years, you really cannot afford to take on much risk.  If you are looking at a timeframe of five years or more—or if you hope to buy in one to three years but you are comfortable delaying if market returns are poor—you can afford to take more risk.  There is no single answer for everyone.

If you are investing only in low-risk assets, however, estimating how much you need to save each month for a required down payment is straightforward enough, because the current expected rate of return on safe assets is close to zero.

 

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How Am I Doing? An 8-Point Financial Checklist

How am I doing?A question that nags at many people is whether they are on track financially.  Even an average financial life can seem remarkably complex.  How does anyone know whether he or she is doing the right things?  A range of studies on how people manage their money suggests that many, if not the majority, are making choices that look decidedly sub-optimal.  Americans don’t save enough money and when they do save and invest, they often make basic mistakes that substantially reduce their returns.  More than 60% of self-directed investors have portfolios with inappropriate risk levels.  Almost three quarters of Americans have little or no emergency savings.  The solution to these problems starts with an assessment of where you are and where you need to be.

The key, as Einstein once said, is to make things as simple as possible but no simpler.  In an attempt to provide a checklist that’s in line with this edict, I offer the following questions that each person or family needs to be able to answer.

The first three questions focus on consumption and saving:

  1. Am I saving enough for to meet personal goals such as retirement, college education, and home ownership?
  2. Am I saving enough for contingencies such as a job loss or an emergency?
  3. Am I investing when I should be paying down debt instead, or vice-versa?

The next five questions deal with how you invest the money that you save:

  1. Is my portfolio at the right risk level?
  2. Am I effectively diversified?
  3. Am I aware of how much am I paying in expenses?
  4. Are my financial decisions tax efficient?
  5. Should I hire an investment advisor?

Anyone who can answer all eight of these questions satisfactorily has a strong basis for assessing whether he or she is on track. Odds are there are more than a few questions here that most of us either don’t have the answer to or know that we are not addressing very well.

Part of what makes answering these questions challenging is that the experiences of previous generations are often of limited relevance, especially when it comes to life’s three biggest expenditures: retirement, college, and housing.

For example, older people who have traditional pensions that guarantee a lifetime of income in retirement simply didn’t need to worry about choosing how much they had to save to support themselves during retirement.

The cost of educating children has also changed, increasing much faster than inflation or, more crucially, household income.  For many in the older generation, college was simply not a consideration. It has become the norm, however, and borrowing to pay for college is now the second largest form of debt in America, surpassed only by home mortgages.  Children and, more often their parents, must grapple with the question of how much they can or should pay for a college education, along with the related question of whether a higher-ranked college is worth the premium cost.

The third of the big three expenses that most families face is housing costs. Following the Second World War, home buyers benefitted from an historic housing boom.  Their children, the Baby Boomers, have also seen home prices increase substantially over most of their working careers.  Even with the huge decline in the housing crash, many Boomer home owners have done quite well with real estate.    Younger generations (X, Y, and Millenials), by contrast, have experienced enormous volatility in housing prices and must also plan for more uncertainty in their earnings.  And of course, what you decide you can afford to spend on a home has implications for every other aspect of your financial life.

In addition to facing major expenses without a roadmap provided by previous generations, we also need to plan for the major known expenses of everyday life. It’s critically important to determine how much to keep in liquid emergency savings and how to choose whether to use any additional available funds to pay down debts or to invest.  There are general guidelines to answering these questions and we will explore these in a number of future posts.

The second set of questions is easier to answer than the first.  These are all questions about how to effectively invest savings to meet future needs.  Risk, diversification, expenses, and tax exposure can be benchmarked against professional standards of practice.

What can become troubling, however, is that experts disagree about the best approach to addressing a number of these factors.  When in doubt, simplicity and low cost are typically the best choices.  Investors could do far worse than investing in a small number of low-cost index funds and choosing the percentages to stocks and bonds based on their age using something like the ‘age in bonds’ rule.  There are many ways to try for better returns at a given risk level, and some make far more sense than others.  Even Warren Buffett, arguably the most successful investor in the world, endorses a simple low-cost index fund strategy.  Upcoming posts will provide a number of straightforward standards for addressing these questions.

Investors who find these questions  too burdensome or time consuming to deal with may wish to spend some time on the eighth and final question: whether they should hire an investment advisor to guide them.  Investors may ultimately choose to manage their own finances, search out a human advisor, or use an online computer-driven advisory service.

While financial planning can seem complex and intimidating, our series of blog posts on the key issues, as outlined in the eight questions above, will provide a framework by which individuals can effectively take control and manage their financial affairs.

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Goldman Sachs Predicts 4.5% 10-year Treasury Yields

Treasury BondGoldman Sachs just came out with a prediction that 10-year Treasury bond yields will rise to 4.5% by 2018 and the S&P 500 will provide 6% annualized returns over that same period.  The driver for this prediction is simply that the Fed is expected to raise the federal funds rate.

Because rising yields correspond to falling prices for bonds, Goldman’s forecast is that equities will substantially outperform bonds over the next several years.  If you are holding a bond yielding 2.5% (the current 10-year Treasury yield) and the Fed raises rates, investors will sell off their holdings of lower-yielding bonds in order to purchase newly-issued higher-yielding bonds.  If Goldman’s forecast plays out, bondholders will suffer over the next several years, while equity investors will enjoy modest gains.

Historical Perspective

This very long-term history of bond yield vs. the dividend yield on the S&P 500 is worth considering in parsing Goldman’s predictions.

Bond Yield vs. Dividend Yield

Source: The Big Picture blog

Prior to the mid 1950’s, the conventional wisdom (according to market guru Peter Bernstein) was that equities should have a dividend yield higher than the yield from bonds because equities were riskier.  From 1958 to 2008, however, the 10-year bond yield was higher than the S&P 500 dividend yield by an average of 3.7%.

Then in 2008, the 10-year Treasury bond yield fell below the S&P 500 dividend yield for the first time in 50 years.  Today, the yield from the S&P 500 is 1.8% and the 10-year Treasury bond yields 2.5%, so we have returned to the conditions that have prevailed for the last half a century. But the spread between bond yield and dividend yields remains very low by historical standards.  If the 10-year Treasury yield increases to 4.5% (as Goldman predicts), we will have a spread that is more consistent with recent decades.

Investors are likely to compare bond yields and dividend yields, with the understanding that bond prices are extremely negatively impacted by inflation (with the result that yields rise with inflation because yield increases as bond prices fall), while dividends can increase with inflation.  During the 1970’s, Treasury bond yields shot up in response to inflation. Companies can increase the prices that they charge for their products in response to inflation, which allows the dividends to increase in response to higher prices across the economy.  The huge spread between dividend yield and bond yield in the late 70’s and early 80’s reflects investors’ rational preference for dividends in a high-inflation environment.

What Has to Happen for Goldman’s Outlook to Play Out?

To end up with a 4.5% 10-year Treasury yield with something like a 2% S&P 500 dividend yield, the U.S. will need to see a sustained economic recovery and evidence of higher prices (inflation) driven by higher employment and wage growth.  In such an environment, investors will be willing to accept the lower dividend yield from equities because dividends grow over time and tend to rise with inflation.  This has been the prevailing state of the U.S. economy over the last fifty years.  Most recently, we had 10-year Treasury yields in the 4%-5% range in the mid 2000’s.  If, however, we continue to see low inflation and stagnant wages in the U.S. economy, bond yields are likely to remain low for longer.

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REITs and the Rally of 2014

There have been a number of surprises for investors in 2014.  Bonds have markedly out-performed stocks for the year-to-date.  The S&P500 is up 2.4% since the start of 2014, as compared to the Barclays Aggregate Bond Index, which is up by 3.5%.  Even more striking, the iShares 20+ Year Treasury Bond ETF (TLT) is up by 12.5% YTD and the Vanguard Long-Term Bond fund (VBLTX) is up by 11.4% YTD.  Interestingly, REITs have been also experienced a substantial run-up in 2014 so far.  The Vanguard REIT Index fund (VGSIX) is up 16.1% YTD and the iShares U.S. Real Estate ETF (IYR) is up by 14.4% YTD.

To understand the rally in REITs, it is useful to start with an overview of this asset class.  REITs are neither stock (equity) nor bond (fixed income).  A REIT uses investor money, combined with borrowed money, to acquire real estate.  The properties that they acquire can be office buildings (BXP, SLG), apartment buildings (EQR, UDR), healthcare facilities (HCP, HCN), or even digital data centers (DLR).  The returns vary between the specific types of property owned.  REITs make money from renting their facilities out.  Please note that I am discussing only equity REITs (those which own property).  There is a secondary form of REITs that buy baskets of mortgages.  These are called mortgage REITS (mREITs).

REITs are classified as ‘pass-through’ or ‘flow-through’ entities and pass at least 90% of their taxable income to their shareholders each year.  For this reason, REITs are often favored by income-oriented investors.

REITs have their own unique measures of value and drivers of performance.  Rather than price-to-earnings ratio, a measure of the valuation of stocks, the preferred measure of valuation for REITs is price-to-funds from operations (FFO).  A notable feature of REITs is their exposure to interest rates.  In general, stocks go up when interest rates rise, while bonds fall.  When interest rates decline, the reverse tend to be true: stocks decline and bonds rise in value.  REITs tend to have a fairly neutral response to changes in interest rates, although this varies.  To the extent to which REITs need to borrow in the future due to rolling credit or new financing, their costs rise when interest rates rise.  REITs often also have the ability to raise rents, however, so that their revenue can also rise when the costs of residential or commercial real estate rise with inflation.  In addition, because REITs own a physical asset (property), the value of the assets owned by the REIT tend to go up with inflation.

An examination of the performance statistics of REIT funds illustrates their properties quite clearly.

