The key variables that determine the future cost of a college education are:

(1) How many years remain until your son or daughter starts college

(2) Whether they will attend a public or private college

(3) How long they will remain in college, and

(4) Whether they will actually pay the “sticker price,” or receive financial aid, grants, scholarships (etc., etc.)

The Morningstar calculator assumes that your student will, in fact, be paying the full advertised cost of the average public or private university. This is a fairly large limitation to the utility of the tool all by itself. The average student does not pay the advertised price of attendance. In fact, the average student at a private four-year college or university actually pays -33% less than the advertised total tuition and fees. At public schools, the discount is smaller, but is still substantial: 18% less. Even students from families in the highest quarter (e.g. 75th percentile) of income received substantial discounts from the sticker price. There is increasing evidence that the advertised price (the ‘sticker price’) of attending an institution of higher education is considerably higher than most students pay. Higher ‘sticker price’ for college attendance may simply be a way for colleges to signal that they are desirable, with students actually ending up paying less when they attend. For an interesting summary of this issue, see the following piece titled, “College is Cheaper Than You Think,” by Judith Scott-Clayton at the NY Times Economix blog. But, for the moment let’s set this issue aside and move along in looking at Morningstar’s calculator.

The estimates of future college costs start with the current average advertised costs for 4-year private, 4-year public, and 2-year colleges. These figures are obtained from The College Board. If you are a parent who has not perused these numbers recently, these numbers may come as something of a shock. The average advertised cost of attending an in-state 4-year college is $19,388 per year. The next step in the calculator is the assumption that college costs will continue to rise at 7% per year, which is around the long-term average inflation rate determined by the College Board. The article by Judith Scott-Clayton cited above, suggests that the actual costs that students end up paying has not risen at all over the past five years and has actually declined slightly, so the 7% escalation rate may be thought of as a rough estimate.

So, on the cost side, the Morningstar calculator looks to be on the high side of what we might actually expect in terms of future college costs. What about on the savings and investing side?

The Morningstar calculator uses a simple return rate for savings prior to starting college and a second simple return rate during college. By ‘simple return rate’ I mean that the calculator assumes that you will get a fixed rate of return each year without consideration for taxes. For the pre-college years, the baseline assumption is that college savings will generate a 5% annual rate of return. Because the calculator ignores variability in returns from year to year, it is essentially assuming that you can find some way to get a risk-free 5% per year. This is an unrealistic assumption. There is, in fact, nothing close to a 5% return than can be achieved risk-free. Because of the use of a constant projected rate of return on invested college savings, the Morningstar calculator will tend to under-estimate the savings rate that will be needed to be able to generate the targeted level of savings with a high degree of confidence. There is also a drop-down menu that allows the user to select historical rates of return that are representative of standard asset classes (stocks, bonds, etc.) but the returns provided here are (according to a footnote) the net-of-inflation returns. The rate of escalation for college costs is in nominal dollars (not net of inflation), so there seems to be a mismatch here.

Ultimately, the estimated costs of college attendance generated by this calculator are probably too high, while the estimated returns that you can get on your college savings are also too high. These two errors will tend to cancel each other out, so that the estimated necessary savings rate to be able to fund college are probably pretty reasonable.

The current cost of a four-year degree in-state at a public university is around $80,000. This is a substantial sum of money and it is not surprising that the average college graduate who borrows to attend school now leaves school with $25,000 in debt. Given the high costs of a college education, calculators like the one provided by Morningstar, are valuable in helping parents and future college students decide how to weigh the costs and benefits of their college choices.

A range of commentary suggests that the growing prevalence of college-related debt has the potential to be the next great financial crisis in America. The ‘easy money’ decades that enabled the real estate bubble also allowed colleges to increase their tuition and fees at a much faster rate than inflation, by providing a ready stream of students who simply borrowed more to compete for slots in desirable schools. This debt-funded competition for education made only slightly more sense than the debt-funded bubble in real estate. For parents and potential students, running a calculation for the future costs of education will range from mildly shocking to downright terrifying. No matter the limitations with a calculator such as Morningstar’s, having a baseline estimate of the true costs of a college education can help to inform better choices.

The final and critical piece of any discussion of the total costs of going to college is examining what the payoff is for the student. The Morningstar calculator does not tackle this additional topic. While there is data that suggests that college graduates have vastly higher lifetime earnings, the proposition needs to be examined in terms of whether any person’s specific choice of college and major is a plausible match to their future earning power.

Related Links:

• The Five Biggest Financial Issues for People with Children at Home
• Dividend Stocks vs. Bonds: Are They Worth the Risk?
• The Disappearing Retirement

Folio Investing The brokerage with a better way. Securities products and services offered through FOLIOfn Investments, Inc. Member FINRA/SIPC.

 The arguments made by the WSJ article are similar to those in a November 2011 blog post by Vanguard’s Chief Economist, Joe Davis, titled “Dividend-Paying Stocks Are Not Bonds.” Similar thinking on this topic can also be found in a 2010 article by Larry Swedroe, a well-known advisor and financial columnist, titled “Why a High-Dividend Stock Strategy Isn’t a Good Approach.” 

 The main implication of these articles is that investors are simply chasing yield and are moving money from low-yield Treasury bonds into higher-yield dividend-paying stocks.  This may be true, but there are some ideas that show up quite frequently in these debates over the relative merits of dividend stocks vs. bonds that do not get sufficient attention. 

