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Finance For Dummies

Finance For Dummies offers personal finance information on investing, retirement investing, finance, insurance, credit cards, loans and more. Personal finance education is our goal.

Thursday, August 31, 2006

Growth Through Global Investing

If you look at historical returns the U.S. stock market, when compared to all markets worldwide, rarely is the leader of the pack.

From 1994-2000 the U.S. lead all markets in performance only once--1995. So by broadening your investment horizons you increase your chances of good performance. It is rare to find one single stock market that consistently performs at the top of the global markets. Because it is impossible to predict which one will be this year's winner, you need to diversify your investments internationally in order to catch these highs.

Wednesday, August 30, 2006

Global Investing 1969-2000

Here will will study the hypothetical growth of investing $1 in U.S. stocks and bonds, international stocks and bonds and inflation.

While U.S. stocks ended this time period with the best returns, but for a majority of this time international stocks outstripped U.S. stocks. International bonds outperformed the U.S. bonds during this long time period as well. Because the two both perform well, but are not alike they complement one another very well. So diversifying and getting good international exposure is great for your portfolio.

Tuesday, August 29, 2006

Global Stock Market Returns

We will examine the historical range of 1970-2000 to see how global markets performed and the risk that went along with these results.

The US averaged a 12.9% return during these years with a peak of 37.4% and trough of -26.5. Now the general international market returned 12.2% with a 69.9% peak and -23.2% trough. Then Europe averaged a 13% gain and had a high of 79.8% and a low of -22.8%. Finally, the Pacific had an 11.9% average with a peak of 107.5% and a low of -34.3%.

This looks like the Pacific had the highest volitility while providing the highest one-year gain. Now Europe had an excellent average return, but the volitility is high as well. The U.S. had a great average with the least amount of volitility. Combining all these classes will lower the overall volitility and allows you to experience big gains.

Monday, August 28, 2006

World Stock Market Capitalization

If you do not invest internationally you are missing out on approximately half of the investable developed stock market opportunities worldwide. While the U.S. does make up 50% of the available investments, by ignoring countries like Japan, England and the like you can be missing some excellent investments. Also, it is important to remember that diversifying your portfolio through international stocks will lower the risk of your overall portfolio.

So look around at some mutual funds that are international types and seek one will solid performance, low expense ratio and is a no-load. Over the long-term this will help your portfolio tremendously and you will see the benefits of exposing yourself to this portion of the market.

Sunday, August 27, 2006

Why Invest Globally?

We are going to discuss the advantages and disadvantages of investing globally in equities.

Investment Opportunities
International markets offer a different set of investment opportunities than just inbvesting in U.S. markets.

Market History
International markets take up a large part of the world's available stocks.

Growth Potential
Some international economies do not reflect the U.S.'s growth patterns.

Diversification
If nothing else investing internationally will lower the risk of your portfolio by diversification.

Expand Efficient Range
Expanding your options and including international investments can help your risk-and-return trade-off of your investment opportunities.

Saturday, August 26, 2006

Value Stock Premium

We have talked about how historically that value has outstripped growth stocks over a long time span, but why is that? What explains the value premium and will this continue?

Many academic studies have shown how the stock market and the herd over-reacts to bad news and under-reacts to good news. This may mean there is more room for value stocks to grow more, and better than growth stocks which have their poremium priced in. Value historically has more risk than growth (standard deviation). Maybe the added return from value stocks is because of this added risk.

In the 1990s large cap growth stocks performed the best, but examining the evidence you will conclude that the long-term still favors value.

Friday, August 25, 2006

S&P Quarterly P/E History 1926-2000

P/E is a essential way to determine if the stock market is over and under valued. Here we will examine the historical P/E for the S&P 500. You take the total market value of a company and divide it by the trailing one-year earnings to determine P/E ratios.

Historical P/Es for the S&P 500 have varied much over the years, but in late 1990s when the average peaked at about 35 is right when the tech bubble and the downturn of March 2000 began. For a majority of the time from 1926-2000 you saw P/Es between 10-20 which meant investors were willing to pay between $10 and $20 for a dollar of earnings by a company. Late in the 1990s P/Es had doubled and many saw this as a major sign the market was overpriced--and it was. The market turned in March 2000 and then was hit again when the attacks of 9/11 came. That double whammy hurt investors that got in at the top when P/Es were at 35.

Thursday, August 24, 2006

Risk versus Return for Growth and Value Stocks

From 1928-2000 you can examine the risk and rewards of growth and value stocks. We will look at large cap growth and large cap value as well as small cap growth and small cap value. The rule of themb is the more risk the more reward should go along with it. However, it is always necessary so we examing the numbers.

