While reading into some of the investment choices, I noticed that many mutual funds have what are called Target Date Funds.  Dated 2020, 2030, 2040, 2050.  Meaning if you were looking to retire by a specific date/year, you could put all your  money into one of these funds and it would be properly allocated so that you would retire by that date.  Sounds pretty simple and straightforward.

But what if we take 5 minutes to dig slightly deeper.  Below are 3 target date funds from T Rowe Price and their top 10 holdings.  I picked T Rowe Price as it was listed in a friend’s investment list and for no other particular reason. Many firms have Target Date Funds as well.

Notice something?  There is quite a bit of overlap in between these funds and that they just so happen to all be T Rowe Price funds inside this Target Date Fund.  These belong (from left to right) the Target Date Funds for 2050, 2040 and 2030.

This would make us think, if we are buying a Target Date Fund, which is pretty much a group of mutual funds and they all already happen to be with the same company, why can’t we just buy the individual funds directly?  Because we believe there is a fee associated with the Target Date Funds.  Usually around 1%, the same as the mutual fund itself.  So 1% for the underling fund, then another 1% for the Target fund holding all the underlying funds.  Assume we had 1,000,000, we would pay 10,000 to the underlying funds, then another 10,000 to have them buy those mutual funds for us.

Interesting…  So if we really wanted to, we could buy the same exact percentages of funds as they have there ourselves and….save 10,000 for about 10 minutes of work.  Sounds like a pretty good deal to me.

The real life example would be going to a candy store and buying 5 candy bars from the store directly.  But if you were to buy the candy from the employee in the store, it would cost twice as much for the same exact candy.

There is some merit in the argument that they do re-balance and adjust periodically the percentages of these holdings, but anyone can go online, dig up some value/blend/growth Morningstar matrix and create their own percentages that would not perform any worse than these and save the same on fees.

It sounds good on paper.  20% bonds, 60% stocks, 20% commodities/alternative investments.  Or if you would like to make it even more detailed:

15% investment grade bonds, 5% high yield bonds, 20% small cap growth stocks, 20% consumer goods and 20% industrial/cyclical stocks combined with 10% in REITs and 10% in a hedge fund.

Keep your investments spread out, and automatically re-balancing your portfolio will ensure your percentages stay spot on and correctly diversified right?

So the only slight issue is that you are ruining your returns.  We can just apply a bit of common sense and we will realize the issues with blind/automatic/frequent re-balancing.  We will not even need a chart or graph or table this time.  Think about what happens when you re-balance a portfolio.

Say you have a portfolio of 10 investments, each one with 10%.

In our first scenario, 5 of them go up 50%, 5 of them stay flat.  You re-balance all of them so that they stay at 10% each.  What you have just done is, take money out of an investment going up and reinvesting that money in a company that is going nowhere.

Scenario 2, 5 of them go down and 5 of them are flat.  You re-balance and dump more money into investments that are going down and taking it out of investments that are holding their value.

For scenario 3, worst case, 5 of them go up and 5 of them go down.  So you are taking money out of investments earning you a good return and dumping them into investments that are losing you money.

Not to mention, each time the portfolio is rebalanced, transaction fees may and probably will apply.

What would make more sense when selling and buying another investment, is if an investment has

• reached it’s estimated intrinsic value
• become impaired, either bad capital allocation, change of management, poor corporate governance, etc…
• lower potential return than another investment that has become known and actionable

This way, you are selectively selling investments that no longer have the potential for good returns and allocating the money to investments that will offer the ability to provide greater returns.

Most brokerages I have dealt with love automatic re-balancing and asset allocation.  Especially if it is done monthly.  With transaction fees on each buy and sell, having that done to every single client account for every single holding to make minor adjustments of 1-2% and then doing it 12 times a year?  Brokerages would love you for it.  While most only re-balance once a year, please keep in mind that automatic re-balancing may not be the best method for you.

One caveat is that it may work in some indexing situations, but when buying and selling individual investments, it can lead to mediocre and depressed returns.  More often than not you may be better off just leaving the investments alone.

http://bloom.bg/RNklXc

I would like to just add a few things.  First, I agree in that equities is where it is at.  With bond prices driven to what they are now, the yields are so small and when, not if, they do raise interest rates, whether it be 1,2, or 5 years down the road, they will take a big hit.  Pretty basic econ 101, interest rates down, bonds up, interest rates up, bonds down.  With interest rates near 0, the only way is up and it is only a matter of time.