A central theme of these articles is that investors do not understand that dividend-paying stocks are (in general) riskier than bonds, and that simply looking at yield is likely to lead them into ramping up the risk levels in their portfolios. This concern is certainly valid. As I show below, dividend stock funds tend to be much riskier than intermediate government bond funds. There is, however, a crucially important point that seems to get lost in this discussion: With the yields on Treasury bonds as low as they are, there are very rational reasons to adjust allocations to reduce the exposure to Treasury bonds and increase exposure to dividend-paying stocks. 

I explored this topic in a previous Portfolioist post titled, “Burton Malkiel: Buy Munis, Foreign Bonds and Dividend Stocks,” which was based on a December Op Ed piece by Burton Malkiel. Malkiel, who may be largely credited with providing the intellectual foundation for simple indexed portfolios, proposes that the current state of the market is so extreme that traditional bond allocations need to be reconsidered. In particular, he believes that the yield of Treasury bonds is so low that the long-term inflation-adjusted yield on these bonds is likely to be negative, and proposes that municipal bonds and dividend-paying stocks should see increased allocations, while Treasury bonds should see their allocations reduced.  Not surprisingly, Malkiel’s position was denounced by index fund purists who believe that such a change in basic asset allocation smacks of market timing. 

 To really think through the idea of substituting income asset classes for all (or part of) a Treasury bond allocation, it is crucial to compare both the yields and risks of possible asset allocations.  By way of example, I have selected a number of ETFs that represent different parts of the income-generating asset universe (see table below). 

Sample of Asset Classes and Representative ETFs.

It is straightforward to obtain the yields for these ETFs.  It is also simple to obtain the historical risk levels of the individual ETFs (from Morningstar, for example).  Calculating the historical volatility of a portfolio is a little harder, and calculating a forward-looking simulation of risk is considerably more involved.  In the table below, I have compiled these figures for a number of alternative portfolios. 

Model Portfolios: Yield vs. Risk (Historical Risk is Trailing 3-Year Volatility and Projected Risk is From Monte Carlo Simulations.)

The first ‘portfolio’ is 100% allocated to an intermediate Treasury fund (IEF).  This ETF has a 2.5% yield as of this writing and historical and projected risk levels that are very similar.  What does 7% volatility mean?  My standard rule of thumb is that you can lose roughly twice the volatility in a plausible ‘worst case.’  So, with IEF you are getting paid 2.5% in yield and may face roughly 14% – 15% in losses in a really bad 12-month period.  The most recent Consumer Price Index data shows a 12-month change of 3%, so the yield of this fund is below the rate of inflation. 

An investor who allocated 1/3 of his money into each of the three representative dividend-oriented stock funds (DVY, SDY, and VIG) would end up with a higher yield (2.9%) but a vastly higher risk level, with historical volatility of 16.8% and projected future volatility of 17.9%.  In other words, such a portfolio has slightly higher yield than the Treasury fund but more than twice the risk.  This hardly seems like a good tradeoff.  I would imagine that this sort of simple-minded substitution is what authors are warning against.  This is not the whole story, however. 

The third sample portfolio in the table above is a simple combination of 20% allocated to dividend stocks (DVY), 40% allocated to investment-grade corporate bonds (LQD), and 40% allocated to a national insured municipal bond fund (PZA).  This portfolio has 4.1% yield, markedLY higher than that of the Treasury fund, and also has less risk than the Treasury fund on a trailing and forward-looking basis.  Even if we are willing to raise the maximum risk level of our model portfolio to 7.7% (the projected volatility for a 100% allocation to IEF), there is no allocation to Treasuries that will raise the yield of this portfolio. 

It is important for anyone contemplating this type of substitution to understand that while the risk levels of the portfolio yielding 4.1% above is similar in magnitude to that of the intermediate Treasury index, the sources of risk are different.  The returns from IEF have a -98% correlation to the 10-year Treasury yield.  All of the risk in IEF is interest rate risk.  In the portfolio that mixes dividend stocks with muni bonds and corporate bonds, the return has only a -9% correlation to the 10-year Treasury yield.  The risk in this portfolio is a combination of interest rate risk, corporate default risk, municipal default risk, and market risk.

What these results demonstrate is that while it is correct that simply replacing bonds with dividend-paying stocks is quite likely to result in a massive increase in portfolio risk, there are intelligent arguments which support investors scaling back on their allocations to Treasury bonds and adding allocations to dividend-paying stocks.  The key to this process is to properly balance risk vs. yield. 

I deeply hope that there are not a lot of investors who sell Treasury bonds and buy dividend-paying stocks simply because the stocks have higher yield.  The possibility of such an ill-advised decision does not, however, detract from the fact that there are sensible ways to scale back Treasury exposure and increase allocations to other asset classes with more attractive yield-to-risk characteristics.

Related Links:

• The Disappearing Retirement
• Can You Create a 7% Yield Portfolio Focusing on Munis and Dividend Stocks?
• Can You Get 7% Per Year in Income with Only Moderate Risk?

Folio Investing The brokerage with a better way. Securities products and services offered through FOLIOfn Investments, Inc. Member FINRA/SIPC.

Well-known financial columnist Robert Powell has a recent article in MarketWatch titled, “Retirement in America is ‘Endangered.” The motivation for this piece, he writes, is that retirement preparedness is a crucially important topic that was missed in the recent State of The Union address by President Obama.

Powell goes on to list the key problems with the current ‘state of retirement’ in the United States:

1) Under-funding of Social Security
2) Low savings rates
3) Poor market returns over recent years
4) Inadequate levels of financial literacy
5) Half of American workers have no employer-sponsored retirement plan

All of these issues are critically important. In just one or two generations, we have shifted from a society in which employers provided lifetime retirement income via traditional pension plans, to one in which individuals now must manage every aspect of their financial futures, including how much to save and how to invest their retirement savings. The good news is that each of these five issues can be solved if we have the will to solve them.