Small cap value stocks had the highest return (14%) and risk, or standard deviation (35%). However, small cap growth had a return a little over 9% and risk was measured at almost 31%. Large cap value had the second best returns at close to 13% and risk at 30%. Large cap growth stocks returned 10% and 21% risk. This does not follow how it should be according to the ideas of risk and reward, but it is interesting to see the numbers over a long time horizon.

Wednesday, August 23, 2006

Growth and Value Trends by Decade

Breaking down growth and value trends through decades is another important way to determine the breakdown of how you should allocate.

Since the 1930s only that decade and the 1990s were periods growth outperfromed value. So the decades of the 1940s through 1980s value stocks were dominant. The 1990s was an anomaly because of the technology and internet-related stocks were in favor and that helped growth stocks outperfrom value. In the coming decades we will see if the 1990s was an anomaly or if it foreshadowed a change to come in behavior in the stock market.

Tuesday, August 22, 2006

Growth versus Value Stocks

Different stock market conditions typically call for an emphasis placed on growth or value stocks. Examining the the annual premium of growth and value stocks in accordance to the book-to-market ratio you will see interesting results from 1928-2000. Growth stocks have low book-to-market ratios while value have high ones. When the annual premium of value stocks is positive they will outperform growth and vice versa. Often during this period there will be time spans of 2 years to seven years. This does not mean you should transfer all your investments to one or the other when premiums are in their favor, but it does mean you can weight your portfolio to take advantage of this potential trend.

Monday, August 21, 2006

More on Growth and Value Investing

As stated previously value investing over the very long term has provided excellent returns especially compared to growth. However, if you shrink the time line to 10 years you will see differing results. For example, 1990-2000 large cap stocks performed the best, with large cap growth leading the way at 18.1%. Small growth stocks were the worst at a 14.0% average rate. Large cap value returned 17.5% over this period and small cap value returned 16.1%.

So although a very long time horizon favors value stocks, in this specific case large caps stocks ruled over ten years with large cap growth being the best.

Sunday, August 20, 2006

Growth and Value Investing

There are many different classess of stock that you can choose to diversify your portfolio. Growth and value stocks are just another way to distribute your investments.

Examing the growth of $1 invested in large cap growth, large cap value, small cap growth and small cap value on December 31, 1927-2000 you will find interesting results.

Value stocks outperformed growth stocks by a significant margin. $1 in small cap value has an average return of 14.2% with an ending balance of $16,027. Large value returns 12.4% average return with a balance ending at $5,170. On the other hand, small growth returned 10.0% and ended with $1,017 and large growth ended with $727 and a 9.4% return.

Obviously there have been periods of time that growth has outstripped value, but this information gives you insight on how to approach growth and value investing long term.

Saturday, August 19, 2006

Personal Budgets

For several months we have discussed budgets. There is no time like the present for examining how your budget is coming.

  • What have you learned so far?
  • Have you been able to apply what you learned?
  • Have you been able to make cuts in your spending?
  • Are you staying within your budget
  • Does keeping a budget make you more conscious of the money you spend?

Budgets can create discipline. You know that the end of the month is coming and you will need to explain to your spouse (or yourself) what money went where and why. There are consequences that you will be able to see. If it was a good month you might be able to save, invest, payback debt, etc. more than before. If it was not so good of a month then you will not be able to pay as much down on your credit card as you wanted. Maybe that means you will be paying it back another several months or you have to pay more in interest.

So take some time out and see how your budget is coming and try to see how it is helping you.

Friday, August 18, 2006

The Stock Market

The stock market has showed significant strength lately with oil prices dropping and the Israeli/Lebanon conflict in a cease fire. Investors hope this rally can sustain itself, but we will need to wait and see.

Currently world conditions are relatively stable, however, with so many issues out there anything could happen and the immediate results would not be good for the stock market. Also, if the Fed’s actions in the coming months does not convince investors that the economy is ok that will hurt the stock market as well.

Examine your portfolio and if there is a dog you have been thinking about getting rid of—now is the time. Take advantage of the high market performance while you can because you never know what will happen next.

Thursday, August 17, 2006

More on Growth and Value Stocks

Growth and Value is another method of classifying stocks or portfolios because usually they will have many aspects of one or the other. Like sectors and asset classes, it is important to know when growth is in or out and when value is in or out.

Growth stocks are stocks of companies that historically have been able to grow their businesses faster than the average company and that growth is expected to continue. Because of this growth investors are willing to pay more for these sticks than they would for value stocks relative to current earnings. They reinvest their profit to continue to grow.

Value stocks are stocks of companies that historically have had slower growth in sales and earnings than average or recently experienced some type of trouble that caused the stock price to decrease. Investors, like Warren Buffet, see value companies to be turn-around opportunities where a change in management or business strategy could increase its potential for growth.Since value companies are not expected to grow quickly their yield will be higher to retain investors.