In addition, with the fear of inflation, whether it is a legitimate worry or not, may exacerbate the situation.  Granted I do not beleive inflation will be a major concern.  We have had it, it is integrated into our economics, it is happening and will continue to happen.  But never say never.

As for predicting what will happen.  These people may be right or wrong, but more often than not, they are wrong.  So the smartest thing to do is what was said around minute 23 of the video.  If you buy undervalued companies with a large margin of safety, you can have decent returns in a sub standard environment.

As a bonus, equities also have a built in inflation protection.  Some more than others.  Below is a rough example.

Let us have another imaginary cola X company.  Say it cost 3 dollars for a 6 pack.  They earn a net profit of 1.50 per six pack sold.  And there is exactly one six pack sold per share of stock.  Meaning each share earns 1.5 dollars per six pack.

Then we introduce inflation of 100%.  Cola X is now 6 dollars a pack.  Assuming all their margins stay the same, their profit will be 3 dollars per six pack. Or 3 dollars per share.

Assuming Cola X originally traded at a P/E of 15 .  The stock price would be 22.50 (15 x 1.5).  Now that the earnings has doubled, to maintain the same P/E, the stock price would need to be 45.

The number will rarely ever work out like this, as this shows Cola X as

As a shareholder of coke.

There is a magic number for everyone.  It will not always be the same, but there is how to get a rough idea.

For  people who index, this is a moot point.  When you buy indexes, you have anywhere from hundreds to thousands of stocks in your portfolio.

Same situation for people who only hold mutual funds.

Now for self investors who buy individual stocks and advisors who purchase stocks on behalf of the clients.  The graph below shows the benefits of diversification.

On the vertical Y axis, it is referring to volatility of the investments.  How much and how often do the investments go up and down in value.  As you can see, around 10 you start having large diminishing returns for each additional stock you add to your portfolio.  As you get closer to 20, the change becomes very minuscule.  So for most investors of individual stocks, 10-20 stock holdings is probably what you would need to be adequately diversified, assuming they are not all 20 tech stocks, or 20 retail stocks or 20 iron miners or something of that nature.

Assuming you are doing your homework on each investment, it would not make sense to hold much more than that.  If I told you to think of 3 good business ideas, you could probably come up with something practical and plausible.  Now if I were to tell you to think of 100 good business ideas.  I’m sure about 90 of them would be worse than you top 3 ideas.

Same goes for investing.  If you have picked out 20 good investments, which is quite a bit in itself already.  If you find a better investment, why would you not swap one of the 20 out?  That and the chances are the investment will not be as good as you first 10 or 20 ideas.

So concentrating a portfolio may give better returns by investing in your best ideas and over diversifying may dilute the returns by having too many mediocre ideas.  If you have 3 great ideas, and 7 good ideas, would you not want to put more into the great ideas?  This line of thinking goes along with the issues of dollar cost averaging (in this post).  Why put money in many mediocre ideas over placing them into your few great ideas?

In the eggs and basket analogy, if you have a basket padded on the inside with the softest goose feathers and the outside is made of indestructible adamantium, then it may make sense to put more of your eggs into that basket, than into 10 baskets of woven grass.

Lastly, it also comes down to what lets you go to sleep at night.  I know of investors who invest in 4-6 stocks.  That is it.  Nothing more.  They drill down deep, do all their homework and double check their facts and the investment style suits their personality.  At Lodestone Capital Solutions LLC, we invest in a mixture of stocks, mutual funds and ETFs, but we limit our ideas to roughly 10-20 different investment positions.

First let us start with the good.  We assume over the time markets will rise, which is a reasonably safe assumption.  Over the course of 10, 20 or even 30 years, the market should rise but inevitably there will be down markets.  If you are purchasing a mutual fund that has a reasonable correlation with the market (that is generally up when the market is up and down when the market is down) you will end up purchasing more shares when it is cheap and less shares when it is expensive, resulting in a higher return.

Example:  We have DCA on top, buying 1000 dollars worth each year vs buying 10 shares a year for 10 years.

Now in a scenario where you invest up front, instead of piece mealing it out in the same mutual fund.  You can see the return is higher.  But often DCA is used to bring in additional money to a mutual fund, or used to add additional funds to invest as you earn more money over time.  But in a scenario where you can DCA vs investing lump sum.  You can see the result, again assuming that the market improves over the long term.