Social Security

Regarding Social Security, it seems almost inevitable that the maximum income which is used to determine social security contributions will be raised and that the age at which workers are eligible to draw benefits from Social Security will be increased. Both of these solutions are discussed in Powell’s article, and these changes are likely to be unavoidable. The only alternatives would be to reduce benefits for current retirees, or to increase the Social Security tax rate itself, which would have a number of negative outcomes. First, Social Security would become a more regressive tax if the rates were simply increased, with lower earners paying even more and wealthier earners largely shielded from increased contributions. Reducing benefits for current retirees would surely be the most politically suicidal stance for any elected official to take. The shortfall in funding is most likely to be further shifted forward onto current workers and future workers. (For more on this topic, read “Social Security and Retirement: The Reality.”)

Savings Rates and Financial Literacy

Dealing with inadequate savings rates is the largest long-term retirement planning problem that we face as a nation. There is no way around the fact that Americans must save a higher fraction of what they earn. Savings rates can be increased somewhat with automatic enrollment into employer-sponsored 401(k) plans, but the majority of the savings increase will need to come from voluntary or mandatory increases in deferral of income into long-term savings plans. Personally, I would strongly support the idea of a mandatory contribution rate into a 401(k) plan, or IRA for those who do not have an employer-sponsored plan.

It is not uncommon to encounter articles that cite recent poor performance of the stock market as a key source of problems in retirement preparation. It is certainly true that the stock market has broadly under-performed many expectations, with an average annual return of 3.7% over the past ten years and 0.47% over the past five years.

However, this period of low returns is not, in fact, the real problem. The real problem is that many investors believed that the stock market would consistently deliver the kinds of high returns that prevailed over much of the 1990s, and there was no solid reason to believe that stocks would always deliver high returns. The fundamental issue may have been that investors do not really understand the balance of risk and return that risky asset classes such as stocks and real estate offer. Even over long holding periods, there is a real chance that an equity-heavy portfolio will substantially under-perform. We should not be making plans on the basis of the bet that stocks will perform well for us in our required time horizon.

Ultimately, low savings rates and lack of understanding of the real risks associated with many asset classes, result in investors betting their future retirements on asset allocations that may be too risky for them. Low savings rates and inappropriate risk choices ultimately come down to a combination of financial literacy (our fourth item in the list above) and behavioral issues (see also, “Are Americans Saving Enough for Retirement?“)

Financial literacy means that investors understand what they need to do, but understanding does not mean that people will do what they should. Taking a class on nutrition does not make you healthy. In other words, I totally agree that we need better vehicles for financial education but we, as a society, need to figure out how to motivate better financial decisions. As a society, we need to encourage frugality rather than overwhelmingly glorifying consumption.

Lack of Employer-Sponsored Retirement Plans

The fifth item in the list above identifies the problem that half of all American workers have no employer-provide retirement plan at all. This population is crucially important and does not get sufficient attention. We know that personal savings rates are very low, but it is a reasonable assumption that savings are lower for those people without retirement plans at work.

Powell makes a more pessimistic assertion:

“…the 75 million workers who don’t have a retirement plan at work aren’t saving anything at all for their golden years.”

The article discusses one proposal for the creating of “automatic” or “universal” IRAs that would allow any person to have a specific portion of their wages diverted to a retirement savings account. Simply creating accounts does not mean that people will, in fact, actually save.

So, what does all of this mean?

First, I think that it is clear that a traditional retirement in which retirees quit work at age 65 and enjoy something close to their pre-retirement income from a combination of Social Security and private pensions (either traditional pensions or 401(k)’s and similar plans) is increasingly unlikely for most Americans. The reality is that many (and perhaps a majority) of people will retire later and live in substantially reduced circumstances once they do retire. There will, of course, be a population of people who plan to work later in life but who cannot, due to poor health or bad economic conditions. For people who can secure employment, working longer will help to overcome lower saving rates or poor investment returns earlier in life. Having a substantial portion of the aging populace planning to work longer has implications for the broader economy, of course, and these implications are not well understood.

[Editor's Note: The Council of Economic Advisers just released, "Supporting Retirement for American Families 2012" which sheds additional light on the problems Americans face when saving for retirement. We think it's worth a read.]

Related Links:

• The Five Biggest Financial Issues for Pre-Retirees
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• New Study Released: How Much Americans Need to Save to Retire

The article suggests that the traditional process of seeking employment or demonstrating your work history and capabilities, (a.k.a. the résumé), is becoming far less relevant. Now anyone who cares about your work experience or professional accomplishments, can simply Google your name and find out for themselves.

The first example mentioned in the article sets the tone:

“Union Square Ventures recently posted an opening for an investment analyst. Instead of asking for résumés, the New York venture-capital firm—which has invested in Twitter, Foursquare, Zynga and other technology companies—asked applicants to send links representing their ‘Web presence,’ such as a Twitter account or Tumblr blog.  Applicants also had to submit short videos demonstrating their interest in the position.”

The rapid growth of social networking sites such as Facebook and LinkedIn (LNKD) is related to a broader social and economic trend that impacts individuals as they manage an asset that is of great importance to them over much of their lives: their social capital.

In fact, I agree with the definition of social capital that I recently found on Wikipedia:

“…social capital is anything that facilitates individual or collective action, generated by networks of relationships.”

