ETFs vs. Mutual Funds: Which One is Right for You?

I’ve always considered getting the CFP designation, and this week I just heard that it might be easier for me than before. Since I already have the CRPC, the College for Financial Planning is now offering a 3 week bridge course that covers the retirement module of the CFP education requirement. This means that in as little as 3 weeks, I could already be 20% completed with the CFP education program. This is an interesting offer since it could effectively shave off many months of studying that would have otherwise been directed towards that part of the program.

So, I’m going to be contemplating this over the weekend, and I need to make a decision soon since space is limited in the class and it starts on September 3rd. This designation isn’t needed for my current line of work, but it also can’t hurt, and would obviously be tremendously valuable throughout my career. I need something else to do like I need a hole in the head, but it could be a great way to jump start the CFP process for me. So, while I think about spending my free time studying, you can enjoy these great articles from the past week.

Strategies to Weather a Bear Market - Everyone is looking for ways to protect their investments in this tough market, but sometimes doing nothing can be your best strategy. That is, if you invested properly to begin with.

Make Morey Money & Be Happy in Your Job Using a Work Portfolio - If you’re one of the many people faced with finding a new job, this advice is just for you. Building a work portfolio is going to be much better than just quickly putting together a resume and cover letter.

Frugal Tip: Write it Down - It’s been said before that things are more likely to be accomplished if they are written down. This goes for everything, including money. Find out how writing things down can help you save money.

Monthly Checklist To Help Speed Up Your Debt Reduction And Increase Your Savings - For those of you trying to pay down that debt so you can begin saving even more money, NCN has a bunch of great tips that will help you make the most of both paying down debt and saving.

Is Eating Organic Food Worth the Money? - This will depend on the person, but in most cases, I could care less about organic if it costs a good deal more. If I’m pricing something at the store and there is little or no difference, I’ll grab organic, but I’m not going to obsess over it and spend twice as much money on groceries either.

5 Signs Your Job Sucks - Do you feel that your job sucks, or do you go to work everyday not realizing your job sucks? Brip Blap has 5 traits that could certainly mean your job does in fact suck.

15 Tips for Saving Money While You Still Have a Job - If you’re fortunate enough to have a job right now, even you can benefit from saving some money. So, Madison has put together a list of 15 tips to save money even when you do have steady income.

Don’t Pay Your Children’s College Education - While this was a devil’s advocate post, I have to say that this is actually the right advice for most parents. If saving for your child’s education sacrifices your ability to save for yourself, then you’re doing it wrong.

How Would You Grade Your Money Management Skills? - How do you, and how might your kids stack up when it comes to money management education? SVB dissects the latest Schwab survey that looked into how different age groups and generations perceived their money management skills.

Harvey Mackay’s Favorite Morals - JLP has a great list of Harvey Mackay’s favorite morals. 42 of them to be exact. There are some great ones on the list, and some of them really make you stop and think.

10 Hottest Mutual Funds in 2008 - People are always looking for the hot new investment, so here are 10 of the hottest mutual funds in 2008. But keep in mind, hot doesn’t always mean best.

Can You Trust Bankrate’s Bank Safety Ratings? - Talk about safety of banks and which ones are safe from failure is all the rage lately, and nickel examines Bankrate’s bank safety rating scores. Are these a good indicator of the true safety of your bank?

How Much Will You Fight for in the Checkout Line? - Mighty Bargain Hunter shares a story about how much it takes to make a stink in the checkout line about an incorrect price. For me, I’m not going to go to great lengths to worry about anything under a dollar or so, but if there is a significant error, I’ll certainly want to get the right price.

Over 5 Million Unclaimed Economic Stimulus Checks - Ahh, government efficiency at its best. Remember the fact that the government spent $42 million and more just to inform people about the stimulus? That didn’t seem to work considering there are still over 5 million unclaimed checks, amounting to hundreds of millions of dollars.

Proper Asset Allocation Requires Understanding Correlation Coefficients

Correlation coefficients? What on Earth does this have to do with creating a diversified portfolio? If this sounds foreign or complex to you, don’t be alarmed. It isn’t nearly as scary as it sounds. You’re probably picturing high school or college math classes, but correlation coefficient is just a fancy way of saying how close two different types of investments react to each other. And if you want to truly create a diversified portfolio, it helps if you understand how different assets move relative to the performance of others.

Think of it this way. You could create a portfolio that consisted of a few index funds that spanned 2,000 different companies, yet have virtually no diversification. I know that doesn’t make sense to a lot of people since it seems as if you were invested in that many companies, you’re very diversified. But the true goal of asset allocation is to create a portfolio that has investments that are not correlated so that you can minimize risk while maximizing returns. So, let’s see how it works.