Now in a 3rd scenario, let us say you are investing in the mutual fund, but as with most investors, I would say it is safe to assume that most people do not read the prospectus, the shareholder reports or evaluate the companies inside the mutual fund to see if the price you are paying for the mutual fund is worth the stocks/companies inside.   So what happens if many of the stocks inside the mutual fund do not perform well?  Meaning if investments are poor companies or are going down, you will be blindly buying more.

What would make more sense is to evaluate Mutual Fund X and determine that it’s fair value is estimated at $200-$250/share.  Then we would proceed to buy more.  Over time, as long as the fair value or intrinsic value of the mutual fund is higher than the current market price, then we would continue to add more.  But if our estimates are at $200-$250 and the price is 300, then we should stop purchasing.

This would limit the damages that DCA does to a portfolio by not buying high and low, and hopefully just buying low.  Buying less when it is high, still requires the same amount of dollars.  The only difference is that the number of shares you obtain are less.  What DCA can end up doing, is dooming your portfolio to mediocrity.  DCA will ensure that your buy price is average, but that does not mesh will with the idea that you want to just buy low and sell high.

Ever hear of a double long or double short ETF?  ETFs with tickers such as double long gold (DGP), double long oil (DXO), double long S&P 500 (SSO) and on the flip side, double short S&P500 (SDS), double short US Financials (SKF), double short US Real Estate (SRS).  While you think all of these may have been a great idea at a moment in time in the past few years, you may be surprised by their real returns.

So let us use an example of an index of 100, using a short ETF of this imaginary index.  In day 1, say this index drops 10%.  So index goes to 90, the short ETF goes to 110.  So far so good.

Then in day 2, say this index rebounds and increases 10%.  So from 90, it increases to 99.  As for the short ETF, it decreases 10% from 110 to 99.  So… what just happened?  Both end up with a value of 99, but they are suppose to be the inverse, so if one is at 99, should not the other be at 101 to balance out?  This is caused by the power of compounding.  Compounding can be a bad thing as well in investing, not just for growth.

This issue is exacerbated in double or triple short/long ETFs and in more volatile indexes as time goes on.

If we take the above example and change it into a double short.  We have a starting index of 100, drops 10% to a value of 90.  Double short ETF increases to a value fo 120.  On the 2nd day, the index rebounds 10% to 99 and the double short loses 20% and becomes 96.

If we take it one step further, on day 3, index decreases 10% again, from 99 back down to 89.10 and the double short ETF increases 20%, from 96 to 115.20.

Then on day 4, index increases 10%, from 89.10 to 98.01 and the double short decreases 20% from 115.20 to 92.16.

While ETFs have their place, they are not always the optimal solution.  They should be fine for shorter term investments, but for a long term holding of perhaps 10-20 years, a mutual fund may be a better choice.  As for speculative plays on gold, oil, S&P, double and triple up/down ETFs should on be held only for a short period of time, as the longer you hold it, the more of the gains will be eaten away.

P/E = Price divided by Earnings.  Price would be the price of the stock and earnings would be the earnings of the stock.  Earnings is the Net Income of the firm after all expenses including interest payments.  Pretty simple right?

Next, P/E ratios can fall under trailing or forward/leading P/E ratios.  Trailing uses the earnings of the past 4 quarters and forward P/E uses the estimated next 4 quarters of earnings.  You can look at a P/E ratio as the amount of time it will take to recoup/double your investment.  A P/E ratio of 10  or stock price of 10 with earnings of 1, or a stock price of 20, with earnings of 2, means it will take 10 years to earn 100%.  So generally speaking, a lower P/E ratio is better.

There are 2 issues with the P/E ratio as a measurement.  First, what if earnings is negative or very small.  It makes it hard to compare to companies with positive P/E ratios or comparing P/Es of 15 vs 500.  Also, having a negative P/E ratio does not mean the firm is worthless either.  Sometimes when earnings are negative, it will just be reported as a P/E of 0.

The second issue is concerning the capital structure of the stock/company in question. Take a look at 2 mythical companies below.  Assuming  everything is exactly the same except how they were funded, one with more debt and one with more equity.  You can see the resulting difference in net income.