It would be hard to come up with a better definition of social networks. Facebook and LinkedIn allow individuals to create a virtual presence that represents them and to create a series of explicit relationships—friends, likes, alumni groups, past employers, (etc., etc.). In a broader sense, however, the entire web is a social network that is unified by the search engines such as Google and Yahoo!

When you go to the web and search on someone’s name, you may find a LinkedIn entry, a Facebook page, a blog, and a personal website along with that individual’s past employers, awards or groups with which they have been involved. The Google rank for websites on any search is determined by a number of variables including the network of links between sites. The collective result of groups, blogs, and social networks with which you interact on the web can have a major impact on the value of your personal social capital. For example, when you are looking for a doctor or choosing a hospital, you can search at a site such as Healthgrades. If you did an internet search on a doctor and discovered that she was a frequently cited author, you might be more likely to select that doctor for care.

The web itself is a giant social capital engine, for better or for worse.

Companies like LinkedIn and Facebook provide platforms that allow individuals and companies to build an online presence via their internal templates, but this must be understood in the broader context of the web. When you apply for a job for example, a potential employer will probably Google your name and you will be judged by the aggregate of the web presence that you have created over time. The Wall Street Journal article quotes employers and suggests that your web presence provides a far more useful and complete picture of who you are and what you can do compared to a traditional paper résumé.

The implications for individuals and companies are clear: There is substantial value in proactively developing and managing a virtual presence. The increasing impact of the web in determining the value of an individual’s or firm’s social capital is an unavoidable trend. Most professionals will do well to develop and manage an online presence in the same way that they maintain a resume.

These days, your web presence is a vastly richer resource for someone seeking to understand what you can do than a few typed pages on a résumé.

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For those who are not familiar with Zvi Bodie, a professor at Boston University, some history is in order.  Dr. Bodie has a long history of challenging the conventional wisdom that individuals saving for their future needs (most notably retirement) need to maintain a substantial allocation to risky asset classes such as stocks.  His research, buttressed by that of others, suggests that investors tend to take on far too much risk in their investing and do not really understand the nature or magnitude of the risk that they bear.

The standard view of investing for retirement is that investors need to own stocks and other risky asset classes in order to accumulate sufficient wealth to someday be able to retire.  A corollary to this notion is that while stocks are risky in the short term, they become less risky the longer you hold them so long-term investors can handle the short-term volatility because it will pay off in the long-term.  Another key assumption that is often part of the standard thinking is that we can have confidence that stocks will soundly out-perform other possible investments in the long-term.  Jeremy Siegel, a professor at Wharton who has often debated with Bodie, is the author of a book, Stocks for the Long Run, which champions this standard view.

Bodie argues from a very different perspective.  He agrees with the idea that, on average, an equity-heavy portfolio can expect to out-perform less risky investments over an extended holding period and that the degree of this expected out-performance increases with the holding period.  The problem that Bodie has noted for years is that while the probability of a bad outcome diminishes the longer you hold a portfolio of stocks, the potential severity of the worst outcomes increases with holding period.  I did my own analysis of Bodie’s argument a couple of years ago, using a Monte Carlo simulation, and I concluded that he was correct that the severity of potential downside events increases with the holding period, even as the probability of these events decreases.

The answer, Bodie concludes, is that investors should focus on saving and investing to provide for their basic future needs with as little investment risk as possible.  If there is investable capital beyond what an investor needs to be on track to meet her basic future needs, this money can be invested in risky asset classes.  The core of the portfolio needs to be as low risk as possible.  There is one asset class that is the best match to investors’ future needs, and that is inflation-protected bonds (TIPS).  These are government-issued bonds that will maintain their purchasing power to keep up with inflation, as measured by the Consumer Price Index (CPI).  Bodie believes that TIPS should make up the vast majority of most individual investors’ portfolios.  Bodie has presented this part of his thesis in an earlier book for individual investors, Worry Free Investing.

While much of Risk Less and Prosper focuses on making the case for taking little investment risk, the book is broader than this one topic.  There is an exploration of how to make a long-term plan with specific goals and how to think through dealing with the contingencies that may arise.  In my extended analysis of Bodie’s argument that investors should put most or all of their portfolios into TIPS, I concluded the following:

The best solution, given all of the uncertainties, is for investors to build portfolios that provide the maximum sustainable income streams, but also to ensure that worst-case outcomes are tolerable. This notion is receiving more attention, but is still not widely understood. An important part of a balanced investment process is to be aware of all of the risks, and the potential for severe under-performance of equities over extended periods of time is a risk that often gets overlooked. A person near retirement who has little or no flexibility in when they retire and how much income they need in retirement must have less exposure to risky asset classes.

Nothing that I have examined since I wrote my piece in 2009 has changed my perspectives on this.  Bodie’s position is that individual investors do not have an understanding of the potential worst-case outcomes for their portfolios and thus should lock in a basic standard of living using TIPS.  I wholeheartedly agree that people do not have a solid understanding of risk and, particularly, that a portfolio of risky assets does not become essentially riskless if you hold it long enough.  This does not, however, mean that I agree with Bodie that a 100% TIPS portfolio should be the baseline portfolio.  That said, Bodie and Taqqu have staked out important ground in terms of reconsidering the basic paradigm for long-term saving and investing and presenting a new approach in an engaging and thoughtful manner.  I would encourage individual investors to challenge their own assumptions and beliefs by reading this book.

Related Links:

• From the Portfolioist Book Shelf: Freefall by Joseph Stiglitz
• From the Portfolioist Book Shelf: Live It Up Without Outliving Your Money!
• From the Portfolioist Book Shelf: Jim Otar’s Unveiling the Retirement Myth

Only one thing always happens in the financial markets: Values fluctuate. Before investing in any market, at any price, in any climate, prudent investors think about how much fluctuation they can handle. In other words, how much can your portfolio go down before you start to lose sleep?

