stock market

How Bond Prices and Yields Work

Tim Lemke — Wed, 04 Jul 2018 08:30:14 +0000

When we talk about investing, we frequently talk about stocks. Stocks are likely to make up a the bulk of your investment portfolio during the majority of your investing years.

Bonds, which tend to be less risky but also less rewarding, are more important as you get closer to retirement. However, bonds can be a helpful part of your investment mix at any age, and it's important to understand how they work — even if you don't own many of them right now.

Let's examine bonds and why we should pay close attention to them these days. (See also: 5 Crucial Things You Should Know About Bonds)

How government bonds work

A bond is simply a vehicle that governments and companies use to borrow money. People buy bonds, and in exchange, receive interest payments. Our country would barely be able to function without bonds.

For the sake of this discussion, let's focus on government bonds. The U.S. government floats many different securities, but the most common are the 30-year and 10-year Treasury bonds. These bonds pay interest every six months, and the principal of the bond — often referred to as "par value" — is paid in full after 30 or 10 years.

There are also popular securities called Treasury Inflation-Protected Securities (TIPS). The principal of a TIPS can go up or down depending on the movement of the Consumer Price Index.

U.S. Treasuries are very popular worldwide because they are backed by the full faith and credit of the U.S. government, which has historically always repaid its debts.

Yield and price

If you plan to hold onto a bond until it matures, you'll likely want to take a look at its yield, which is simply a calculation of how much money you'll make on the investment. So for example, let's say you have a $10,000 30-year bond with an annual interest rate of 5 percent. This would mean you'd get $500 per year. This is the bond's annual yield. It's also referred to as the "nominal" yield.

There's another factor that determines how much money you make from a bond, and that is price.

Let's say that the owner of the $10,000 bond above chooses to sell the bond before it matures, for $9,000 — maybe because the issuing company is struggling to stay afloat, or because interest rates are about to see a substantial rise. The buyer of the bond will still continue to get interest payments based on the face value of the bond ($10,000). These interest payments are fixed.

Thus, the buyer is receiving the same payments, but because the buyer paid less for the bond, the yield is 5.55 percent. ($500/$9,000=0.0555, or 5.55 percent).

When a bond is selling for more than its issue value, we often hear people say it is trading "at a premium." If it is selling at less than its issue value, it is selling "at a discount."

Generally speaking, people seek to find bonds selling at a discount, because they result in a higher yield.

Why prices rise and fall

The price of bonds is very closely impacted by interest rates. The prevailing interest rate — that is, the interest rate on bonds being issued at that particular time — can make any other bond seem more or less attractive to investors.

To illustrate this, let's say you hold a 30-year bond with a 5 percent interest rate, but rates have been rising and now average 6 percent. Because your bond now has an interest rate that is lower than the prevailing average, it's less attractive to investors. Thus, if you want to sell the bond, you may have to lower the price to ensure investors can get the same yield.

The opposite is also true. When interest rates are falling, any bond with a higher interest rate becomes more attractive and can demand a higher price.

Inflation is known to indirectly impact bond prices because it is accompanied by higher interest rates.

Bond prices are also indirectly impacted by the performance of the stock market. When the stock market is doing well, people tend to flock to stocks and their potential for higher returns, which in turn depresses demand and prices for bonds. But during times of economic distress, investors will often flock to the relative safety of bonds and this can cause prices to rise.

Why it matters now

Treasury yields have been on the rise in 2018, with the interest rate on a 30-year Treasury growing from about 2.8 percent at the start of the year to 3.1 percent as of the end of May. The yield on the 10-year Treasury is more than 2.9 percent, compared to 2.4 percent at the start of 2018.

There are many reasons why yields have increased, but generally they have to do with confidence in the economy and in the stock market. Treasury yields rise inversely to prices. Thus, a high yield suggests that demand for bonds is weak and that's depressing prices.

The trend is only expected to strengthen. The government is predicted to issue a lot of new bonds in 2018 as it looks to cover the cost of new tax cuts. Having more bonds in the market will lower demand for any individual bond, so prices will fall and yields will rise.

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This article is from Tim Lemke of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

Do You Have These Key Character Traits for Investing Success?

Toni Husbands — Fri, 22 Jun 2018 08:30:23 +0000

Warren Buffett, the Oracle of Omaha, summed up the key to investing success like this: "Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing."

Let's say you and I have ordinary intelligence and want to improve our investing chops. What are the traits that make for a great investor?

Compassion

Hollywood is awash with stories of money men who live by this mantra: "Greed is good." The Gordon Gekko character is burned into our collective memories for life. From The Boiler Room to The Wolf of Wall Street, we get it — the industry is full of sharks.

It turns out, sharkiness may work against you in the world of finance.

A study published by the Society for Personality and Social Psychology looked at the behavior of hedge fund managers over a decade. Managers with psychopathic, narcissistic, or Machiavellian personalities underperformed their peers by 1 percent annually. Over time, their ruthless approach to decision making added up to notable losses.

By avoiding aggressive instincts and underhanded tendencies, we can focus on developing the positive, compassionate traits that have helped billionaire investors like Warren Buffett and George Soros achieve amazing results. This means leaving the shady, cunning type of investor to Hollywood. (See also: The 5 Best Pieces of Financial Wisdom From Warren Buffett)

Optimism

Some people avoid investing altogether because they believe they'll never succeed at it. That mentality can become a self-fulfilling prophecy. Make no mistake; if you never take the plunge into investing, you're guaranteed to never see any returns.

Believing that you have the ability to be successful at investing and building wealth is the frame of mind you should always strive for. Whether you endeavor to develop the skills and DIY your approach to investing, or seek the services of a qualified money manager, believing in your ability to make sound financial decisions will help you move forward.

Optimism can be hard to sustain, but immersing yourself in a world of productive investment information has never been easier. Connect with groups through Facebook, browse personal finance websites, and follow the advice of investors with a track record of long-term success. Seeing your glass as half-full is great for the bottom line. (See also: 6 Confidence-Inspiring Facts About the Stock Market)

Patience

Successful billionaires like Warren Buffett take a long-term approach to investing. "Our favorite holding period is forever," he's quoted as saying. Patience will help you avoid reacting rashly to groupthink surrounding market fluctuations or hyperbolic headlines predicting the end of life as we know it. You may have done some research and found that the stock market's average annual return is 7 percent when you look at any 10-year period. This information feeds your optimism, and therefore you're willing to be patient. And your patience will help you keep a long-term perspective.

Goal-orientation

Since investing success requires a long-term perspective, goal-oriented people tend to have a leg up in this arena. Staying focused on the end goal helps you avoid distractions. Deciding whether you're investing for retirement, to purchase a house, or to save for a child's college fund will determine your best course of action. Setting interim goals, like completing an investing for beginners class or interviewing three financial planners, keeps goal-oriented people on the path to desired results.

Levelheadedness

Do you keep a cool head when everyone around you is in meltdown mode? Do you immediately default to the next steps required in the midst of a crisis? Your levelheaded temperament may easily be the most important personality predictor of success with investing, not your intellect. That is according to Mr. Warren Buffett.

Panic in the markets can be contagious; especially when our hard-earned cash is at stake. Your ability to remain calm in the face of short-term fluctuations will lead to better decisions and opportunities that investors who follow the crowd may overlook. (See also: 6 Investment Truths to Remember When the Stock Market Is Down)

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This article is from Toni Husbands of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

Here's How Rich You'd Be If You'd Invested $500 in FAANG 6 Years Ago

Damian Davila — Thu, 31 May 2018 09:00:19 +0000

Warren Buffett said it best: "Someone's sitting in the shade today because someone planted a tree a long time ago." One of those big trees in the investing world is FAANG, an acronym for five high-performing technology stocks: Facebook, Apple, Amazon, Netflix, and Google (now Alphabet, Inc.).

Let's find out how a cool $500 investment in FAANG would have fared over a six-year investment period.

2012: Off to a good start

Since Facebook held its initial public offering (IPO) on May 18, 2012, this date will be our starting point. And it's a great one because Facebook's IPO at that time was the largest technology IPO in U.S. history, raising more than $16 billion.

Let's imagine that you allocated exactly $100 to each one of the FAANG stocks. Assuming that you could buy fractions of shares, here's how many shares of FAANG you would have acquired back on May 18, 2012, rounded to the nearest hundredth. In this and all calculations throughout this article, we'll use the closing price.