Wednesday, August 16, 2006

Growth and Value Stocks

We have discussed the ying and yang of investing many times. Another way of examing stocks is growth and value.

Here are some characteristics of both:

Growth
  • High growth rate of earnings and sales
  • High price-to-book, price-toearnings ratios
  • Reinvesting earnings in the business and paying little to no dividend
Value
  • Slower growth of earnings and sales
  • Higher dividend yields
  • Low price-to-book and P/E ratios

Tuesday, August 15, 2006

Capitalization

The stock markets has cycles and at certain times certain asset classes or sectors can be in or out of favor. If you chart out sectors and asset classes you will see specific times when a sector is in favor and then will have a down period. So if you can find companies or mutual funds with good earnings and future growth with a P/E under the benchmark you can sometimes ride a strong wave to excellent stock market performance. On the other hand, the opposite can happen as well. So consider these factors when investing in non-retirement funds.

Sunday, August 13, 2006

Long-Term Investment Strategy

A bull stock market makes it easy to stay on course with your long-term investment goals; the challenge is to do this during bear markets. It can be tough, but when that bull market comes if you are well-diversified there is nothing you should do but stay the course.

If you examine performance during a a recessionary period of 1971-1974 you can see that stocks went down about 25%; if you had a 50/50 stock and bond portfolio you lost around 9% and if you had all bonds you were up around 10%. On the other hand, looking at a long period of time (1974-2000) the opposite becomes true. $1,000 would be worth over $48,000 if invested in stocks; about $25,000 in a 50/50 bond and stock portfolio and about $11,000 for an all bond portfolio.

So you might be at a loss in the short run, but if you can stay with your plan of diversification through the bad times you will win out in the end.

Power of Compounding

It is amazing to examine how investing early in life will help you in the long run. Compounding is the main reason for this.

If an investor started investing $2,000 per year for each of the next ten years. Then in 1990 they stopped putting in $2,000 annually and let their account grow until 2000. At this time you would have invested $20,000, but your portfolio worth would be almost $230,000 because of compounding. ANother investor waited 10 years and began in 1990 and invested $4,000 each year in stocks for 10 years. By the end of 2000 your totally amount invested would be $40,000 and your total portfolio worth would be only $105,700 because of compounding interest.

So start early, no matter how small the investment is will not matter because extra years of compounding will make a huge difference in your portfolio value.

Saturday, August 12, 2006

More Dangers of Market Timing

Examining the period from 1980 to 2000 you can see that market timing can be detrimental to your portfolio value. Take $1 at December 31, 1980 and by December 31, 2000 that $1 would be $18.43--pretty good, right? However, when you take that $1 over the same period it would be worth $4.73 if you missed the best 15 months of the stock market returns. $1 invested in Treasury bills would be worth $3.61. So if you were unsuccessful in your market timing your performance would be just above the return for Treasury bills.

Friday, August 11, 2006

The Importance of Rebalancing

Rebalancing is often overlooked in the grand scheme of investing, but can be very important in reaching your goals. Asset classes grow at different rates of return and this causes rebalancing to be necessary.

Look at the 20-year period from 1980-2000. In 1980 you start with 50% stocks and 50% bonds. Without rebalancing by 2000 you would be 70% stocks and 30% bonds. This can lead to higher volatility because your stocks are now overweighted in your portfolio.

Thursday, August 10, 2006

Power of Reinvesting

When investing it is essential to reinvest the income you make off those investments. Your returns will decrease significantly if you take out your dividends or coupon payments.

Look at the time period of 1980-2000 and take $1,000 and invest it in stocks with reinvestments, stocks without reinvestments, bonds with reinvestments and bonds without. It is stunning to see the differences.

Ending Wealth Average Return
Stocks with Reinvestments $18,408 15.7%
Stocks without $9,728 12.0%
Bonds with Reinvestments $9,633 12.0%
Bonds without $1,789 3.0%

This information should go a long way into your decision of reinesvting your earnings or not.

Wednesday, August 09, 2006

Dangers of Market Timing

We have spoke many times on this blog about marketing dangers. This will be another illustration.

Examining investors who attempt to market time run a significant risk of missing periods of huge returns. This, typically will have a negative effect on your portfolio.

Take $1 in stocks at December 31, 1925. By the end of 2000 it would have grown to $2,587. However, if you missed the 40 best months of returns your would only have $15.33. Even Treasury bills beats that at $16.56 over that time period.

Now successful market timing can make you a lot of money, however, it is extremely difficult to pull that off with any consistency.

Monday, August 07, 2006

The Risk of High Withdrawal Rates

When you consider your retirement savings you need to forecast the withdrawal rate. You need to look at the portfolio mix, how long you plan to withdrawal from the portfolio, how much risk you want to take on, and spending patterns.

At retirement a 50% stock and 50% bond portfolio is not uncommon. Let's say your retirement savings is $500,000 and you retired on December 31, 1972. Obviously, the higher the withdrawal rate the greater the chance of potential shortfall. If you took out 9% you would be out in 1981 and 1982 if you took out 8%. But as the withdrawal rate drops the longer your money lasts. At 7% withdrawal rate you would reach 1984. At 6% you last almost to 1988. Finally at 5% you last until 1994.

So by examing this you can tell how much you will have and for how long.

Sunday, August 06, 2006

Diversified Portfolios and Bear Markets

During a severe market downturn diversification can save you from deep losses. Bear markets are actually the best time to see the benefits of diversification. The December 1972-June 1976 recession and the June 1987-December 1990 are two examples.

If you take $1,000 and diversify it: 35% stocks, 40% bonds, Treasury bills 25%. Then compare it versus a stock 100% portfolio.



1970s $1,149 Diversified
1970s $1,104 Stocks

1990s $1,324 Diversified
1990s $1,227 Stocks

Over the long run diversification will lower your risk and oftentimes increase your return.

Saturday, August 05, 2006

Reduction of Risk Over Time

Risk is an important factor to consider when investing. You have to be able to accept risk if you want the opportunity at increased returns over a long period of time.

From 1926-2000 period you should understand that the highs and lows of performance will offset one another. And as time passes volitility lowers.

If you take 1-year, 5-year and 20-year time frames you can see this illustrated. Small cap stocks in one years can have returns as high as 130% and as low as -60%. As you get to 5 years it has dropped significantly and by 20 years your return will average 12.4% and your risk will be much less. Even if you do not like risk you can invest in small caps over the long term, it is no longer so risky.

Friday, August 04, 2006

The Benefits of Deferring Taxes

It is almost impossible to avoid taxes with most investments, but taxes can be deferred. Deferring your taxes can profit you substaintially over the long term.

IRAs, 401k, 403b, Keogh plans and tax-deferred annuities are all examples tax-deferred investment vehicles. Tax-deferred plans work by allowing interest, dividends and capital gains to accumulate without incurring taxes. Taxes are due when the investment is sold (once withdrawls begin).

Let's say you invest $10,000 in a taxable and tax-deferred account. There is not much of a difference over ten years--approximately $50,000, but once you get to 20 years it is around $80,000 and at thirty years it is about $175,000.

Thursday, August 03, 2006

Stocks, Bonds, Treasury Bills and Inflation


As we have discussed the more risk taken over a long time horizon the greater reward. It is also to include inflation when looking at long-term (1925-2000) investing because it can have a dramatic effect on how you should invest. Small caps hiostorically return over 12%; large caps around 11%; Government bonds over 5%; and T-bills around 3.8%. During this same period inflation has averaged 3.1% per year. There fore, you must consider risk, return and inflation to make wise long-term decisions on your investments.

Wednesday, August 02, 2006

Retirement: Pre-tax Savings

Another important aspect of investing in your retirement is tax-deferred plans are allowed to be deducted from your paycheck before the goverment takes out any taxes. Pre-tax contributions to a retirement plan will often reduce the amount of taxes you pay each year.

The government wants to encourage citizens to invest in their retirement and this is a main reason why you can make pre-tax contributions to your qualified reirement plan. This benefit might increase the amount of money you keep after taxes and savings are considered.

An example of this benefit would be to assume you make $75,000 annually and you set aside 8% of your pre-tax wages per year for retirement. Another earning the same amount and same contribution contributes 8% of pre-tax wages per year to a 401k plan at work. Both invest the same, but the pre-tax investor will tax home earnings of almost $2,000 more a year.

Tuesday, August 01, 2006

Stocks, Bonds, Treasury Bills and Taxes

As you might guess, taxes have a major impact on the overall perfromance of an investment portfolio. Stocks are one of the few asset classes that has provided significant after-tax growth from 1925-2000.

Examing returns after-taxes is a humbling experience because your winners do not seem as good as they did before you accounted for taxes. In this time period investments after taxes for stocks were 8.5%; Municipal bonds (exempt from federal taxes) 4.2%; government bonds 3.8%; and Treasury bills at 2.2%. Remember, inflation in this time period was 3.1%, so when that is added to the equation the results are even more somber. After taxes and inflation you actually lose money in treasury bills. Government and municipal bonds bareful outpace inflation. Finalyy, you will see that stocks will give you 5.4% after taxes and inflation.

So if you want your portfolio to grow over time bonds can help in diversification, but hurt you in performance.