We all have our trigger points. After the stock market began skidding in October 2007, frayed nerves sent investors scrambling for havens they hoped were less risky. Then the market reversed course. Strong gains in much of 2009 left risk-averse investors on the sidelines, watching stock prices climb and wondering when, if ever, they’d have the stomach to invest in stocks again.

The lesson? You can’t invest—or even not invest—without risk. There are no certain wins, even for experts, but you should understand the kinds of risks that affect stocks, bonds and cash, the three main asset classes. How risks and asset classes interact supplies a basis for investment strategies tailored to your risk appetite.

History Lesson

Stocks are subject primarily to market risk (the danger that stock prices will fall below their true value) and investment risk (the danger that the firm you’re invested in does poorly). Bonds are loans, most vulnerable to credit risk (the chance of the borrower experiencing default or bankruptcy) and interest-rate risk (the chance that interest rates will go up, pushing bond values down). Cash—or equivalents such as money market accounts or Treasury bills—is most affected by inflation risk (the risk being that inflation will reduce its purchasing power over time).

Bonds are generally more stable than stocks and in any single year may outperform them. Long term, however, bonds have posted lower returns.: From 1926-2009, large-cap stocks returned an average of 9.6%, while bonds, as measured by intermediate-term government bonds, returned 5.4%. Cash delivered the lowest returns over time: only 3.7% since 1926. It’s important to note that over this same 83-year period, inflation averaged 3%. So the real-world value of these returns is actually 3% lower. That makes cash returns, for example, less than one measly percent.

Combining stock, bond and cash investments to balance their different types of risk is the key to managing overall risk in your portfolio. That said, how your investments match up with your appetite for risk is key. So the question becomes, what’s your risk appetite?

Time Heals All Swoons

Risk appetite—alternatively called risk tolerance or risk aversion—hinges on one overarching question: What is your time horizon? The answer will basically indicate the mix of stocks, bonds and cash best suited to meet your investing needs.

Generally, the longer your time horizon, the more tolerant of market risk you can afford to be. If the stock market hits a bump when you’re in your twenties or thirties, you have decades to recover. If you’re in your fifties or sixties, however, you’ll need your savings too soon to be too tolerant of market risk. On the other hand, if you’re in your twenties or thirties, you can be less tolerant of inflation risk, which can erode the value of your savings over many years; and investors in their fifties or sixties have less to worry about from inflation risk because their time horizon is shorter.

That’s why investing rules of thumb advise you to steadily shift your mix toward bonds and cash as you age. One common rule is to invest in the percentage of stocks that matches your age subtracted from 100. In other words, at age 66, for example, 34% of your portfolio should be invested in stocks (100-66=34). The remaining 66% should be invested in bonds, with a small percentage in cash for liquidity.

While it’s a good idea to lower risk as you get older, remember that your assets must last through your retirement, not just until you retire. And your retirement could last 30 years or more. So always keep a portion of your portfolio in stocks.

Whether you crave risk or flee from it, sound long-term investing requires a balanced and diversified asset mix. That’s how informed investors strive for financial security and sleep well in any market climate. You can, too.

Related Links:

• Risk Budgeting: A Critical Tool for Portfolio Management
• The 50-50-Portfolio Solution?
• The Five Biggest Financial Issues for Pre-Retirees

(Disclosure: The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Quicken.com is not affiliated with FOLIOfn or the Portfolioist.)

First, France now has the same credit rating from S&P as the United States.  As you’ll remember, S&P downgraded U.S. sovereign debt from AAA to AA+ back in August 2011.  Second, the yield on France’s 10-year bonds is at 3.08%. While this yield is well above the U.S. 10-year Treasury yield of 1.9%, it is certainly not a sign that the bond market sees substantial credit or interest rate risk associated with France. The media response to the downgrade is reminiscent of the situation in July last year when there was a media frenzy surrounding the possibility that the U.S. would fail to raise the debt ceiling and technically default on its debts.

Third, we can better understand the markets for debt (bonds) if we also look at the markets for equity (stocks).  They are related.  The appetite of investors for risk (and that of the market as a whole) varies through time.  When investors are broadly risk averse, they are less willing to take on equities and more inclined to put money into ‘safe’ assets such as sovereign bonds.  We are in just such a situation today.  Volatility in equities is high and investors are fearful—and perhaps rightly so.  In this environment, it is perfectly predictable that government bond yields will remain stubbornly low.  Let me explain.

The iShares MSCI France ETF (EWQ) is designed to track a broad index of French stocks.  We can look at the historical volatility (risk) of this index fund versus the historical volatility of Germany and the U.S.  I chose Germany for this comparison because the bond yield in Germany remains very low, with ten-year bonds at a yield of 1.8%.  Volatility is a standard proxy for risk. Volatility measures the variability through time of the return on a stock, fund, or index around its average value.  High volatility means that the market is constantly changing its consensus estimate of fair value.  For this reason, volatility is a standard measure of risk. The larger the swings in value from day to day, the higher the volatility.

We can also look at the implied volatility, a measure of future risk. As the proxy for the German stock market, I will use EWG, the iShares MSCI Germany ETF.  For the U.S. stock market, I will use the S&P500 ETF, SPY.