Facebook: $100 @ $38.23 per share = 2.61 shares
Apple: $100 @ $75.77 per share = 1.32 shares
Amazon: $100 @ $213.85 per share = 0.47 shares
Netflix: $100 @ $9.99 = 10.01 shares
Google: $100 @ $300.50 = 0.33 shares

At the end of 2012, your initial $500 in FAANG would be worth $537, up 7.51 percent mainly due to a 32.43 percent jump in Netflix's stock price over the same period.

2013: Netflix leading the pack

You would have loved watching Netflix's stock price this year, as it went up 297.6 percent year-over-year, closing at $52.60. After 2012, Facebook traded sideways and didn't trade above its IPO price until July 31, 2013. But then it too ended 2013 strong with a 105.30 percent year-over-year increase in price. At the end of 2013, your FAANG portfolio would be worth $1,147.50, up 113.69 percent from the previous year.

2014: A year of stock splits and slow growth

On June 9, 2014, Apple issued its fourth stock split — this time, a seven-for-one stock split. This means that your 1.32 would have become 9.38 shares. Earlier that year on March 27, 2014, Google executed a 100 percent stock spinoff, which is similar to a two-for-one stock split.

All said and done, your portfolio's 2014 year-end value of $1,160.95 ended slightly above that of 2013 (a 1.17 percent year-over-year increase). What caused the small return? On December 31, 2014 the stock prices of Amazon, Netflix, and Google were down 22.18, 7.22, and 4.24 percent respectively from exactly the year before.

FAANG beats the S&P 500 over six years

Let's fast-forward a few years to May 18, 2018 and analyze the performance of our investment in FAANG against the most common stock market bench mark, the S&P 500.

Assuming that you were to hold onto your entire $500 FAANG portfolio from May 18, 2012 until May, 18, 2018, your portfolio would have been worth a cool $5,059.62, a whopping 911.92 percent return over the six-year period. If you had put the same $500 investment in the S&P 500 you would have ended with $1,047.30 at the end of the six-year period. That's a very decent 109.46 percent return over the same six-year period, but far below that of the FAANG portfolio.

Should you invest in FAANG?

If it ain't broke, why fix it, right? After all, the FAANG investing strategy continues to pay off in 2018. However, this doesn't mean that you should put your entire nest egg in FAANG. Here are three key caveats when considering an investment in FAANG.

Investment strategy fit

"Does FAANG match my investment strategy?" This is the biggest question that you should ask yourself before considering an investment in FAANG. If you're very close to retirement age, are very adverse to risk, or require a consistent stream of dividend payouts for income, then FAANG stocks may not be right for you. Make sure to first analyze FAANG from the perspective of your portfolio strategy.

Tolerance for volatility

As FAANG companies continue to push the boundaries of technology, the stock market continues to reward their valuation. However, sometimes the pendulum swings in the other direction. Remember the Facebook CEO's testimony before Congress on April 10, 2018 due to privacy concerns? The price of one Facebook share went from a high of $185.09 on March 16, 2018 to $165.04 on April 10, 2018. Could you have stomached a 10.83 percent loss over a 25-day period?

Overexposure to FAANG

If you hold an S&P 500 index fund, you're already exposed to FAANG. Let's assume that you hold the Vanguard 500 Index Fund Investor Shares. By owning one share of this Vanguard index fund, your portfolio has an allocation of 3.7 percent to Apple, 2.8 percent to Amazon, 2.7 percent to Google, and 1.80 percent to Facebook.

And that's before taking account any other investments you might hold. If you also have another index fund in the technology sector, you probably have an even greater holding of each one of those investments. For example, the Vanguard Information Technology Index Fund Admiral Shares [Nasdaq: VITAX] has Apple, Amazon, and Google among its top four largest holdings.

There are many mutual funds out there that already include Apple, Facebook, Amazon, Google, or Netflix among their holdings. Make sure to consider how much your existing portfolio already has allocated to FAANG before you add even more shares of these high-growth stocks.

How can you invest in FAANG without breaking the bank

With individual shares of Amazon and Google trading at $1,574.37 and $1,066.36, respectively on May 18, 2018, it is impossible to make the same original investment of $500 to buy all five of the individual stocks that make up FAANG as we did in this experiment.

Still, there is a simple way to start investing in FAANG: exchange-traded funds (ETFs). Similar to an index fund, an ETF tracks an asset or basket of assets. Unlike an index fund, an ETF can be traded several times throughout the day and doesn't require a minimum investment.

There are three key reasons why ETFs make investing in FAANG more approachable for the average investor.

The expense ratio (the percentage of assets deducted each fiscal year for fund expenses) for ETFs is generally lower than that for funds tracking the same type of investment. For example, the Vanguard Growth ETF has a 0.05 percent annual expense ratio, while the average annual expense ratio of similar growth funds is 1.10 percent.
Some brokerage houses charge no trading fees when you stick to in-house ETFs. For example, users of the Vanguard Brokerage Account can trade without fees as long as they buy Vanguard ETFs.
There is no minimum investment, so you could buy as little as one share of an ETF. Generally, prices for one share of FAANG ETFs range from $10 to a few hundred dollars. This prevents you from putting all your eggs in one basket. Remember that historical returns (even as great as those from FAANG) are no guarantee of future returns. So, you still should diversify your portfolio.

Here's a list of FAANG ETFs to get you started on your research, but make sure to look at other lists as well. Buyer beware: By definition, a FAANG ETF is one that offers an investor at least 1 percent exposure to FAANG stocks. While diversification is great, select an ETF that best matches your target exposure to these five high-growth technology stocks.

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This article is from Damian Davila of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

Should You Treat Your Social Security Benefits Like a Bond?

Matt Bell — Thu, 17 May 2018 08:30:19 +0000

As you may know, one of your most important investment decisions has to do with asset allocation — that is, how much of your portfolio should be invested in various asset classes, such as stocks and bonds. The optimal answer has mostly to do with your age and risk tolerance.

When you're young, you have time to ride out the market's ups and downs, so it's generally best to tilt your portfolio toward riskier but potentially more rewarding investments, such as stocks. As you get older, it's wise to change that mix, reducing your stock exposure and increasing your use of less volatile investments, such as bonds.

Your risk tolerance also plays a role. If you're comfortable with risk, that may point you toward a more stock-heavy portfolio. If you prefer the safer side of the spectrum, you may want a more conservative investment mix.

But here's where our esoteric-sounding opening question comes in: What if you could put a present value on your future Social Security benefits? And what if you added that amount to your current investment portfolio? That would make your portfolio much larger, and it would change how you're investing, which is exactly what investing legend and Vanguard Founder Jack Bogle recommends. (See also: The Basics of Asset Allocation)

Running the numbers

Let's say you have investments totaling $450,000 and your optimal asset allocation is 60 percent stocks and 40 percent bonds. That means you should have $270,000 invested in stocks and $180,000 in bonds.

Let's also assume your estimated Social Security benefits will be $1,250 per month, or $15,000 per year, beginning at age 67 (you can see your estimated benefits by making an account the Social Security Administration's website). This exercise also requires that you make an assumption about your life expectancy; let's assume you'll live another 20 years after you start collecting Social Security.

Bogle would suggest valuing your portfolio at $750,000. That's $450,000 of actual investments plus $300,000 of assumed future Social Security benefits ($15,000 per year times 20 years). There are other ways of determining the present value of your future benefits, but taking the annual estimated benefit amount and multiplying it by the number of years you expect to live after starting to claim benefits is the simplest.

Applying a 60/40 allocation to your newly inflated $750,000 portfolio would mean your optimal investment mix is $450,000 in stocks and $300,000 in bonds. Bogle suggests that since Social Security is a virtually guaranteed benefit, that $300,000 "asset" is a conservative asset — more like a bond than a stock. That means you're free to invest your entire actual $450,000 portfolio in stocks. (See also: 7 Reasons You're Never Too Old to Buy Stocks)

What could go wrong?

Proponents of this idea, such as Bogle, point out that the much more aggressive approach it would enable you to take with your actual investments would give you the potential to grow your nest egg much larger. Historically, stocks have far outperformed bonds, so in theory that's correct.

However, it would also mean taking on much more risk than you are right now and having to endure much more volatility than you may be comfortable with, especially as you get older. For example, how would you like to be 65 years old, have your entire retirement portfolio invested in equities, go through a bear market similar to 2008, and lose 50 percent?

Plus, let's say that leaving an inheritance is important to you. What if you go through a 2008-style bear market when you're in your 60s or 70s and that assumption you made about living to age 87 doesn't work so well? The only part of your portfolio that would be left behind is your actual portfolio, which just got cut in half.

