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My First Stock Purchase

by Smithee on February 27, 2009

in Investing

So, I got this credit card that deposits 2% cash back into a brokerage account. I started using it for all my daily purchases, paying off the statement balance each month. At the end of January, my points on the card were redeemed for the first time, and a few impatient days later, I had $38 dollars to start investing.

I could just set up a transfer from the brokerage account to my regular checking account and use this free money for other purposes, but I’ve always wanted to try investing in the market, and because it’s free money, I’m allowing myself to do so.

I figured that I could buy 3 shares of an ETF called PBW, which is a collection of companies specializing in renewable energy, which seemed like a good fit because:

  1. I didn’t feel like I have the time needed to do the right amount of research to buy shares in only one company
  2. I’m an aspiring hippie
  3. I knew that the American Recovery and Reinvestment Act of 2009 was in the works, and it set aside a serious amount of money for renewable energy projects

Here’s the funny part: that $38 dollars that Charles Schwab gave me for free? It was double the amount that they should have given me. So a few days later, I noticed in my portfolio that $19 was missing. It took me three tries to get the credit card and the free brokerage account linked in the first place, so this was extremely frustrating. I assume it was an honest mistake on Schwab’s part, but I had gotten myself in the position where I was investing with my own money, and not with free money, anymore.

I still think that this card/brokerage setup is a good idea, but if you’re setting this up for the first time, keep a close eye on the amounts being moved around.

Incidentally, I’ve only lost $17.66 on my investment so far, including the $12.95 commission. I can laugh about it, because it’s free money.

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E*TRADE Eliminating Index Funds

by Flexo on February 27, 2009

in Investing

E*TRADE has decided to discontinue its collection of index mutual funds. If you hold shares of ETSPX (S&P 500 index fund), ETRUX (Russell 2000 index fund), ETTIX (technology sector index fund), or ETINX (international index fund), E*TRADE or your broker will automatically sell your shares by March 27, 2009.

Even though index funds are likely the best way for most people to invest in the stock market thanks to low fees and returns that match the index, brokerages don’t have much motivation to offer them. Thanks to the low fees, fund managers don’t generate that much income. Without that income, the managers can’t advertise as prominently. E*TRADE’s S&P 500 index fund is quite competitive, with a expense ratio of 0.09%, lower than Vanguard’s 0.15% for VFINX. But VFINX is much more popular.

E*TRADE will likely try to convert index fund customers to managed fund customers. That’s probably the only way for the company to make money. But keeping the customer in mind, I would recommend using the liquidated funds to buy the equivalent low-cost index fund from Vanguard or Fidelity.

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The Paradox of “Buy Low, Sell High”

by Flexo on February 24, 2009

in Investing

If everyone could “buy low and sell high” when making investment decisions, everyone would be a successful investor. I would never give this advice to anyone. First, it is obvious to anyone who understands basic arithmetic. If you want to make money, you have to sell something for more than you paid for it. This is why people are reluctant to sell houses right now. Buyers are waiting for lower prices because they think the market will continue to go down for some time and sellers — unless they are highly motivated — don’t want to sell until prices go back up.

Second, it is impossible advice to follow. Unless you have inside information on a specific company — and that is very unlikely — you don’t know with certainty whether a stock price is going to up or down over the next month, year, or decade. The price set by the market, with so many buyers and sellers, is generally the accurate price for that stock at that time. The only way to know whether a price was a “low” or a “high” is to look at the numbers well after the fact.

On Friday, the S&P 500 index hit a low point not seen since the mid 1990s. But will future investors look at Friday’s price as a low? It depends on where the stock market goes from here. Many experts predict that the bottom has not yet arrived. Friday’s low might be high compared to what the future may hold if stocks retreat to levels not seen since the 1980s.

In reality, people don’t buy low and sell high. Yes, there is the argument that people follow trends (rather than lead trends), often resulting in buying high and selling low. But more importantly, investors buy when they have cash and sell when they need cash. As it happens, on average, people have cash when the economy is good and need cash when the economy falls. Stocks are often a victim of this same economy. The stock market generally follows the sentiment of the greater economy, so your cash moves into stocks when they are high and moves out back to cash when stocks are low.