Source: Morningstar.com

I have obtained the trailing three-year volatility of each of these ETFs and compared these to the implied volatility of put options with an expiration of about six months (note: there are options on EWQ and SPY expiring in June but not July and options on EWG expiring in July but not June, so I am using June options for EWQ and SPY and July options for EWG).  There are several interesting features of the table above.

First, the implied volatility for the S&P500 (SPY) is very close to the trailing three-year volatility.  The near-term risks in the U.S. stock market (as measured by options prices) look similar to the risks we have been facing for several years.  Over the past three years, both France and Germany have been far more volatile than the U.S.  The estimate of future volatility provided by options prices suggests that both France and Germany look riskier in the near-term than they have even in recent years, and that France has gotten more risky relative to Germany and the U.S.   Interestingly, the trailing six-month volatility of EWQ is 49.8%, consistent with the forward view from the options. One important point to understand here is that all of these options are traded in U.S. dollars.  For this reason, the implied volatility of the options reflects currency risk associated with the exchange rates between the Euro and U.S. dollars.

Let’s put the downgrade of French sovereign debt into context. The bond market has totally taken the downgrade in stride. The stock market, including the effects of currency risk, assesses France as a very risky proposition—about twice as risky as the U.S. when we look at implied volatility.  In a detailed article that I wrote for Advisor Perspectives, called “The Danger in European Stocks,” (November 2011), I concluded that Euro-zone stocks looked very risky moving forward. However, the downgrade by S&P does not alter my outlook on European equities.  Indeed, the fact that the S&P International Dividend ETF (DWX) has a yield of 6.15% tells us that investors see European stocks as a risky proposition (55% of the assets of this index fund are invested in what Morningstar classifies as Greater Europe).  For investors to require a 6.15% yield to invest in stocks but only 3.1% to invest in bonds means that investors perceive very high risk in stocks.  Investors see sovereign bonds in the largest Euro-zone economies as something of a safe haven from equity risk even as credit ratings fall.

In summary, the downgrade on French sovereign debt is of little significance for the time being. There is no new information here that the market has not already anticipated and processed into market prices. For U.S. investors, it remains unclear to me why one would want to put a meaningful allocation into international bonds. The fact that European equities look too risky to suit many investors’ risk tolerance does not mean that we should be willing to accept super-low yield on bonds issues by Euro-zone countries.  The 3.1% yield on 10-year French bonds is generally on par with inflation in the U.S., but investors are taking on considerable currency and interest rate risk to achieve this modest return.  My recent analysis of risk-vs.-yield across a number of asset classes does not make international bonds look attractive. The recent round of downgrades by S&P simply bolsters that perspective.

Related Links:

• The Government Default: The Market vs. The Media
• Can You Create a 7% Yield Portfolio Focusing on Munis and Dividend Stocks?
• Burton Malkiel: Buy Munis, Foreign Bonds and Dividend Stocks

While the aggregate performance of the 7% yield portfolio in recent years has been very good, this does not change the fact that this asset allocation can exhibit substantial volatility. That’s why (as a rule of thumb) I estimate that the maximum loss that you can reasonably expect from a portfolio is about twice the estimated volatility. My projected volatility for the 7% yield model portfolio was 15% so the projected “worst case” loss over a twelve-month period was 30%.

Shortly after that piece was published, Burton Malkiel published an Op Ed piece in the Wall Street Journal suggesting that muni bond funds, and leveraged muni closed-end funds (CEFs) in particular, were an attractive alternative to Treasury bonds in the current low-yield environment.  I wrote a post that discussed these themes. Given the large response that we got to the original 7% yield article and to the analysis of Malkiel’s piece, I decided to design another portfolio with that same level of current yield and with an emphasis on the key asset classes that Malkiel likes for income investors: Leveraged muni funds and dividend stocks.

My analysis (which is certainly not exhaustive) resulted in the following portfolio:

(Source: Yield data from morningstar.com; asset allocations based on my calculations.)

This portfolio was created using forward-looking projections of risk, accounting for all of the correlations between asset classes.  As of this writing, the projected volatility of this portfolio is 14.6%. To put this in context, I also re-analyzed the risk of the original 7% yield portfolio and my current estimate for future volatility is 14.5%, a bit lower than the previous estimate. The decrease in projected volatility for the original portfolio is largely due to a decrease in forward-looking volatility derived from long-dated options on the S&P500.

Portfolio Design

This portfolio was designed in a similar fashion to the previous 7% yield portfolio.  I started with a universe of possible funds and other securities and used an optimizer combined with my Quantext Portfolio Planner (a Monte Carlo portfolio analysis tool that I designed) to try to identify a portfolio that has a 7% total yield with the lowest projected risk possible. I also constrained the maximum allocations to any single stock or fund on the basis of trial and error. My goal was to keep the maximum allocation to any single stock or fund as low as possible, without sacrificing yield. In the model portfolio presented here, the maximum allocation is 11%. My selection of individual stocks was fairly arbitrary. Malkiel mentions that dividend-paying stocks are an attractive way to boost yield, so I selected a small number of stocks with fairly high dividend yields on the basis of my experience.

Subjective?  Absolutely.

To gauge the relative attractiveness of dividend stocks and muni funds, I also needed to include some solid alternatives. For this reason, the possible universe of investments includes Treasury bonds, corporate bonds, high-yield bonds, and master limited partnerships (MLPs). I also included two muni ETFs to see how they would compare to the leveraged muni CEFs.  Finally, I included a REIT from the previous 7% portfolio.

In selecting the muni CEFs, I started with a fairly long list of these funds and gradually cut down the list.  I was looking for a small number of these funds to include as alternatives. I selected three of these funds that appeared to have the best diversification benefits among themselves and relative to the other assets under consideration for the portfolio.