What about the rest of your portfolio — the $300,000 of future Social Security benefits? The minute you die, the value of those benefits drops to $0. Are you comfortable with that?

One more concern is whether Social Security will even exist by the time you retire. While it's hard to imagine the organization ever completely disappearing, it's much easier to envision a day when benefits will be reduced based on household income — so-called means testing. The amount of money current workers are paying into the program simply isn't enough to continue paying beneficiaries the full amount they are owed indefinitely.

Not for the faint of heart

Only if you are extremely risk tolerant should you consider factoring future Social Security benefits into your asset allocation. Even then, you would be wise to factor in only a portion of those benefits.

For most, however, because of the added stress this approach would bring, especially at a time of life when peace of mind will be increasingly important, it probably doesn't make sense.

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This article is from Matt Bell of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

7 Reasons You're Never Too Old to Buy Stocks

Tim Lemke — Mon, 12 Mar 2018 09:00:06 +0000

One common rule of thumb for investors is to move away from stocks into more conservative investments as you get older. The thinking behind this is that stocks always carry the risk of losing value, and that's not something you want to see with your retirement fund.

But completely abandoning stocks may not be the right strategy, either. Holding some stocks in your portfolio can be a hedge against inflation, and can help ensure that your retirement money lasts as long as you do.

Here's a look at some reasons why, even for older investors, stocks are always a good buy.

1. You may live longer than you think

Many people assume that once you approach retirement age, all of your efforts should be focused on protecting your assets rather than growing them. But the reality is that many retirees will need their money to last 30 years or more, and the only way to make money last that long is to continue to accumulate it.

Having some money in stocks will, in most years, allow you to replenish money that you spend from your portfolio. Consider this: If you have a nest egg of $1 million and spend $50,000 annually, your savings will be gone in about 20 years. But if you are able to add 4 percent to your portfolio each year from stocks, your savings could last another decade or more. (See also: 5 Ways Longevity Is Changing Retirement Planning (And What to Do About It))

2. Many stocks can be safe investments

We tend think of stocks as risky and volatile investments, but that's not always the case. Many stocks are actually very common and useful investments for people looking to bring stability to their portfolio.

Dividend stocks are a common component of retiree accounts, because they generate income for the investor and generally don't rise and fall dramatically in price. There are also some industries, such as consumer goods, that have offered steady returns year in and year out. Some stocks, such as Wal-Mart, are good bets even during bad economic times. You don't have to lay off stocks entirely as you get close to retirement age. It's just a matter of finding stable, income-producing stocks that can serve you well as you get older.

3. Markets rebound fairly quickly

No one likes to see the stock market take a big dive, but the good news is that it always goes back up. There are only a handful of times in history when the stock market has had consecutive down years. Moreover, years with negative returns are often followed up with positive returns of greater magnitude. History shows that if you lose money in the markets one year, you'll likely make that money and more back within a few years. In other words, even if you are well into your senior years, you're unlikely to see your entire savings gone in a single swoop. (See also: 6 Confidence-Inspiring Facts About the Stock Market)

4. Stocks don't need to comprise your whole portfolio

Buying stocks when you are at or near retirement age is only a bad idea if you're not also invested in more stable things like bonds and cash. Stocks don't have to make up 100 percent of your retirement fund. They don't even have to make up 50 or 25 percent. But having stocks as a relatively small percentage of your portfolio can help make your money last longer without adding much risk.

For example, let's say you have $1 million in your retirement fund. And let's say 10 percent of that ($100,000) is in stocks, with the rest in bonds and cash. If the stock market were to take a dive of 30 percent in one year, you might lose $30,000 from the stock portion of the portfolio. That's $30,000 out of a total of $1 million saved, or just 3 percent of your total savings. You'd still have $970,000 left. Given that the market historically goes up more than it goes down, this is a reasonable risk to take. (See also: How the Risk Averse Can Get Into the Stock Market)

5. Returns from bonds and cash are lousy these days

For many years, it was common for Americans to get good returns on government and municipal bonds, as well as normal savings accounts and certificates of deposit. Thus, retirement accounts were constantly being replenished with new money.

Nowadays, interest rates are still at some of their lowest rates in history, so it's easy to see how your personal spending rate will outpace the returns from your retirement funds. In fact, there is some risk that your returns may not even outpace the rate of inflation. Only with stocks will you be able to see the types of gains once seen from bonds and cash in the past, and you'll never be at risk of seeing inflation eat away at your nest egg.

6. Transgenerational wealth is a powerful thing

Have you ever wondered how massively wealthy people got their money? It's often because they inherited it. In fact, many younger Americans say they are expecting a sizable inheritance. According to a recent survey from Natixis, 60 percent of millennials believe they will inherit some money from their parents.

If you want to ensure financial security for your children and even generations beyond, your own personal retirement time horizon is irrelevant. Only through stocks can you continue to accumulate returns that generate the kind of wealth that will transform the lives of your heirs.

7. Stocks are just more fun

Cash is safe. Bonds are safe. But they are boring as heck. And it's downright wrong to assume that older people can't have some excitement in their lives.

Placing money in the stock market and watching it grow is fun. Being a shareholder of a company is fun. And if you are retired, you actually now have time to pay attention to your investments. Of course, you never want to let a desire for fun force you into a silly investment decision. Stocks should comprise a relatively small section of retirement funds for older people. But I'm not about to tell our seniors they can't let loose a little bit. (See also: 7 Reasons to Invest in Stocks Past Age 50)

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This article is from Tim Lemke of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

4 Ways to Keep Envy From Ruining Your Retirement Investments

Matt Bell — Wed, 31 Jan 2018 10:00:06 +0000

The stock market had a great year in 2017, with the S&P 500 rising more than 19 percent. Did your portfolio do as well? If not, you may feel like you missed out. You may even be tempted to make some changes, going all in on headline-making companies that did well in 2017.

But hold on. Just as scrolling through your social media feed can make you feel like you need to up your vacation game, reading about hot investments can tempt you to invest reactively instead of proactively, and that often does more harm than good.

What's a person with investment envy to do? Read on.

1. Keep hot investments in perspective

If you pay any attention to investment news, you've seen plenty of headlines about the so-called FANG stocks, an acronym that represents Facebook, Amazon, Netflix, and Google (Alphabet). Other popular consumer-oriented companies include Apple and Microsoft. Each stock had a great 2017.

Should those investments be part of your portfolio? Maybe, but the principles of wise investing would suggest buying them only as part of a diversified portfolio and only if you understand that what goes up quickly can also come down quickly.

For example, in 2008, when the S&P 500 fell 38 percent, many of these hot stocks also plummeted — some by more than 50 percent. (See also: 9 Ways to Tell If a Stock is Worth Buying)

2. Keep a hot market in perspective

At the end of each weekday, there are news reports about how "the market" performed. In reality, such reports are usually about how the S&P 500 or Dow Jones industrial average performed. Both are stock market indexes, but both are designed very differently — the S&P 500 represents the collective performance of 500 of the largest U.S.-based public companies, and the Dow represents just 30 companies.

The only investors for whom it would be fair to benchmark their portfolios against such indexes are those who invest solely in an S&P 500 or Dow index fund.

If you have other investments in your portfolio, you need to remember that "the market" is not the same thing as your particular portfolio. It's fine to view the market's performance as a general investing barometer. Just don't be envious if your portfolio doesn't perform as well, or overly confident if it performs better. (See also: Want Your Investments to Do Better? Stop Watching the News)

3. Keep your benchmark in mind

The best point of comparison to use when evaluating your portfolio's performance is a benchmark tailored to your age, goals, and risk tolerance. More specifically, it's the average annual rate of return that's part of your investment plan.

If you don't have such a plan, it isn't that difficult to create one. Begin by completing Vanguard's investor questionnaire. It'll suggest an optimal asset allocation. From there, you can review the historical performance of portfolios with various stock/bond allocations, which can help you choose a reasonable rate of return assumption for your own portfolio.

4. Get the best of both worlds

Once you know your optimal asset allocation, you can use index funds to create a diversified portfolio designed to share in some of the overall market gains, as well as the gains of individual hot investments.

In fact, just investing in an S&P 500 index fund enables you to do both. Of course, it gives you exposure to "the market" as defined by that index. But it also gives what may sound like a surprising level of exposure to the fast-growing individual stocks mentioned earlier.