Defining Correlation

Proper asset allocation requires knowing the degree in which different asset classes correlate with one another. The possible correlation values range from -1.00 to 1.00. A value of 1 is perfect correlation, and a value of -1 is negative correlation. For example, if you were comparing two investments, A and B, and they had a correlation of 1, if investment A saw a return of 1%, investment B would realize a 1% return as well. If A and B had a -1 correlation, if investment A had a 1% return, investment B would have a 1% loss.

Of course, in the real world, 1 and -1 correlations almost never exist. But for the sake of comparing asset classes, most people view a correlation value between 0 and 0.5 as a very weak correlation, which is a good starting point for finding diversification. The farther from a +1 correlation two investments are, the more diversification you’ll realize by holding those two investments. A correlation of -0.5 provides more diversification than 0.1, and 0.1 provides more diversification than 0.5.

Correlation of Returns Among Asset Classes Between 1970-2006

Source: Jack Wilson and Charles Jones, North Carolina State University

Looking at this chart, you can get a rough idea of the correlation across different asset classes. Looking at large-cap stocks, you’ll see that it is most closely correlated with mid-cap stocks, and they become less correlated as you work your way down the list. So, by looking at the list, if you had a portfolio consisting of mostly mid-cap stocks, adding some small-cap holdings would provide little diversification since their correlation is nearly 0.9. Even large-cap and mid-cap are fairly correlated with a 0.76, so if you want to really add diversification, you should be looking for asset classes with 0.5 or less. In this case, adding some foreign stock or bonds would provide the greatest diversification.

The same goes for bonds if you’re looking to add some diversification. If you look at the chart, the correlation between government bonds and corporate bonds are nearly 1. So, if you already have a corporate bond position in your portfolio, adding, or changing to a government bond would provide little difference since history shows they move almost exactly the same.

Why Even Worry About Correlation?

This probably seems like overkill. Who has the time to worry about these silly numbers? Well, I only bring it up because I meet with a lot of people who have spent time constructing what they think is a good diversified portfolio, only to find that even though they may have five or six good funds, their overall allocation is hardly as diversified as they thought.

Most of the time, this happens when people build a portfolio centered around large-cap stocks and then add just a little bit of small and mid-cap stocks, and some international to round out the mix. Sure, you may be diversified across every sector in the market and across various market caps, but if your average correlation between everything is generally around 0.8, you’re creating a more complicated portfolio than you need to. There is no need to worry about a handful of funds that are more or less highly correlated if you could achieve the same thing with one or two index funds.

So, this is just another tool at your disposal to help you build the right portfolio. Don’t get too caught up in it. But just because you own a bunch of funds doesn’t automatically make it diversified. You can spot opportunities for true diversification by adding investments that are less correlated, or even reverse correlated to minimize volatility.

Remember, These Are Long Term Averages

The correlation between asset classes does change depending on recent economic events or global market performance. So, when diversifying based on correlation, make sure you’re applying it to a long-term portfolio since the numbers can fluctuate in the short-term.

Even If You Practice Safe Credit and Debit Shopping Habits, You Could Still be a Target of Fraud

Today, 11 people were indicted for stealing more than 40 million credit and debit card numbers. The 11 people were part of a crime ring that spanned across the globe. Three people were from the United States, two from China, and the rest from Eastern Europe. How is something on this scale even possible?

The hackers allegedly hacked into the computer systems of nine major U.S. retailers. Once inside the systems, they were able to install software that could track and log the card information that was used for the transaction. So, even if you were shopping in a retail store, in person, and the cashier even verified your signature or you used a secure PIN code, your data could have unknowingly found its way into the hands of thieves.

The Stores Affected

Nine major retailers were affected:

• Marshall’s
• T.J. Maxx
• BJ’s Wholesale Club
• OfficeMax
• Boston Market
• Barnes & Noble
• Sports Authority
• Forever 21
• DSW

If you do, or have shopped at any of these locations in the past and used a credit or debit card, you should pay close attention to the charges on your bill or for unusual activity in your checking account linked to a debit card. It’s unsure at this time how long the “sniffing” programs were in place collecting the numbers, or how far the numbers have been distributed, so it’s best to be aware and monitor your activity closely. It also might not hurt to grab a free credit report or even request a new card from the issuing company.

This could actually explain the fraudulent activity we had on a MasterCard debit card last year. My wife’s debit card had a few suspicious charges on it one day and the bank called to alert us and cancel the charges. I thought that was odd since we never use that debit card online for anything, so I had no idea how the numbers could have been stolen. And my wife had the card in her possession when the charges were made, so for the longest time it was a mystery. But looking at the list of retailers, there is a good chance she used her card at DSW, Marshall’s, or Barnes & Noble at some point since those are stores we shop at occasionally.