In the final optimized portfolio (above), I have sorted the funds from highest allocation to lowest allocation.  Of the seventeen components of the final portfolio, the leveraged muni CEFs rank 2nd, 3rd, and 5th in having the highest allocations. The portfolio optimizer with forward risk projections agrees with Dr. Malkiel: leveraged muni CEFs look quite attractive if you are trying to maximize yield relative to risk.

As I mentioned in my earlier post on Dr. Malkiel’s Op Ed, the fact that Treasury bonds look fairly unattractive on a stand alone basis, does not mean that they are unattractive as one component of a diversified portfolio. The optimized portfolio above reinforces this conclusion. There is a 7.8% allocation in this portfolio to long-term Treasuries.

A Surprising Result

One result that surprised me somewhat is the low allocation to international bonds, one of the asset classes that Dr. Malkiel recommends for income investors.  The T. Rowe Price Emerging Markets Bond Fund (PREMX) ends up with a 5.2% allocation but other international bond funds that I experimented with simply did not seem to add appreciable value to the portfolio. This is not an exhaustive analysis by any means—my conclusion here is based on a limited sample of funds that I tested.

So what do we learn overall?

First, we affirm that it is possible to create a portfolio with a 7% yield with about the same risk as a portfolio that holds about 50% in stocks and a 50% allocation to bonds.  Second, the ability to create a 7% yield portfolio at a given level of risk is not terribly sensitive to the specific set of stocks and funds.  Third, we agree with Dr. Malkiel that leveraged muni CEFs are an attractive alternative for inclusion in an income-oriented portfolio.  The new 7% yield portfolio has quite different specific stock and fund selections and allocations than the original 7% yield portfolio.  This is as it should be.  Markets would have to be dreadfully inefficient if our projected portfolio results (yield vs. risk) were highly sensitive to the exact tickers and weights.  To put this in more technical terms, there are multiple alternative portfolios that can reach the frontier of risk vs. yield at a given level of risk.

Getting a 7% yield from a portfolio can be achieved in the current market (albeit, with meaningful market risk). This conclusion is notable given the very low yields of Treasury securities.  Whether such a portfolio or some variation on it makes sense for you depends on the specifics of your risk tolerance and the details of your specific needs.

Related Links:

• Burton Malkiel: Buy Munis, Foreign Bonds and Dividend Stocks
• Risk Budgeting: A Critical Tool for Portfolio Management
• Asset Allocation: An Alternative View

Having worked in the equity markets for awhile now with a primary focus on finding profitable stock-picking strategies, I sometimes feel like the keeper of great stock picking ideas. That being said, as the New Year is upon us, I’m in a giving mood and would like to gift you three great ways to pick stocks in 2012.

In the previous two articles I’ve posted here, you’ll remember that I discussed the merits of Research Wizard as an essential stock picking tool for the individual investor to create and test new ideas. So today, I’m going to give you an example of how to develop a stock-picking strategy within the Research Wizard using three specific strategies:

First, it’s very important to start with a good ranking or rating system. Most of the time, there’s a lot of research already committed to a rating and starting with a good working foundation is a great way for you to save time. (Examples of these are broker stock ratings or the Zacks Rank. I’ll use the Zacks Rank since it’s more comprehensive than broker ratings and also has a great track record for selecting stocks.)

Second, look for stocks that the market judges favorably too. Nothing is more frustrating that discovering a great company, but the stock price just doesn’t go up. So, it’s a good idea for the stock to have a good price appreciation over the past twelve months. Numerous research studies have shown that winning stocks continue to be profitable in the future. It sounds a little too easy, but it’s effective and very persistent in the stock market. (Why wouldn’t this effect go away if it’s so effective? Well, that’s why it’s called the Momentum Anomaly.)

Third, I think it’s a great idea to buy stocks at a bargain or discount. So let’s add a dash of value by looking for stocks with a low price-to-sales ratio (P/S Ratio). The P/S Ratio is a measure of how much you’re paying for each dollar in corporate revenue. Obviously you want to pay as little as possible. For example, if Stock A P/S Ratio of 1 and Stock B has a ratio of 2, then you’d pay twice the amount per dollar of sales if you bought Stock B instead of Stock A.

So at this point, if you read my last article, you’re probably thinking: It all sounds good, but just how effective is this strategy? Using Research Wizard, I built this strategy and tested it monthly from the beginning of 2000 through the end of October 2011. Over this time period, the S&P 500 returned a compounded annual return of 0.1% (So people are right when they say the equity market really hasn’t gone anywhere in 12 years!)

However, the strategy I suggested returned a compounded annual return of 16.2%. So, while the overall market’s wheels were spinning on ice, there were strategies out there that moved forward and were highly profitable–you simply need to find them.

Remember also, that if you have a low number of stocks in your portfolio, you’re going to have more volatility. For example, the strategy that I outlined contained only 10 stocks, and thus had 64% more volatility than the S&P 500 with its 500 stocks. In this case, the volatility was worth it.

5 Steps to Finding Highly-Rated Stock with Good Momentum

Here’s a 5-step methodology for finding highly-rated stocks with good momentum at a reasonable price:

#1: Start with U.S. Common Stocks.

#2: Create a liquid, investable set of stocks with the largest 3000 market values and a average daily trading value to 100,000 shares (if there’s not enough liquidity, it’ll be hard for you to trade it).

#3: Add another filter by selecting those stocks with a Zacks Rank=1. (Again, let’s stick with only the best rated stocks.)