You see, the S&P 500 is a "market capitalization-weighted" index, meaning each company that's included is represented based on the value of its outstanding shares. Because Apple, Alphabet, Microsoft, Facebook, and Amazon have done so well in recent years, they make up a disproportionate share of the index. For example, those five stocks account for nearly 13 percent of the Vanguard S&P 500 index fund, VOO.

However, even if your optimal asset allocation is 100 percent stocks, you'll probably want to diversify beyond an S&P 500 mutual fund, perhaps including smaller companies through an extended market fund, and foreign companies through an international fund.

Benchmarking your portfolio against headlines about this fast-growing sector or that hot investment will just cause you stress and may even hurt your returns. Instead, develop and follow a plan that includes a realistic assumed average annual return based on your circumstances and goals.

Using the right benchmark will do wonders for your portfolio and your peace of mind.

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This article is from Matt Bell of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

7 Money Moves That’ll Protect You During the Next Recession

Kentin Waits — Tue, 23 Jan 2018 09:00:07 +0000

Full disclosure, folks — I’m a worrier. What’s been keeping me up at night lately? Unchecked financial optimism. The Great Recession ended nine years ago and the bull market we’ve been enjoying since can’t go on forever. In fact, many economists think we’re overdue for significant contraction. If round two is even half as bad as round one, will you be ready? Here are seven money moves that’ll protect you during the next recession.

1. Bulk up your emergency fund

According to a 2012 Bureau of Labor Statistics report, the U.S. unemployment rate in 2008 reached 10 percent, and the long-term unemployment rate (defined as unemployment lasting 27 weeks or longer) hit 4.4 percent. If another recession caused a mass wave of unemployment, would you have enough cash on hand to weather months without a job? If not, now’s the time to bulk up your emergency fund. You should have a minimum six months' worth of income stashed away. (See also: 7 Easy Ways to Build an Emergency Fund From $0)

2. Pay off consumer debt

High-interest consumer debt only makes you more reliant on your job and less adaptable to changes in fortune. Use this relatively strong economic period to beat down debt. When the next recession hits, you’ll be glad you did. (See also: The Fastest Method to Eliminate Credit Card Debt)

3. Avoid new debt

If you’re trying to pay off debt, it probably doesn’t make sense to increase your debt load. To prevent a debt spiral, keep the credit cards on ice. And unless you plan on taking advantage of a 0% balance transfer offer, shred every new credit card application you receive. (See also: The Best 0% Balance Transfer Credit Cards)

4. Take aim at fixed expenses

When it comes to trimming budgets, variable expenses are usually the focus. But you shouldn't ignore fixed expenses, either — they aren't set in stone. If your car is older, consider switching to liability-only insurance. Try to negotiate a lower interest rate on credit card balances. Swap premium cable for a less expensive on-demand service. And if you’re not a heavy internet user, choose a cheaper data plan. (See also: The 6 Monthly Telecom Bills You Can Negotiate)

5. Learn new skills

Knowledge is always in demand. Practical skills like basic auto maintenance, carpentry, and gardening can save you money at home and generate extra income. A broader set of professional skills can make you more indispensable at work (and less likely to be laid off). Pursue both as part of your creative recession preparation. (See also: 8 Ways a Side Hustle Can Advance Your Career)

6. Update your resume

Your job is your primary source of revenue, right? Anything that keeps your career running smoothly helps keep your financial life on track, too. With an up-to-date resume, you can take advantage of new opportunities now and launch a job search quickly in the event of a sudden layoff.

Remember, use your resume to focus on measurable accomplishments (“managed a team that increased sales by 10 percent in six months”), include relevant titles and keywords to facilitate automated scanning, and proofread every word obsessively. (See also: 12 Words You Need to Delete From Your Resume Right Now)

7. Review your portfolio

Now is the perfect time to review your 401(k) and IRA investment choices. If you’re nearing retirement or simply feel your current risk level is too high, dial down your stock market exposure. And as long as you’re making a few tweaks, see if there’s room in your budget to bump up your contribution rate. (See also: 7 Retirement Planning Steps Late Starters Must Make)

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This article is from Kentin Waits of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

How an Exit Strategy Can Make You a Better Investor

Tim Lemke — Thu, 04 Jan 2018 09:30:11 +0000

While I am generally a big fan of buy and hold investing, I'm well aware that sometimes it makes sense to unload a bad investment. Similarly, there are times when it’s smart to take some profits from an investment that has done well.

But how do you know when to sell? Trying to find the right timing for the sale of a stock, mutual fund, or other investment is hard, but it helps if you have mapped out an exit strategy — a set of guidelines to give you a sense of when to sell.

The right exit strategy can help you maximize profits from good investments and reduce losses on bad ones. If you are pondering whether to be a seller, ask yourself if any of these things apply to you or your investment.

It’s in a bad industry

If you own shares of a company that’s struggling, it’s fine to wait and see if management can turn things around. But often, the company is in an industry that is in a downward spiral with no signs of recovery. It’s hard to admit, but there are some business sectors that are simply dying as a result of changes to technology, consumer habits, or other reasons.

Would you invest in a print newspaper chain, or a brick-and-mortar retailer? How about a coal mining operation? If you own shares of a company that’s part of a shrinking industry with no signs of renewal, it’s probably time to get out. (See also: Help, I Bought a Stock Dud! — What Now?)

It’s priced unreasonably high

It’s important to know when to sell a stock when it’s a loser, but there are times when you should consider unloading a stock when it’s performed exceptionally well. The point of owning a stock is to profit, so once a healthy profit has been reached, it’s smart to at least consider taking your profits and investing them elsewhere. This is especially true when a stock is overpriced and potentially due for a fall.

One way to determine if a stock is too hot is its price-to-earnings ratio. An average price-to-earnings ratio is between 20 and 25, though it can vary depending on industry. Ratios can go higher if investors are betting on future growth. But if the ratio is high and you’re not confident of the growth path of the company, consider taking your profits and moving on. (See also: Make Smarter Investments by Mastering This Simple Ratio)

You wouldn’t consider buying the stock now

If you own a struggling stock, it’s often important to ask yourself whether you would buy the stock today. It often makes sense to buy stock when it’s priced very low if you believe it will rise and make you a profit over time. But if you reflect on a stock you own and realize that you’d probably pass on buying if it was presented to you now, that’s a sign that it may be time to unload. When crafting an exit strategy, note the lowest price at which you’d be willing to buy a stock. Once shares dip to that point, consider selling.

Selling at a loss can help you save on taxes

If you’ve been thinking about selling a losing stock but have felt uncertain about when to pull the trigger, consider using the sale to offset your gains and save on taxes. For example, let’s say you sold some shares of one company and made $1,000 in profits. That $1,000 is subject to capital gains taxes. But if you sell a different set of shares at a loss, your tax liability will be reduced or even eliminated. This is called tax loss harvesting, and it’s one way to feel less bad about the duds in your portfolio.

You’re breaking the 10 percent rule

It’s not so much a “rule” but a guideline that many financial planners use to prevent big losses. If you have an investment that has lost 10 percent of its value in a short amount of time, it may be wise to sell before it goes down further. You can even put in place a “stop” order that automatically sells a security once it hits a certain price.

For example, if you buy Facebook stock at $180, consider setting up a stop order to automatically sell it at $162. By using a stop order, you have the peace of mind to know that the investment will sell even if you are not paying close attention. It’s also possible to put in a sell order when a stock reaches a predetermined high point, so you can take profits without worry.

You’re breaking the 1 percent rule

Under this rule, the idea is that you never want a single investment to cost you more than 1 percent of your total portfolio. So for example, if you have $100,000 saved in a 401(k), you don’t want to lose more than $1,000 from a single stock or mutual fund. Having this approach will prevent one dud investment from ruining your overall retirement nest egg.

You’re nearing the “support” and “resistance” levels

Technical analysts use the term “support” to refer to the low price that an investment has historically never dropped below. At the “support” price, investors have generally decided to buy in and have prevented the price from moving lower. However, if a security moves below the historic “support” level, it’s a sign that there is more downward pressure and that things could get even worse for the investment. It’s a good idea to sell at this point to avoid further losses.

Similarly, the “resistance” level is the price at which a security has been historically unable to break through. If an investment keeps approaching the resistance line but isn’t breaking through, it may be time to take your profits.

There are other good investments available

There are some instances when it’s OK to stick with a subpar investment because there are few other good places to put your money. If interest rates are low and the market is performing badly, it might make sense to wait and see if an investment rebounds. But if you find yourself wishing you could put your money in other, better-performing investments, maybe it’s time to sell. There is a cost to selling, but if you free up cash to purchase something that is more likely to net you a profit, you may end up doing better in the long run.