This phenomenon is a result of looking at averages; on an individual level, anything can happen. You could be flush with cash while the rest of the economy suffers and more people are out of work, or you could be struggling while everyone else flourishes. On average, economic conditions force investors to buy high and sell low.

One way to turn this around for your own benefit is to try to understand what most people are doing, and do the opposite. If you buy stocks while there is a general tendency among the rest of the market to panic and sell stocks, you have a better chance of buying at a low point. If investing becomes the latest craze and you can’t go anywhere without having stock tips thrown at you, the exuberance could be irrational and you have a better chance of selling at a high point.

Rather than advising someone to “buy low and sell high,” a strategy which would involve knowledge of the future, perhaps it would make more sense to advise to “buy during panics and sell during exuberance.”

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Is “Buy and Hold” Still a Good Investing Strategy?

by Flexo on February 23, 2009

in Investing

From the time I started investing for the long term, almost all the advice I’ve read has pointed towards buying stocks (usually in the form of index mutual funds) and holding them for decades, rather than following trends in the news and trying to buy and sell stocks frequently. The reasons for this strategy were always similar to these:

  • Stocks are risky and volatile, but provide the best opportunity for growth over the long term with annual average returns of 7% to 12%, depending on whom you ask, higher than any other type of investment.
  • Trading costs money thanks to fees, and these fees eat into your returns. They exist to help brokers get rich, so brokers encourage you to trade.
  • Index mutual funds allow you to invest in stocks for a low cost. Other mutual funds try and mostly fail to beat the indexes, and charge higher fees regardless of their success.
  • Index funds also allow you to broadly diversify, reducing your exposure to the success of any company you invest in.

Have these fundamentals changed? A recent article in MSN Money claims that the advice is a lie. The reason for this is that the “level of risk in the stock market changed violently” in 2007. If this were true, investors who believed they built a moderately risky portfolio including stocks and bonds or cash prior to 2007 would suddenly have a riskier portfolio. I was under the impression that stocks were always risky, which is why they provide the opportunity for the largest long-term growth.

Looking back at 2007, it’s quite easy to pinpoint the exact moment you should have sold stocks. It’s also easy to look at what was happening in the market, point at something, and declare it was a “sign” that it was time to get out of the market.

I am still sticking with “buy and hold” as a long-term growth strategy. Yes, if I were to sell my investments now, I would lose a large amount of invested money. But I’m not selling now, I’m still buying.

Have the fundamentals changed? Are stocks riskier now or is this volatility just a side effect of the risk that has been there all along? Is the “buy and hold” strategy just a fad that is no longer relevant for today’s stock market?

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ETFs or Index Funds: Which are Right for You?

by Flexo on February 6, 2009

in Investing

About the author: This guest article is presented by ABCs of Investing, a new website for novice investors which offers two short and simple investing posts each week. Feel free to subscribe the the RSS feed.

With last year’s market meltdown affecting both managed mutual funds as well as their low-cost counterparts index funds and exchange-traded funds (ETFs), many investors are asking why they are paying extra money for managers who manage to lose just as much money as the passive instruments. They might also be thinking ahead to the good times when those same high fees will help reduce the managed mutual fund returns.

If you decide to jump into passive investing you may ask yourself a question common among investors, “Should I invest in index funds, exchange-traded funds, or both?”

There is no quick answer to this question. I think low cost index funds are the best choice for most investors and I will illustrate why in the rest of the post. First, let’s take a quick look at some important differences between index funds and ETFs.

What is an index fund?

An index fund is a mutual fund that invests in the same stocks that are contained in a stock market index, in the same proportion as the stock index.

Imagine a stock index that contains two stocks, IBM and Microsoft (MSFT). Let’s call it the ABC index. Let’s say that the ABC index consists of 60% IBM and 40% Microsoft. If an index fund is based on the ABC index then it, too, will invest in IBM and Microsoft, in the same proportion and allocation as index: 60% in IBM and 40% in Microsoft.