#4: Select the top 50 stocks with the highest return over the past 52-weeks. (We’re looking for stocks with great price momentum over the last year.)

#5: Select the top 10 stocks with the lowest P/S Ratio. (Lower means that you want to pay less per unit of company revenue.)

Now it’s your turn to use Research Wizard yourself to create your own stock picking strategies. You’ll be a better investor for it.

Here’s to a safe and profitable 2012!

(Disclosure: The views and opinions expressed here are those of the author(s) and do not necessarily reflect the views of the Portfolioist. Zack’s is unaffiliated with FOLIOfn Investments, Inc. but does use its services.)

Related Links:

• Is Your Brain a Barrier to Smarter Investing?
• The Reversal Effect
• The 50-50 Portfolio Solution
  

The evidence showing that most individual investors significantly underperform the market is compelling. A study done by Dalbar, a leading financial services market research firm, found that, during the 20 years from 1991 through 2010, the average stock fund investor earned returns of only 3.83% per year, while the S&P 500 returned 9.14%.

The ramifications of this study are startling. It’s very easy to capture the returns of the market. All you have to do is purchase index funds that track the returns you are seeking to replicate. You will pay low transaction fees, but your returns should be pretty much in line with the indexes.

There is overwhelming support for buying a globally diversified portfolio of low management fee index funds in an asset allocation suitable for you. It is summarized in my new book, which is co-branded with Mint.com, The Smartest Money Book You’ll Ever Read. Yet, most investors stubbornly ignore this research and persist in stock picking, market timing and trying to find the next “hot” mutual fund manager, often with the encouragement of their broker or investment advisor. The results of pursuing these flawed strategies are predictable, as indicated in the Dalbar study, chasing returns and trying to predict the random moves of the stock market are disastrous strategies for investors.

In an article in the New York Times, David Swensen, the chief investment officer at Yale University and author of Unconventional Success: A Fundamental Approach to Personal Investment, noted that, “For decades, investors suffered below-market returns even as mutual fund management company owners enjoyed market-beating results. Profits trumped the duty to serve investors.”

The financial media plays an insidious role in misleading investors. It is largely premised on the purported ability of stock market pundits to make sense of random events and predict the future. At year-end, these pundits make their predictions for the following year. They give us their views on where the Dow is headed or pick stocks that are likely to outperform. Sometimes they are right but often, they are wrong. There is no way to tell into which category their current predictions will fall.

The question is: Why do so many investors repeat the same mistakes year after year? Is it collective cognitive dissonance? Is the enticement of hundreds of millions of dollars of advertising by the securities industry too powerful to resist? Is there an irresistible desire by some investors to engage in socially acceptable gambling?

While all of these factors may play a role, it turns out that your brain may be the biggest barrier preventing you from becoming a successful investor. Consider this:

You Seek Order When None Exists

Daniel Kahneman is an Israeli-born psychologist and winner of the 2001 Nobel Prize in economic sciences and he is best-known for his work in behavioral economics, which attempts to explain how investors make decisions. In a thoughtful article adapted from his book, Thinking, Fast and Slow, Kahneman reached this insightful conclusion: “We are prone to think that the world is more regular and predictable than it really is, because our memory automatically and continuously maintains a story about what is going on, and because the rules of memory tend to make that story as coherent as possible and to suppress alternatives.”

The stock market is random and unpredictable and efforts to seek order and direction are likely to undermine your returns.

You Confuse Luck with Skill

When stock gurus get it right, they attribute their accurate predictions to skill. Their success is most likely due to luck, as indicated in studies by well-credentialed authors. The subtle difference between luck and skill is lost on many investors, who are quick to anoint the next investment guru. Kahneman’s study (reported in the same article) led him to his conclusion: “The results [of the performance of wealth advisers over an eight year period] resembled what you would expect from a dice-rolling contest, not a game of skill.”

Your Level of Confidence is Not Reality-Based

According to a recent blog by David B. Armstrong in USNews.com., 80% of the drivers surveyed in Sweden thought they were better than average drivers. Most investors probably feel the same way. The Dalbar and other studies demonstrate that most investors are below average, if you consider “average” as the ability to capture the returns of the market. This level of overconfidence leads to poor investing decisions which are not based on peer-reviewed research.

Your Emotions Overcome Your Logic

Most investors find the “agony of defeat” (losing money) more intense than the “thrill of victory” (making money). Armstrong notes that this reaction to losses causes emotions to overtake logic, resulting in bad investing decisions.

You Can’t Resist the Thrill of the Hunt

According to Meir Statman, a professor of finance at Santa Clara University and an expert in behavioral finance, many investors enjoy the competitive element involved in to trying to “win.” They pursue efforts to obtain outsized gains with their investments even though, in Statman’s view, “Individual investors should treat the market as unbeatable and realize that when they try to beat it, because it is inefficient, they are likely to injure themselves, rather than gain at the expense of another.”

The next time you are confronted with an investing decision, remember that you may be influenced more by the involuntary reaction of your brain than the solid research which should be your guide.

About the Author

Dan Solin is a Senior Vice-President of Index Funds Advisors.  He is the author of the New York Times best sellers The Smartest Investment Book You’ll Ever Read, The Smartest 401(k) Book You’ll Ever Read, The Smartest Retirement Book You’ll Ever Read and The Smartest Portfolio You’ll Ever Own.  His new book, The Smartest Money Book You’ll Ever Read, will be released January 3, 2012.

Related Links:

• Answering David Swensen’s Call to Arms
• U.S. Investor Behavior: The Government Report
• The Wealthy Solution

(Disclosure: The views set forth in the blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services.)