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How to Pick Your First Stocks and Funds

Tim Lemke — Tue, 19 Dec 2017 09:00:07 +0000

You know you need to start investing, but you’re not sure where to begin. There are a million different investments, so how can anyone determine which to start with?

There is no real wrong way to begin investing, but it helps to start in a familiar place and educate yourself about some of the most common stocks and mutual funds. Follow this advice, and you’ll be well on your way to building a great investment portfolio.

Pick something you know

When just getting started, it helps to have some familiarity with the company you are investing in. So go with a company whose products or services you use every day. Maybe it’s Starbucks, or Walmart. Perhaps it’s Coca-Cola or Pepsi. Do you have an iPhone? Investing in Apple might make sense for you. By starting out with something you know, you’ll have a greater interest in tracking the stock’s movements and paying attention to the company’s operations.

It’s also fun to know that when you buy something from the company, you may be indirectly boosting the stock price. Moreover, if you invest in something well known, it’s likely to be an established company with some track record of success. (See also: How to Buy Your First Stocks or Funds)

Listen to your grandfather

You may tune out when your granddad starts espousing the virtues of shopping at Sears. But there are many companies that were huge 40 years ago that are still big today. Think Coca-Cola, General Motors, General Electric, IBM, or McDonald’s. These are still “blue chip” stocks that have shown consistent, solid shareholder returns over time.

In many cases, these companies don’t even do what they originally did when your grandfather was your age. But that’s OK. If your granddad has invested in a stock for decades and is living comfortably in retirement, it’s probably a solid stock. Following your grandfather’s advice is a great way to familiarize yourself with “large cap” stocks that include some of the world’s biggest companies. (See also: 9 Ways to Tell If a Stock is Worth Buying)

Go after growth

The entire point of investing is to see your money grow, right? So it’s a good idea to familiarize yourself with growth stocks. These are stocks that represent companies poised to see strong earnings growth over time, and are often in fast-growing industries, such as technology. Growth stocks will often have earnings and cash flow that are higher than the average company, and will often have some sort of competitive advantage that gives it an edge in the marketplace.

Famous tech companies including Apple, Netflix, and Alphabet are well-known growth investments. Smaller companies can offer great growth stocks as well, because their size allows for rapid increases in share value. Keep in mind, however, that growth stocks can often carry higher risk than other investments. (See also: What Are Growth Stocks?)

Find a good dividend stock

When learning to invest, it’s important to know that stocks cannot only grow in value, but provide you with some income along the way. Many stocks will pay out a portion of their income to shareholders in what is known as a dividend. Getting your first dividend payment can be very exciting. This is real money that a company gives you each quarter simply for being a shareholder. And many companies will shell out dividends at a rate much higher than interest from the bank.

When researching the best dividend-producing companies, look up how much the company will pay quarterly for each share of stock. That amount relative to the company’s stock price is known as the dividend yield. A good dividend yield, coupled with solid financials and some growth in share price, can make for a great company to invest in.

To find good dividend stocks, research the list of “dividend aristocrats.” These are companies that have managed to increase their dividend payments for 25 years or more. They include Procter & Gamble, Exxon-Mobil, and AT&T.

Invest in “The Market”

If you’re confused about what stocks or funds to purchase, why not invest in everything? Or at least a small piece of everything. There are many mutual funds and exchange-traded funds that are designed to mirror the performance of the broader stock market or major indexes like the S&P 500. You won’t necessarily “beat the market” with these investments, but you’ll see your investments move with the overall stock market, and get exposure to a wide range of companies in various industries.

These investments are often available with very low fees, as well. Good examples of these kinds of investments include the iShares Core S&P Total U.S. Stock Market ETF [NYSE: ITOT], Vanguard Total Market ETC [NYSE: VTI], or T. Rowe Price Equity Index 500 Fund [NYSE: PREIX].

Look for value

One of the most basic pieces of investment advice you’ll receive is to “buy low and sell high.” At its core, this means it’s smart to find investments that are undervalued and have a strong potential to grow and make you a profit over time. These “value” stocks aren’t always easy to find, but they have driven the portfolios of some of the world’s most successful investors, including Warren Buffett.

There are several key things to look for when searching for value stocks. First, it’s important to understand why a stock may have a low price. Often, it’s because the company is not doing well financially. But sometimes, a stock price can fall for reasons that have nothing to do with company performance, in which case it may be poised to rebound.

A company’s price-to-earnings (P/E) ratio is another thing to consider. You can determine this ratio by dividing a stock's earnings by its stock price. A low P/E ratio compared to other stocks may indicate it’s undervalued. (See also: Make Smarter Investments by Mastering This Simple Ratio)

If you are unsure of what value stocks to buy, consider mutual funds that zero in on value stocks. Popular options include the Vanguard U.S. Value Fund [NYSE: VUVLX] and the T. Rowe Price Value Fund [NYSE: TRVLX].

Understand competitive advantage

There are some companies that are just kicking butt. Their edge over their competitors is as vast as the Pacific Ocean, and they are practically synonymous with the industries they are in. Some investors refer to this as a “moat.” A company with a wide “moat” is often viewed as having a large enough competitive advantage to withstand any operating hiccup or economic downturn.

Think Amazon in the e-commerce sector, or Facebook in the area of social media. Alphabet, the parent company of Google, also leaves most of its competitors in the dust, and Walmart dominates the traditional retail sector.

If you’re looking to buy one of your first stocks, consider any company that seems to be just crushing the competition. You may not be able to get shares on the cheap, but you’ll be getting ownership in a company poised to make you money over time.

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Don't Be Fooled by an Investment's Rate of Return

Tim Lemke — Fri, 08 Dec 2017 10:00:07 +0000

When you invest, you are looking for return. You want your money to grow over time, preferably at a rate that will allow you to achieve your financial goals.

An investment's rate of return can be a deceptive thing, however. The amount of money that an investment has made in the past isn't a guarantee of future returns. Moreover, these returns by themselves don't tell you a whole lot about what you are investing in.

Learning how to analyze an investment's returns — and understanding its limitations — will help you on the path to financial freedom. Just remember these key facts about an investment's return when examining it.

Short time frames don't tell you much

"Hey, this mutual fund went up 29 percent last year! Woo hoo!" That's great, but what did it do the year before? And the year before that? How has it performed over the last decade? Looking at the rate of return for a single year is not particularly useful, as any investment can have a hot 12 months. To get a sense of how an investment may perform in the future, it helps to have a long record of performance to examine. Fortunately, most brokerages and financial websites have comprehensive information on historical returns, so you're not simply looking at the performance of the last year.

It offers no information on the type of investment

It's great if an investment has a solid rate of return, but that should not be the only consideration when looking to buy shares. If you are buying a stock, you need to ask yourself key questions aside from just looking at performance. What industry does the company operate in? How big is the company? Does it operate internationally? If you're talking about a mutual fund, what is the investment mix? Answering these questions will help you understand whether you already own similar investments, and whether it makes sense to add them to your portfolio.

It's almost useless without context

Let's say you come across a mutual fund that earned a 9 percent return last year. You might think that is pretty good, right? Well, it doesn't look so good when you consider the S&P 500 returned 11.96 percent. Information on returns is only meaningful when it is paired with information about the broader stock market, comparable investments, and specific indexes. A small cap ETF, for example, should be examined alongside the Russell 2000 index. A mutual fund focused on technology should be compared to prominent technology indexes. Fortunately, most brokerage firms and financial websites do provide this, so it's important to analyze market returns using that context.

It does not always factor in all costs

If you purchase a mutual fund or ETF, a certain portion of your investment is taken in expenses and fees. While mutual fund returns are usually reported net of expenses, not every cost is included in this calculation. Many funds have sales charges and commissions (also known as loads) that you pay when buying and selling. Your brokerage firm may also charge a commission to execute the trade. This can reduce your overall return. The good news is that there are many good no-load mutual funds out there, and many can be traded without a commission, depending on the broker.

One more caveat regarding costs. Capital gains taxes will also reduce your balance when you sell. Be sure to factor in these costs when examining an investment's rate of return.

It does not offer detail on volatility

Let's say you have a stock that rose in value from $50 to $90 in five years. The annualized return on that stock is 16 percent. But that does not tell you whether the stock's performance has been consistent or wildly up and down.