Assuming both firms are in a very stable industry with no chance of the business dying off and having the same amount of shares outstanding, if you used the P/E ratio to compare these two firms, you would have 2 very different results.

One method of working around this is a ratio called EV/EBITDA.  EV stands for enterprise value.  The math for EV is market cap of the firm + debt + minority interest + preferred shares – cash and cash equivalents.  Or in other words, it is what the company is really worth.  (Note how the price of the company should also be the measure of the company’s worth)

Now EBITDA stands for Earnings Before, Interest, Taxes, Depreciation, and Amortization.  In other words, the money the company makes before you factor in how the company is structured financially, with debt/equity.

What it boils down to is that you are using EV to replace Price and EBITDA to replace earnings.  This will give you a measure of the value of the stock/company regardless of if it relies heavily on debt or not.  Do keep in mind, firms that rely heavily on debt, have the benefit of reducing taxes for the firm, but may also be a sign of serious financial issues if they have trouble paying off their debt.

This proxy will allow you to compare the firms if capital structure is not a major consideration.  In addition, it allows you to see the true operating performance of the company, as generally speaking, one company with plenty of debt can pay it down, and one company with plenty of debt, can borrow money and increase debt in their structure.

We can understand it more clearly if we take a deeper look at what a mortgage is and how it works in finance.  I made this a short, 5 year, 4%, 500,000 loan to keep it from running too long, but what happens in the loan is exactly the same as a 30 year mortgage.  The monthly payment is 9,208.26.  Take a look at the numbers below.  Then head over to the interest column.  Notice how the number keeps dropping?

This is an amortization schedule that we use here at Lodestone Capital Solutions when we buy/sell residential and commercial properties.  The tax deductible part for a residential loan is the interest.  So over the life of the loan, the amount of interest deductible each year decreases as the loan balance decreases.

One item that is not as skewed is the interest vs principal payments.  As this is a 5 year loan, it is paid off quite quickly so the initial principal payments are actually larger than the interest portion of the payment.  In general, for most residential 15-30 year loans, the initial interest port of the total payment will be much greater than the principal portion of the payment.  For example, if I were to make this 500,000 loan, into a 30 year loan vs a 5 year loan, the first few interest payments would be, 1,666.67, 1,664.27, and 1,659.44 corresponding to principal payments of  720.41, 722.81, and 725.22.  You can see the longer the loan, the larger percent the interest is of the earlier payments.

This graph below shows the general trend of what happens to principal and interest over the life of the loan.

So what happens over time is the interest portion of the payment diminishes while the principal payment increases, keeping the monthly mortgage payments the same over the life of the mortgage and is why the interest deduction on your tax returns is reduced every year.

• The donor has control over the account – meaning no new xboxes, shiny new cars, or Vegas trips for your child.
• Contributions grow tax deferred, taxed if not used for educational purposes when taken out.
• Educational purposes include tuition, books, room, board, transportation and even computers.
• Account can be transferred to other family members, especially if you have multiple children.
• Contribution limit is 13,000 per person to the beneficiary with no gifting tax issues as of 2012.
• A maximum of 5x annual contribution limit may be made up front and the gifting may be spread out over 5 years to avoid use of the lifetime gifting limit.  5 x 13,000 = 65,000 per person or 130,000 for a married couple.  The 130,000 would equal 13,000 per person, and then considered a gift each year for the next 5 years.

There it is.  Short and sweet.  Hope it helps!

Part 1

Part 2

Part 3

Jim Cramer is a very intelligent man.  Graduated from Harvard and has his own TV show in addition to being a former hedge fund manager and chairman of TheStreet.com.  So his intelligence is not in question.

While the show purports to give good investment advice.  If you watch the show, often people call in and he solves their issues within 30 seconds.  This may work occasionally, but more often than not I feel not enough detail is given or enough thought.  Plus his stock picking….. seems a bit too sensational.  Because of his fame, his ideas affect the markets in the short term.  While I understand his show needs to attract viewers, there should be a line drawn somewhere to protect the individual.  Keep in mind during both crashes, tech bubble and housing bubble, his picks have cost people their entire fortunes….twice.  I do not believe I need to say more, as the interview with Jon Stewart sums it up pretty nicely.

It is as good to watch as it is awkward for Jim Cramer.

P.S.  Don’t get me wrong, I love his show, it is entertaining, but I would be very careful of taking any of it as investment advice.