Be Careful Out There

As you can see, there are ways for people to obtain your sensitive information even if you are vigilant in keeping your information safe while trying to prevent identity theft. Hackers can work from around the world to snatch your data right out from under you while shopping at your local store. Make sure you’re regularly checking your credit report and keeping an eye on the transaction details on your credit or debit accounts. It could happen to anyone.

One Couple Suggests That Investing in Bonds is the Right Thing to Do in This Market

This was the title of an article I came cross in one of the recent editions of Investment News. It was written by Stan and Hildy Richelson, who are very credentialed, have written four books on bonds, and even the president of Scarsdale Investment Group. After taking notice of the provocative title, I just had to dig into it and see how this concept played out.

The basic premise is that individual investors would should be advised to move entirely into the safest government bonds. This flies in the face of the traditional methodology of creating a diversified portfolio and holding on. Surely, this goes against everything I’ve been taught, so there has to be something behind this theory.

According to the authors:

Investors are told to put their faith in the holy name of diversification, and they will be saved. But why diversify into multiple asset classes to reduce risk when investors would be much safer if they bought only safe bonds?

Why diversify? Well, I just wrote about the benefits of diversification on Monday. If you recall from that post, the benefits of diversification, at least over the past 20 years, is very clear. Is there still a risk of negative returns at times? Of course, but with that little bit of risk comes greater long-term rewards.

Fees and Expenses

The authors go on to make another case for bonds because you can save on fees. While I will agree that buying individual bonds, just like individual stocks can save you from annual expenses, it is their information of how high these fees are that really gets to me. According to the article, they say that the average actively managed large-cap fund has annual expenses of 2%, small-cap and foreign funds have an average of 4% annual expenses, and emerging-markets have annual fees of nearly 10%. Are you kidding me?

According to Morningstar:

The average individual investor paid 0.93% for U.S. stock funds in 2006 compared with 0.96% in 2005…The biggest price break came in international funds where big returns have spurred big inflows. The average individual investor paid 1.07% for international funds in 2006 compared with 1.13% in 2005. Balanced funds’ expenses fell from 0.82% to 0.79%, while taxable bond expenses dipped from 0.84% to 0.81%.

Bottom line is if you’re paying 2, 4, or 10% annual expenses, not even investing in bonds will help you. The fact that they throw around these high numbers to make a case for bonds is troubling.

History is no Predictor of the Future

The authors continue on to discuss returns. People expect stocks to average around 10% over the long-term, and while they may not have performed that well in the past few years, going back 20 or more years shows that this is the case.

If the typical investor actually earned a historical return of substantially less than 10% after the three categories of reductions [bad timing, taxes, and fees], why would anyone believe that a 10% or more return would be earned in the future? … No one knows what stocks will earn in the future. If there are losses followed by gains, individual investors may not have enough time to recoup their investment losses before retirement.

Again, the claims being made are on some pretty dramatic assumptions. First, bad timing. Now, I’ll admit that most investors have terrible timing, but this is assuming people are regularly making changes to their portfolio. But if you’re regularly investing money each month and stick it in a diversified portfolio, target date fund, or a few index funds, you aren’t fooling with timing, so that point is moot. Then the issue of fees. If the fees were even remotely close to what they mentioned, that would be a concern. But considering most investors, even in actively managed funds and not index funds are paying less than 1% a year, this impact is minimal. And finally, the comparison is being made to tax-free bonds. Well, if you’re investing in a Roth IRA or 401k, you’re already going to receive tax-free earnings. Even if you’re in a pre-tax account, you’re getting the added benefit of tax-deferred growth. All of these so far are weak arguments for bonds.

Who Should Buy Bonds?

After reading this, I was hoping there would be a caveat saying this advice is for people very near, or already in retirement and relying on cash flow that bonds can provide, but I was disappointed to find nothing to that extent. This is general advice trying to convince people that ultra-conservative bonds are where you should put your money right now. All this is doing is advocating market timing. Sure, we’ve had a a rough 8 or 9 months, but we don’t know what the future holds.

I know this is fairly strong criticism coming from me since I’m a strong proponent of bonds, even for younger people, but this advice and rationale is a bit over the top. I believe bonds can do a great job in assisting in creating a diversified portfolio that minimizes risk while maximizing returns. It isn’t an all or nothing choice like the authors suggest.

In fact, look at a portfolio over the past 20 years that was nearly a 50/50 mix of stocks and bonds. In 20 years, it had only 3 years with losses. Two of those were under 1% and the greatest annual loss was only 3.35%. With these minimal losses, the average annual return was nearly 10%.

Had you been invested in government bonds over that same time, you would have earned about 6.2% annually. I don’t know about you, but I’ll gladly take another 3% on average while taking on only slightly more risk. 3% over 25-30 years is a lot of money to throw away for a little bit of safety. But you’re free to invest your money however you want, but don’t be too quick to jump on the fixed income wagon just because we’ve had a bad few months in the market.