For example, during that five-year period, that stock may have risen 20 percent, then dropped 25 percent, then risen 44 percent, dropped 10 percent, and finally rose 53 percent. That's pretty volatile, and may be outside the comfort zone of many investors even though the overall return is good. To get a better picture of the investment's performance, you need to look at the returns from each individual year, but even that offers no insight into price swings within any given year.

It can't answer the question "Why?"

An investment's rate of return may be the crucial piece of information you need to know before investing, but there's a lot that it doesn't tell you. Perhaps most importantly, it does not offer any insight into why an investment's price moved up or doing during a certain period.

Investment values go up and down for a variety of reasons, not all of them related to company performance. Perhaps a retailer saw its shares fall sharply during one quarter due to a series of natural disasters. Perhaps another company saw shares rise dramatically because of hype over its Super Bowl commercial. Returns on investment are crucial to know, but if you are an investor, it's important to do your own homework to understand why a price went up or down. Doing so will help you better understand how an investment may perform in the future.

It gives you no information on fundamentals

An investment's historical rate of return can give you insight into how it might perform in the future. But the company's actual financial performance may be even more important. It's not enough to just examine an investment's return. You should also look at company balance sheets, analyze earnings reports, and look at things like cash flow, debt, and price-to-earnings ratio. This will help you understand whether an investment's price is justified. Examples abound of companies that saw share prices skyrocket based on speculation although earnings weren't there to support it.

It tells you nothing about taxes

Let's say you invested $1,000 in a company stock and it earned an annual return of 9 percent a year over five years. That means you'll end up with $1,450 when you sell, right? Well, not exactly. Remember that unless you are investing in a tax-advantaged account such as a Roth IRA, the government takes its share when you sell. Assuming that you'll be taxed at the long-term capital gains rate of 15 percent, suddenly, that 9 percent annual return became something closer to 7 percent. Keep this in mind when trying to calculate how much money you'll actually walk away with.

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This article is from Tim Lemke of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

4 Simple Ways to Conquer Your Fear of Investing

Matt Bell — Wed, 06 Dec 2017 09:30:11 +0000

If you're nervous about investing in the stock market, you're not alone. Stock ownership in the U.S. is down, and a recent poll indicates that frightening memories of the last bear market may be to blame.

According to a Gallup survey, just 54 percent of U.S. adults own stocks, including those owned through mutual funds that people invest in via their 401(k) or other retirement accounts. That's down from 62 percent who owned stocks before the last bear market. During that devastating downturn, which began at the end of 2007 and ran through early 2009, the market fell by more than 50 percent. In part, Gallup blames the decline in stock ownership on that painful, fearful time.

"It appears the financial crisis and recession may have fundamentally changed some Americans' views of stocks as an investment," the company stated on its website. "The collapse in stock values in 2008 and 2009 seems to have left a greater impression on these people than the ongoing bull market that has followed it, as well as research showing the strong historical performance of stocks as a long-term investment."

If that sounds like you, here are some suggestions for overcoming your concerns. (See also: How to Get Over These 5 Scary Things About Investing)

1. Develop a healthy fear of not investing

If it's safety you're after, there are few safer places to put your money than a bank. Because deposits are insured by the Federal Deposit Insurance Corporation, you could put up to $250,000 in a bank account and rest easy knowing that if the bank went out of business, the federal government would make sure you got your money back.

While a bank account can be a good place to keep some savings for emergencies, right now many banks are paying just .01 percent interest, making them a horrible place to pursue long-term goals like retirement.

For example, let's say you're 30 years old and deposit $10,000 at .01 percent interest. In 40 years, your $10,000 will have turned into — wait for it — $10,040. That's right. After 40 years, you will have made just $40 on your 10 grand. And once you factor inflation into the mix, the buying power of your $10,000 will have taken a big step backward.

Let's say you earn 7 percent interest instead. In 40 years, your $10,000 will have turned into $150,000. And 7 percent is a very conservative assumption since the stock market's long-term average annual return has been 10 percent.

So, instead of being fearful about investing, it is more logical to be fearful about not investing.

2. Learn a little market history

Many of the mistakes investors make are due to their emotions. If the market falls, some people get scared and pull money out of the market, usually to their detriment. A little knowledge of market history can help you stay the course.

The longer you keep money in the market, the more likely you are to make money. When Morningstar analyzed the stock market's performance during each one-, five- and 15-year period from 1926 to 2016, it found that 74 percent of the one-year periods showed positive returns, 86 percent of the five-year periods generated gains, and 100 percent of the 15-year periods were up. In other words, based on 90 years of history, if you stay in the market for at least 15 years, it's a virtual certainty that you will make money.

Putting time on your side is also the key to surviving a significant market downturn. According to Morningstar, someone with $100,000 invested in the stock market at the beginning of 2007 would have lost nearly half that amount by early 2009. Brutal, right? However, if they had stayed invested, by January 2017 their portfolio would have been worth nearly twice its value on January 2007. Despite that horrible downturn, their average annual return over those 10 years would have been nearly 7 percent. (See also: How the Risk Averse Can Get Into the Stock Market)

3. Start small

If you have a chunk of money to invest but just can't work up the courage to hit "buy," consider investing a little at a time through dollar-cost averaging. The idea is very simple. Just take the total amount (let's say $12,000), divide by the number of months you plan to invest (let's use 12), and invest that amount at the same time every month ($1,000 per month).

If the market has a good month, your money will buy fewer shares. If the market has a bad month, your money will buy more. You never have to worry about getting the timing just right. By spreading your investments over a year a more, you minimize the risk of losing a lot of money through an immediate downturn. (See also: Is Dollar Cost Averaging the Right Strategy for You?)

4. Keep it simple

Investment terminology can be confusing. Diversification. Asset allocation. What does it all mean? You can put these helpful concepts to work without qualifying for a job on Wall Street by investing in a super simple target-date fund.

Because they are mutual funds, target-date funds are inherently diversified — that is, the money you invest is spread out among multiple stocks, bonds, or other investments. And they take care of asset allocation decisions for you. That means they are designed with an appropriate mix of stocks and bonds for someone your age. They even automatically adjust that mix as you get older, tilting their stock/bond allocation more toward bonds to make your portfolio appropriately more conservative as you near your intended retirement date.

It's understandable that the last bear market may have dampened your enthusiasm for the stock market. However, the market continues to offer most people their best opportunity for building wealth. The steps described above should help you wade back into the investment waters without fear.

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Does Skill Really Matter in Stock Market Investing?

Dr Penny Pincher — Wed, 06 Dec 2017 09:00:07 +0000

My young son once expressed concern when I told him I had money invested in the stock market. Perhaps he had seen stories about blindfolded monkeys throwing darts picking better stock portfolios than "expert" traders.

"Buying stocks is just like gambling," he said.

"No, it isn't," I explained.

I am not sure my son was convinced by my explanation, and I began to doubt it myself. What made me so confident that my process of choosing stock market investments was better than random chance?

How lucky stock picks can beat the market

People tend to overrate their investment skills as their portfolio grows. Over the years, the stock market tends to go up and the value of anyone's portfolio — even a portfolio picked by a monkey — would likely go up. But the measure of a successful investor isn't merely getting a positive return on investment. Real success is beating the market by getting a return that is better than the market average. This is where the skill comes in … or does it?

Let's consider randomly selected stock portfolios drawn from the broader stock market. Most such randomly selected portfolios will perform near the overall rate of return for the market. Some of the stocks may perform better than average and some worse, but the ups and downs across the portfolio tends to work out to about average. But by pure luck, some portfolios will end up with more winners than losers and beat the market average. Sometimes these randomly selected portfolios do a lot better than the market average.

For some specific examples, let's simulate portfolios randomly drawn from a market with 10.5 percent return and a standard deviation of 20 percent after 20 years. Under these conditions, the average return portfolio value based on the broader market is $7,366. Here were my "returns" from eight randomly selected portfolios after 20 years:

$4,330
$34,603
$19,572
$9,971
$10,925
$1,482
$8,482
$3,460

You can see that five of our eight randomly selected portfolio beat the expected value of $7,366 from average market returns over 20 years. One portfolio (#2) beat the market significantly, achieving an annualized return of 19.4 percent and growing 4.5 times that of an average portfolio. This portfolio was selected by pure chance, but the performance looks like something that would take a financial genius to achieve. If you were lucky enough to put this portfolio together, people would probably be lining up to ask for your investment secrets to learn how you beat the market. And since you were so successful, you might believe you had actually figured it out!