Chart 1

REIT funds vs. major asset classes (10 years through April 2014)—Source: Author’s calculations

The returns above are the arithmetic average of returns over the past ten years, including reinvested dividends.  Beta measures the degree to which an asset tends to amplify or mute swings in the S&P500.  The betas for VGSIX and IYR show that these funds tend to rise 1.3% for every 1% rise in the S&P500 (and vice versa).  These broad REIT funds tend to do well in rising stock markets and will also tend to perform worse than the S&P500 when the market crashes.  The S&P500 fell 36.8% in 2008, for example, and IYR fell 39.9%, for example.  The high beta is only one factor that determines the returns from these REIT index funds, however.  Despite a massive decline in real estate in 2008, the average annual return for these two REIT funds has been very high over the past ten years.  The volatility levels exhibited by these REIT funds is, however, very close to that of emerging market stocks, as shown above.

The best way to understand the unique features of REITs is to look at the correlations in the returns between asset classes, bond yields, and the returns from a traditional 60/40 portfolio (60% stocks, 40% bonds).

Chart 2

Correlations between monthly returns over the past ten years (through April 2014) for major asset classes, 10-year Treasury bond yield, and the returns from a 60/40 portfolio—Source: Author’s calculations

Equity indexes tend to have positive correlations to Treasury bond yields (because yield goes up when bond prices go down, and vice versa).  This effect is evident in the table above.  S&P500 stocks (represented by SPY) have a +30% correlation to the 10-year Treasury yield.  The same relationships hold for the other major equity classes in the table above (EFA, EEM, QQQ, and IWM), with correlations to the 10-year Treasury yield ranging from 20% (EFA) to 36% (IWM).  In 2013, Treasury bond yields rose and stock indexes gained substantially.  By contrast, the returns of bond funds (AGG, TLT) are negatively correlated to the 10-year Treasury bond yield.  The returns from these funds tend to be positive when Treasury yields are falling and vice versa.

Treasury bond yields follow interest rates and inflation.  When rates or inflation rise, bond yields rise because investors sell Treasury bonds to avoid getting caught with relatively low-yield bonds in a higher rate environment.  The selling continues until the yield on the bonds is in line with new rates.  This is why returns on the two bond funds are so negative correlated to Treasury yield.  When yields go up, bond prices fall and vice versa.

VGSIX and IYR have 6% and 7% correlations to the 10-year Treasury yield—which means that these REIT funds are not highly sensitive to movements in bond yields.  While investors were betting on rising yield in 2013, opinion seems to have shifted in 2014.  If you are looking for asset classes that don’t require a bet on whether interest rates will go up or down, REITs look pretty attractive.

The correlations between the returns from each asset class and the returns from a 60% stock / 40% bond portfolio show the degree to which adding these asset classes to a simple stock-bond mix is likely to provide diversification benefits.  The higher the correlation, the less diversification benefit you can expect.  The key idea in diversifying a portfolio is to combine assets with low correlations so that when one is losing money, others are likely to be doing something different (hopefully rising in value).  As compared to the major equity asset classes, the REIT funds have a lower correlation to the 60/40 portfolio.  This, in turn, suggests that REITs can provide more diversification benefit than equities to a portfolio that currently holds stocks and bonds.

In summary, the basic narrative to explain the rally in REITs goes something like this.  REITs provide substantial income compared to bonds and equities, as well as being essentially interest rate neutral.  While REITs are a volatile asset class, the relatively low correlation between REITs and equities provides diversification benefit to a portfolio of domestic stocks and bonds, as well as providing some modest protection from rising interest rates.  REITs appear have come back into favor after being sold off during and after the so-called taper tantrum of 2013, with yield-hungry investors leading the charge.  In a slow-growth environment, with the Fed indicating that they foresee an extended period of low rates, REITs look quite attractive.  The caveat to the positive view on maintaining an allocation in REITs is that there are substantial differences between the yield, risk, and interest rate exposure and that REITs have historically been a volatile asset class.  Unless you firmly believe that you can outsmart the broader market, REITs should be thought of as a long-term income producer and diversifier.  For those investors who have maintained a strategic allocation to REITs, the gains in 2014 YTD have helped to bolster portfolio returns as equities have provided very little to investors beyond their dividends.  The downside to this positive narrative, however, is that increased prices for REITs translate to lower yields for today’s buyers.

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Understanding How Fund Performance Comparisons Overstate Returns

May 13, 2014

Every investor has, I hope, read the standard disclaimer on mutual fund and ETF performance documents that ‘past performance does not predict future performance,’ or other text to that effect. Still, when you read a fund company’s statement that ‘x% of our funds have out-performed their category average’ or that ‘x% of our funds are rated 4- and 5-star by Morningstar,’ this seems meaningful. Similarly, if you read that the average small value fund has returns ‘y’% per year over the last 10 years, this also seems significant. There is a major factor that is missing in many of these types of comparisons of fund performance, however, that tend to make active funds look better than they really are (as compared to low-cost index funds) as well as making a mutual fund family’s managers look more skillful than they might actually be.

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