These percentages will change as the values of IBM and Microsoft change. If the price of the IBM stock increases and the price of Microsoft decreases then the index will change so that maybe 65% will be IBM and only 35% will be Microsoft.

What is an exchange-traded fund?

An exchange traded fund or ETF is an investment that contains the same stocks of a stock market index, in the same proportion as the stock index. If you are thinking this sounds a lot like index funds, you would be correct!

How index funds and ETFs are valued

The price of an ETF or index fund is determined by the value of the stocks contained in the underlying index. For example, the Vanguard Total Stock Market exchange traded fund (VTI) is an ETF that covers most of the stocks available in the US. As the price of the underlying stocks change value, the ETF price will also change because investors will bid the ETF shares higher or lower.

Differences between ETFs and index funds

One of the key differences between index funds and ETFs is that index funds are priced once a day. It doesn’t matter what time you put your order in, the price you get will be set at the end of the trading day (4:00pm EST). ETFs on the other hand are priced throughout the day in a similar fashion to stocks.

A second key difference is in order to purchase ETFs you have to pay a trading commission like you would with a single company stock.

Factors to consider when deciding between ETFs and index funds

Management expense ratio (MER). This is the basic cost of running an index fund or ETF. You won’t see the management fee deducted in any of your statements but you can find out what it is from the investment company website or Morningstar.com. Generally speaking, ETFs tend to be cheaper than a similar index funds however this can vary. It is very important to make sure you know the MER of any type of index fund or ETF you are considering.

Let’s look at an example. VTI contains all the publicly traded American stocks. The expense ratio is 0.07% which means that for every $10,000 of VTI you own Vanguard will charge you $7. Keep in mind this fee gets deducted directly from the fund. You don’t get charged separately.

The index fund counterpart to VTI is called the Vanguard Total Stock Market Index Fund (VTSMX). This fund comes with two different expense ratios.

  • 0.15% if you have between $3,000 and $100,000. These are the Investor Shares.
  • 0.07% if you have more than $100,000. These are the Admiral Shares.

From these numbers you can see that if you have less than $100,000 then the ETF version would be lower cost, but with over $100,000 the fees are a wash. But the expense ratio is not the only cost!

Trading costs. These are the costs associated with buying more units or shares of an index fund or ETF. Typically you don’t have to pay trading costs with mutual funds (index funds are a type of mutual fund), especially if it is a regularly scheduled purchase.

ETFs on the other hand need to be purchased through a brokerage so you will have to pay trading fees every time you make a purchase. There are some cheap options. For example, Zecco charges $4.50 per trade (or no fee if you have over $25,000 in your account) and TradeKing charges $4.95 per trade. These fees can add up, especially if you want to make more than one purchase per month.

If you consider both the expense ratio and the trading costs then the best choice really depends on the specific funds you are looking at as well as your trading costs. Usually you need a fairly large portfolio to be able to take advantage of the (usually) lower costs of ETFs. As a simple rule of thumb, if you have less than $100,000 in total you are probably better off with index funds. The Admiral series from Vanguard has great deals for index funds but you need a minimum of $100,000 per fund unless you want only one fund in your portfolio then you need some serious dough to be able to take advantage of them.

Automation of trades. One of the great advantages to index funds (and mutual funds in general) is that you can automate your purchases. If you want to contribute a certain dollar amount each month in a few different funds, automating that process allows you to “set it and forget it.” Once you set up the automated monthly purchases, money will be pulled from your bank account and the purchases will be made without any human intervention. This is the single biggest reason why I think that most investors should invest in index funds rather than ETFs if they make regular purchases.

Automation is a big issue for two reasons:

  1. Laziness is the enemy. If I have to log in and do some trades every month, once the novelty wears off then I will be sure to forget.
  2. Market timing. As a passive investor I know I’m wasting my time by trying to time the market. Regardless, every single time I’ve ever had to place an order for an ETF, I always try to time the market. I will sit there and watch the price movements for a while and see if I can get a better price. Once the order is finally placed then I’ll check back later to see if I should have waited a while before buying. This behavior is a complete waste of time but inexplicably, I do it every time. Buying index funds on a monthly purchase plan will save me a lot of time and stress.

Conclusion

Like many things in life, there is no clear answer to the question of whether index funds or ETFs are the better investment vehicle for you. Expense ratios, size of portfolio and frequency of trading are all important variables to consider, but I think for most investors, index funds are superior.

If you enjoyed this article, please visit ABCs of Investing for more articles for the investing novice. We would appreciate your comments and reactions, so if you would like to contribute to the discussion, add your comment below.

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Investing Ethically

by Smithee on January 30, 2009

in Investing

Last year we wrote an article about Ethical Consumerism, the practice of spending your money on businesses who support your ideas of a healthy community and environment.

In addition to where you spend your money, you can also put a lot of thought into which investment vehicles agree with your personal ethics. This is something weighing on my mind as I start from scratch learning about investing as a whole (see my previous article on the subject: What Do I Know About Investing?). There are a few different strategies, as I see it so far:

Invest in things you think will succeed, regardless of your own ethics

One of my co-workers is the sort of person who eats well, exercises all the time and generally treats his body as a temple. When I asked him if he ever does any investing, he quickly answered, “Only in the Vice Fund”. The Vice Fund invests in alcohol, gambling, tobacco and aerospace and defense industries. You could think of it as the “World is Going to Hell Fund”. The way I see it, investing in something with that kind of mission statement is akin to hoping other people keep destroying themselves.

For a guy who treats his own body as a temple, this seems like a weird contradiction, but as he tells it, the fund has been very lucrative for him, excluding 2008.

A similar example might be a vegetarian with a lot of stock in Burger King. Doesn’t make a whole lot of sense, except it could be quite profitable.

Invest in things you wish would succeed

For example, I wish that solar, wind and geothermal energy would succeed, and if I believed my Fifth Grade teachers, by 2009 those are the only sources of energy we should be using. I’m not particularly opposed to oil and coal because they’re dirty and they may be funding who-knows-what kind of overseas operations; I’m opposed to them primarily because they are finite resources. Eventually we will run out, and we may as well start weaning ourselves off of them now, because of the other environmental and political reasons. But do I think all humans will stop using oil and coal by the time I should be retiring, in about 30 years? I’m not sure.

Hedge your bets

Well, there’s one method of hedging your bets, which is to invest both in the things you think are successful-but-harmful, and in the things you think would benefit the world if only people saw things the way you do. But this doesn’t seem like a strong, long-term strategy to me. One of them will eventually fail. Thankfully, there’s another nuance:

The oil giant Shell is following BP and releasing a bunch of commercials highlighting how they’re committed to refining new ways to power things. This reminded me of another transition that shook up some companies: when photos moved from film to digital.

Nikon, for example, cruised along for decades making some very good (and some very cheap) film cameras. When computers became fast enough and connected enough, people started sharing their photos digitally and demand for digital cameras grew. Not willing to let a different company take their market share, Nikon became expert at making digital cameras as well.

Oddly, I don’t hear the names Kodak and Polaroid as often as I used to, though I know they’re still around.

Today we think of Exxon and Shell as “oil companies”, but they may very well position themselves as leaders in the geothermal energy space in the future. Here’s where my earlier advice about doing lots of research come back into play.

Further reading

Consumerism Commentary has written many, many articles about investing in the past. Flexo is a lot more knowledgeable than I am, so far, but I hope to catch up soon.

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What Do I Know About Investing?

by Smithee on January 23, 2009

in Investing

Flexo has often touted the benefits of using a real credit card (as opposed to a debit card) for daily spending, and paying off the balance each month. I guess this finally permeated my skull, since as soon as I saw the news about a credit card that deposits 2% cash back into a brokerage account, I went and got one. At the time, I knew as much about investing as my dog knows about plumbing. I also don’t know a lot about plumbing, but I know how to fill up a water dish, and that’s all the dog cares about.

I did a lot of reading online in preparation, and I’ll be doing a lot more. I even got one of those best-selling books, but I didn’t like what I read in it. That’s okay; it’s just as important to know what you don’t agree with as what you do agree with. There are still plenty of terms I couldn’t define for you, like “solvency”, but my eventual goal is to be a wise, seasoned investor. To start with, I thought I’d summarize for you the things that I’ve read that have resonated with me.

Invest only with the money you don’t need

For the purposes of this article, I’m going to have to assume that you’re not close to retirement. If you are, don’t listen to me. The rules are very different for you; please talk to a financial planner.

I use the phrase “money you don’t need” because I want you to think about the big picture. Think about your monthly budget, savings goals, 3-month emergency buffer, upcoming vacations, birthday and yuletide presents, lofty home improvement goals, and your daydreams of moving somewhere with a nicer climate. Now that you’ve thought about those things, do you have any money leftover? In other words, is it just sort of hanging out in a savings account? If you do, you can consider investing it.

Note: There’s at least one exception to this guideline: company-sponsored 401(k) and IRA plans. If your employer has one of these, and if they’re matching some part of your contribution, take them up on it. My employer is matching 100% of the first 3% of my gross paycheck I contribute, so I’m contributing 3%. This is free money your employer is offering. Now, there’s a good chance that the matching contribution they’re making won’t “vest” (meaning: actually benefit you) until your employment with them reaches some milestone, like 3 or 5 years. So if you don’t like your job, re-think this plan.

Another category of “money you don’t need” is a sudden windfall. You’re chugging along, working within your budget with no credit card debt, and a relative gives you $2,000, or you find through MissingMoney.com that someone owes you $155.

Finally, there’s always the proverbial garage sale. You probably won’t earn enough from a garage sale to make a big investment, I’m just saying it’s free money.

There’s more wisdom on this subject over at fool.com.

There are no low-risk, high-reward investments

Investing and gambling are not quite the same beasts, but they have one huge quality in common: you’ll be making a bet on what you think will happen in the future. And none of us has a plutonium-powered Delorean, flying or otherwise.

Thankfully, brokerage firms don’t offer you free drinks when you’re doing well (on second thought, with some clients they probably do …). My point is that if you’re hoping to see a 50% return on your investment, it won’t be through a mutual fund. So if you want a big reward, you’ll have to forgo a managed investment and make your own predictions, which brings me to research.

You’ll be doing a lot of research

Yes, you’re using the money you don’t need, and you should be willing to lose it, but you don’t want to, so do everything you can to avoid that. Namely, learn about the investment opportunity in front of you. Read about the company, its history, its founders, their histories, etc. We’re living in an Information Age; Google is your best friend.

If you have a friend, even a close one, who comes to you with an “it can’t fail!” opportunity, they’ll probably encourage you to invest all you can, as soon as you can. Take it from a guy who’s just starting to learn (call it beginner’s wisdom): there isn’t a worthwhile investment in the world that couldn’t wait a week for your learned contribution.

If you can, invest as early as possible

I don’t mean quickly, I mean early in your lifetime. I’m 33, so I failed at this. Until now, I’ve had all of my money tied up in food and shelter. I encounter this “start early” advice more frequently than I care to, because it makes me angry at myself. Compound interest is your best friend (Google is now your second-best friend).

But on the other hand, I’ve enjoyed a lot of my life so far, seen a lot of good movies and eaten at some nice restaurants. I wish I’d had the discipline to save even $10 a week when I started working, but I did what I did, and I have to accept that and move forward. If I had that Delorean, I’d go backward, instead.

That’s all I know so far

It’ll be a while before my brokerage account has enough “free money” in it to make any kind of worthwhile investment. In the meantime, I’m going to keep reading, learning from others and absorbing wisdom. I’ll be back every Friday to discuss what I’ve learned and share general investing news with you.

If you have any advice for me or the other readers, please leave a comment or start a topic in the forums (registration password: pluto).

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Your TARP Money Put to Good Use

by Flexo on January 21, 2009

in Investing

About the author: Jeff Rose is an Illinois Certified Financial Planner™ and co-founder of Alliance Investment Planning Group. He is a veteran of Operation Iraqi Freedom, having served in the National Guard.

Warning: For those of you that have been laid off recently, received a pay cut due to the recent economic crisis or frustrated with the government’s misuse of TARP money, this article might be hard for you to read. First, let me give a bit of a background.

Prior to becoming an independent financial planner, I worked for a regional brokerage that was bought out by Wachovia Securities back in 2007. Upon the announcement of the buyout is when I first learned about the concept of the “retention package.” Basically, when a brokerage firm gets bought out, it is industry standard for the purchasing firm to pay the newly acquired brokers to retain them and prevent them from jumping ship to the competition. Most people who survive a buyout or merger are usually thankful that they have a job, and definitely don’t expect to get an upfront check to stick around. So the idea that somebody makes a payday for just staying put sounds a bit absurd, even more so considering the state of the economy.

What the buyout means to you

Okay, let’s fast-forward to modern day. As I’m sure you’ve heard by now, the largest and well known brokerage firm, Merrill Lynch, was bought out by banking giant Bank of America. When I first heard this announcement, the first thing I thought of was, “How in the heck are they going to pay retention packages to the brokers?” The housing market has been a mess and write downs are still a reality. From a PR standpoint, I just couldn’t see them justifying paying huge amounts “just to keep” brokers that are already in the top 1% of all wage earners. But then again, this is corporate America. Here’s what was offered, according to planadviser.com:

Advisers who produce $1.75 million in fees and commissions will receive 100% of their last year’s book of business (as of September 15): 75% of their bonus in a seven-year forgivable loan, and another 25% in deferred cash over three years.

Advisers who produce $1 million to $1.749 million in fees and commissions will receive a seven-year forgivable loan equal to 75% of their last year’s book of business, and can receive up to a 25% growth reward, payable over four years.

Advisers who produce $750,000 to $999,999 will receive a 50% seven-year forgivable loan and can receive up to a 25% growth reward.

Advisers who produce $500,000 to $749,000 will receive a 25% seven-year forgivable loan and can receive up to a 25% growth reward.

Advisers who produce less than $500,000 will receive get a 20% deferred cash payment.

For those that are outsiders to the industry, let me explain the first bullet point. An adviser that produces $1.75 million in fees and commissions generally will take home about 50% plus. The other half goes to the firm. So figure a broker who is at that level will make about $875,000 (minus taxes of course), plus deferred comp and other little perks that aren’t mentioned. That same broker is now getting paid $1.31 million up front just to stay put with another $437,000 coming over a three year period. Notice, too, the number is based off their trailing production as of September 15th, 2008, just prior to the market collapse in October. Isn’t that convenient? Keep in mind that the broker is still getting paid the fees and commissions that they generate. Remember, they didn’t lose their job. They just got bought out.

Your TARP money to work

Just the other day, Bank of America just received another $20 billion of TARP money to help with their acquisition of Merrill. Based on rough numbers, it’s estimated that $3.6 billion of this will be paid for the top brokers to stay in their seats. How’s that for our tax dollars at work? The $20 billion is in addition to the $15 billion that Bank of America received last October and the $10 billion that Merrill received on January 1st. There’s more to it, but I’ll leave it at that for now. In a nutshell, our tax dollars are going towards paying brokers to not seek employment from a competitor. In case that last sentence did not register, please reread it, think it over, and let it digest. How did that taste?

How does that make you feel?

With U.S. unemployment flirting with 8%, how does it make you feel knowing that a broker who already makes almost a million dollars a year is going to get paid over a million just to stay with his company? There are many words that come to my mind, but I’ll let you fill in the blank for me. Please share your thoughts.

If you enjoyed this article, please read more from Jeff Rose at his blog, Good Financial Cents, where he writes about financial planning and investing. You can also subscribe to the Good Financial Cents RSS feed. We would appreciate your comments and reactions, so if you would like to contribute to the discussion, add your comment below.

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