Our simulation results show that by pure luck, an investor could end up with a portfolio that greatly beats the market. A dart-throwing monkey could pick a great set of stock picks by chance. Random picks can result in underperforming portfolios too, but people tend to notice the big winners.

We have seen how you can end up with a high performing stock portfolio by pure chance. Does this mean that successful investors are just lucky?

The argument for investing skill

As we have seen, it is possible to get lucky and beat the market. But some investors seem to beat the market consistently. It's one thing to get lucky once in awhile, but is someone like Warren Buffett just really lucky, or is there more to it than that?

From reports over the years, we can see that Berkshire Hathaway beat the market 39 out of 49 years, earning more than the market average rate of return. A 2015 paper by James Skeffington uses some simplifying assumptions to analyze the probability that such a run of success would occur by chance. In a simulation with randomly drawn portfolios of 500 companies to represent the S&P 500, Warren Buffett turns out to be luckier than the luckiest of the simulated portfolios by a factor of about 100x.

While this analysis does not conclusively prove that Warren Buffett has exceptional skill as an investor, it does indicate that luck alone is not likely to be the secret of Mr. Buffett's success as an investor.

Should you throw darts to pick stocks?

The conclusion that skill — not just blind luck — likely played a big role in Warren Buffett's investment success means you could potentially study up and make informed investments or find a fund manager that can consistently beat the market through skill. If you want a piece of Warren Buffett's action, you could buy Berkshire Hathaway at a premium or a similar fund at a discount. (See also: How to Buy Berkshire Hathaway and Other Blue Chip Stock for 17% Off)

But in general, past performance does not predict future performance. If you see a fund that is advertising good recent performance, it does not mean the fund will stay hot. It is impossible to know if a fund manager is good or lucky, and investment strategies that work now may not keep working forever.

You could follow Warren Buffett's advice and go with index funds with low expense ratios that take away some of the risks, expenses, and inefficiencies of actively managed funds. As Warren Buffett's famous $500,000 bet showed, a low expense index fund can beat an actively managed fund. This investment strategy allows you to be successful without luck or skill. (See also: Why Warren Buffett Says You Should Invest in Index Funds)

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8 Signs You're a "Helicopter Investor" (And How to Stop)

Tim Lemke — Fri, 01 Dec 2017 10:00:06 +0000

We're all familiar with the term "helicopter parent" in reference to the mom or dad that hovers over every aspect of their child's life. Do you have a similar approach to investing? Do you obsess over every detail of your portfolio? Are you constantly checking in, even when it's clear your stocks are handling things pretty well on their own?

If so, you may be a "helicopter investor," and it may be costing you money as well as your peace of mind. Watch out for these warning signs. (See also: 11 Investment Mistakes We All Make)

1. You check your portfolio every day

How often do you log in to see your investment account? Are you checking in every day, or even multiple times a day? Monitoring your investments is important, but there's no real need to check in on them that frequently. Most people can get away with looking at things once a week, and could probably go months without a check-in as long as they are paying attention to broader market movements.

Checking your investments frequently might tempt you to fiddle with them. You might sell or buy stocks based on emotion. You'll get angry when investments go down slightly, and irrationally happy when they go up.

Consider setting a personal policy of checking your investments once a week (or even less) at a certain time, and have a plan for what you want to accomplish when you do. (See also: 5 Essentials for Building a Profitable Portfolio)

2. You watch a lot of financial news programs

Any smart investor should follow the news and be aware of market trends, but tuning in constantly to CNBC or another financial channel is completely unnecessary. If you want to tune in once to see where the market closes, fine. But you never want to find yourself watching for hours a day, reacting to every stock tip and piece of advice from a talking head.

Proper retirement investing requires time and patience. Watching too much financial news can lead you to think that every business event is more significant than it actually is. Unless you are a day trader or professionally manage a fund, you can do without the information overload. (See also: Want Your Investments to Do Better? Stop Watching the News)

3. You subscribe to too many financial publications

There are many great financial publications out there that can help you hone your investing prowess, but many of them also have similar content. Subscribing to one or two publications is useful, but subscribing to a half dozen or more or is overkill. This is especially true today, when there is a lot of solid advice available online for free.

Consider subscribing to one or two well-respected financial news sources to stay on top of the latest trends and market performance. Chances are, you'll make out just fine.

4. You have alerts on your phone

Smartphone apps have certainly made it easier to track and trade investments. I draw the line, however, in setting up alerts to tell you about the activity of specific investments. The average investor does not need to know, for example, that Amazon's stock just hit $180 per share, or that the market fell 1 percent on the day.

Ideally, your investments are working behind the scenes to make you money while you live your life. Turn off any notifications that would encourage you to check your investments more often than necessary. In fact, consider getting rid of the smartphone investing apps altogether.

5. You panic when investments decline

Guess what? Sometimes your investments lose money. They are not guaranteed to go up day after day. If this bothers you, and you find yourself buying and selling stocks while in the midst of emotional meltdowns, you may be a helicopter investor.

No one wants to see stocks decline, but if you are invested in the long term, you should be able to overcome a blip in the market. And any money you need within a few years shouldn't be tied up in the markets anyway.

If you're getting emotional every time you see stocks go down, do yourself a favor and back away from your computer screen. Breathe. Go do something else. Your portfolio will be fine, and you won't have to deal with the shame of making a bad situation worse by reacting in the moment.

6. You obsess over rebalancing

It's always a good idea to check your portfolio to make sure it's not out of whack. You don't want to wake up one morning and find that you're 85 percent invested in volatile tech stocks, for example. A properly balanced portfolio will be well-diversified and will match your risk tolerance.

However, most portfolios don't need to be rebalanced all that often. Remember that every time you rebalance, you are likely to incur transaction fees for every trade, and there may be tax implications as well. There's a cost to rebalancing too frequently. Once a year or once every six months for a rebalancing check-in should usually do the trick.

7. You're constantly going after the hottest thing

So you heard some buzz about Bitcoin, and now you want in. You saw Facebook's shares rise 5 percent in a week, so you jump. You're paying such close attention to your investments and the market that you're going after short-term hits rather than maintaining a long-term, disciplined approach.

Going after the hot thing often results in you buying high and selling low, which is the opposite of the ideal investing approach. It's fine to be generally aware of what's hot in the markets, but don't be like the cat going after the shiny toy.

8. Transaction fees and taxes are cutting into your gains

Buying and selling stocks has gotten cheaper in recent years, but most discount brokerages will still charge you at least $4.95 for every trade. So if you are constantly checking your portfolio and constantly buying and selling, this can add up. Consider that if you buy 10 shares of a stock at $50 a share, you've automatically given away 1 percent of your investment. If you are buying and selling smaller lots, that's an even higher percentage.

Additionally, selling stocks can come with tax implications if you are trading in a taxable brokerage account. If you sell a stock soon after buying it, you may pay a short-term capital gains rate, which can be as high as 39.6 percent.

Buying and selling stocks can be enjoyable, but if you do it too frequently, there's a cost involved. Hovering over your portfolio and constantly looking to trade can actually make a dent in your earnings over time. (See also: 4 Sneaky Investment Fees to Watch For)

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This article is from Tim Lemke of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

How the Risk Averse Can Get Into the Stock Market

Philip Brewer — Mon, 06 Nov 2017 08:30:15 +0000

The stock market can be risky. Just 10 years ago, due to the financial panic and subsequent Great Recession, stocks lost half their value in the course of not much more than a year. But the stock market is also a great investment: Long term gains are large, and even the biggest losses are routinely reversed in a matter of a few years.

The upshot is that you should almost certainly have at least some money in the market.

But since it's always either rising or falling, and since nobody wants to be foolish, it's often hard to get into, or back into, the market. And yet, because of the large gains the market routinely offers over the long term, it's absolutely worth doing — even for those terrified of risk. (See also: How to Get Over These 5 Scary Things About Investing)

Figuring out how much to invest

The best way to think about your portfolio when you're risk-averse is by recognizing that a significant amount of your money is not part of it and should not be invested at all. If you cover your other important financial bases first, you may feel better about investing.

First, make sure you have adequate liquidity balances — that's cash on hand to deal with the fact that your income arrives on one schedule (biweekly paychecks, perhaps) while your bills arrive on a different schedule (some monthly, others perhaps annually or semi-annually).

Second, make sure you have an adequate emergency fund to deal with events like an unexpected loss of income, or expenses that come out of the blue. (See also: 7 Easy Ways to Build an Emergency Fund From $0)

Third, make sure you have a plan to fund medium-term expenses (a savings account or CD or maybe an intermediate-term bond fund). These are things you know you're going to buy in the next few years.

Once you've got those bases covered, the rest of your money is your investment portfolio.

By identifying how much of your money is not part of your investment portfolio, you may find yourself much more comfortable thinking about committing some fraction of the rest of your money to the stock market.

However, maybe you've done that and you're still not comfortable. That brings us back to where we started. In particular, it raises the question: If you know the market is the right place for a sizable chunk of your portfolio for the long term, why are you hesitating to commit funds now?

Ask yourself why you're afraid

There are probably two big reasons why people hesitate to get into the stock market: Either because the market seems "too risky," or because they're "waiting for the right time."

The way to get yourself to make the move into the stock market depends on which reason is blocking you right now.

Too risky

If it's just that the market seems too risky, you can often get started investing by going small. If you can't bring yourself to put 70 percent of your portfolio into stocks (which is actually a reasonable allocation if you're fairly young), can you bring yourself to put 5 or 10 percent in?

When I was first starting to invest, most mutual funds had minimum investments that were pretty large (compared to the size of my portfolio), but there are now ways to invest amounts as small as just a few hundred dollars into stocks.

If the market seems very risky, pick a very small amount of money — small enough that you could absorb even a 50 percent loss without endangering your long-term goals — and take the plunge. Put that small amount into the market. Better yet, set up some sort of automatic investment (a payroll deduction into a 401(k) or an automatic transfer to a mutual fund or brokerage account) that would send a small amount away every month or every paycheck.

If you can find an amount small enough that you're willing to risk it — and especially if you can set up some sort of automated further investments — you set yourself up to get past your risk aversion the easy way: By seeing gains start piling up right away. And if they don't — if your investments start off by losing money — you'll still be OK, for two reasons. First, you'll know that your losses are so small that they scarcely matter over the long term. Second, you'll know that your future investments are buying stocks at a lower price (and buying low is an essential part of "buy low/sell high"). (See also: How to Invest If You're Worried About a Stock Market Crash)

Waiting for the right time

If the issue is that you accept that the market is the right place to be for the long term, but right now is the wrong time to get in (perhaps because the market seems kind of high, perhaps because it has recently dropped and you worry it might drop further, perhaps because you see major risks to the economy from business conditions or the international situation or Congress), I have two thoughts.

First, understand that it hardly matters. I saw a study some years back that compared two hypothetical brothers. Each had invested $2,000 a year in stocks in his IRA, but each year one brother had the good luck to make his investment on the day the stock market hit its low for that year. The other brother had the bad luck to make his investment on the day that the market hit its high for the year.

The result? After 10 years, it barely mattered. The lucky brother had a tiny bit more money, but both of them had a lot more money than the guy who kept his money in cash waiting for a "better time" to invest that never came.

Second, approach it just as I advised the person who thought the market was too risky: Start small.

Maybe now isn't the right time to jump in with 70 percent of your portfolio, but surely having 0 percent of your portfolio in the market is the wrong choice.

Go ahead and put a little money in. It doesn't have to be a lot. (And, once again, even better if you set up some sort of automated investment so you're continuing to put money into the market regularly over time.)

Finding the right balance

Suppose you do start small, but through a combination of further investments and growth in the market, find yourself a few years down the road with a sizable portfolio and with a large portion of it invested in stocks. When do you have too much in stocks?

One answer is that you have too much if it's worrying you. If you're having trouble sleeping at night, or if hearing the market report on the news ruins your appetite, then by all means sell some stocks and put the money into a CD or something. If you're still anxious a month later, sell some more. (See also: Find the Investing Style That's Right for You)

I would advise that you not use this as an excuse to time the market. The market will always be going up or down and neither circumstance is a good reason to change your mind about having stocks in your portfolio.

Instead, you should probably have a target asset allocation. Figure out what you want in stocks (and bonds, real estate, gold, cash, etc.) and buy and sell as necessary to return to that target allocation from time to time — usually annually is good. This is a process called rebalancing your portfolio. (See also: The Basics of Asset Allocation)

An old rule of thumb is to set your stock allocation percentage at 100 minus your age, and invest the rest in bonds. So someone in their 20s would put 70 to 80 percent into stocks while someone in their 60s would put 30 to 40 percent into stocks. That's a perfectly good rule, although with people living so much longer now than even a generation ago, it should probably be a bit more aggressive for people in the years just before and just after retirement. (See also: 7 Reasons to Invest in Stocks Past Age 50)

Your asset allocation is important, but don't let that paralyze you. The worst thing you can do is agonize over your asset allocation to the point that you never get around to investing.

Put a little money in stocks right away. Set up some sort of automatic investment. Once you have a tidy sum invested in stocks, start putting some of the new money in bonds. Only after those investments start getting large do you need to think about whether it's time to add some more exotic choices.

Start small. Start simple. But above everything else: Start.

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This article is from Philip Brewer of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

The Secret to Successful Investing Is Trusting the Process

Matt Bell — Mon, 23 Oct 2017 08:30:06 +0000

To a great degree, the biggest threat to your success as an investor is you. Making investment decisions based on fear, greed, a hot tip from your brother-in-law, the headline of the day, or any of many other flawed inputs can wreak havoc on your results. What's needed instead is a trustworthy investment process.

It should be rules-based, time-tested, easy to understand and execute, and it should be one you have enough confidence in to stick with in good markets and bad.

Here are three broad types of investment processes to consider making your own.

1. DIY

You can absolutely invest on your own. The recommended process involves following traditional rules of asset allocation, using an online calculator or questionnaire to determine your optimal stock/bond mix, choosing investments accordingly (index funds that represent each desired asset class are the easiest way to go), and rebalancing annually. Or, you could choose an appropriate target-date fund, which would simplify the asset allocation process.

DIY is the least expensive investment process, but also the one that leaves you most vulnerable to emotion-driven portfolio tinkering. After all, the process I just described, whether you choose your own index funds or use a target-date fund, is essentially a buy-and-hold strategy. That means you need to have a strong enough stomach to handle the losses that will come with a bear market, trusting that the process will deliver respectable gains over the long haul. (See also: 9 Costly Mistakes DIY Investors Make)

2. DIY with help

You could subscribe to an investment newsletter that takes a rules-based approach to implementing an investment style you agree with (value, momentum, etc.). This process is DIY in that you maintain your own account at the broker of your choice and you make the trades, but it's "with help" in that the newsletter tells you exactly what to buy or sell.

This is more expensive than a pure DIY approach because you have to pay for a subscription to the newsletter (from as little as $100 to more than $1,000 per year). Newsletters typically aim to beat the market through a more active process, providing buy and sell recommendations based on objective, rules-based criteria designed to identify undervalued, high-momentum, or otherwise attractive investments. They can also better protect you from being swayed by emotion because a trusted outside authority is guiding your decisions.

3. Work with an adviser

Here the key is understanding the adviser's process. First, does he or she work as a fiduciary? That means the adviser has formally agreed to only recommend investments that are in your best interest and to disclose all fees and commissions. Next, how does he or she make investment decisions? Again, you're looking for objective rules you understand and agree with and the adviser's discipline to follow the rules.

Working with an adviser is usually the most expensive process you could employ (typically, you'll pay 1 percent of the value of the portfolio they manage for you). However, it may also provide the best protection from yourself. For one thing, a good adviser acts as a therapist during times of market stress, talking clients out of emotional buy or sell decisions. For another, the adviser typically has direct control over your portfolio; you don't. (See also: Ask These 5 Questions Before Deciding On a Financial Adviser)

Each of these processes could guide you through any market. But you have a role to play as well. Here are two ways you can tip the scales further in your favor:

Manage your expectations

The market ebbs and flows and so will the performance generated by even the best investment process. Your willingness to accept some down months, and even some down years, will go a long way toward helping you stick with your chosen process.

Having some sense of what to expect will help. If you're taking a DIY approach, you can see how various allocations have performed over the years (see Vanguard's portfolio allocation models). By the same token, you should understand how a newsletter's strategy, or an adviser's, has performed during past bull and bear markets.

While past performance won't tell you exactly how each process will perform in the future, it can help manage your expectations. That may not make riding out a downturn easy, but it should make it easier.

Tune out the noise

Adopting a trustworthy investment process will not silence the headline writers, investment analysts, or your coworkers who like to brag about their latest investment conquest. However, it should help you turn down their volume and keep you focused on following your chosen process. (See also: Want Your Investments to Do Better? Stop Watching the News)

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This article is from Matt Bell of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread: