Random Thoughts on Dividend Payers vs Non Dividend Payers

These are just some random thoughts I've had recently. There are probably a few errors in my thinking below, but I still consider it worth thinking about and posting. A previous post on the subject can be found here.

Companies can be categorized in all sorts of ways, like small caps, consumer discretionary, industrials, etc. Two general categories are dividend paying companies and non-dividend paying companies. During the course of this bear market, I've been thinking about their advantages and disadvantages, and about stocks in general.

Although it is a rather plain fact, I don't think most of us usually regard shares of stock as basically pieces of paper that provide documentation of our rights as owners of a business (it's slightly more complicated, of course, but this simplification should do).

When individual investors buy shares of stock of businesses that we cannot afford to buy controlling interests in (I mean companies listed on the major exchanges, and I don't mean small businesses like the corner store), we buy pieces of paper that we hope we can sell to someone else at a later time for a higher price. This is true of both categories of companies, but less so with dividend payers. With dividend payers, you get a cash deposit into your brokerage account or a check in the mail one, two, four, or more times a year. To a certain extent, owning shares of a major stock exchange listed dividend paying company is close to owning a large or full stake in a small business. You get paid regularly for your ownership stake. While having all the same rights that come with owning a non-dividend paying company, owning shares of a dividend paying company gives us cash on a regular basis that we can use to buy other stuff.

With non-dividend paying major stock exchange listed companies, we buy only with the plan to sell our stake to someone else for a higher price at a later date. It struck me recently that with these types of stocks, we're not really getting anything "real" for our trouble. That is, we have to sell them to derive any benefits from them. Yes, we can go to shareholder meetings, contact management, etc, but most of us, by ourselves, can't really affect the course the business takes. And even if we manage to affect the course of the company's business, short of making it pay dividends or hiring us, we don't really get anything in return until we sell. Owning shares of a non-dividend paying company is like owning a painting, except we can derive aesthetic enjoyment from the painting before we sell it. If you want financial benefits, you cannot own a non-dividend paying stock forever.

Suppose I bought shares of Berkshire Hathaway (BRK-A) when Warren Buffett did, and, like him, I never sell a single one. Assuming I have no descendants and don't care about the government or charity, I'd be better off had I never bought them. Unlike a deed to a house, a non-dividend paying stock certificate doesn't amount to anything until you sell it. You can live in a house, on the other hand.

There are market booms and busts. Share prices for both dividend and non-dividend paying companies fall during market busts. Suppose company A is a solid dividend payer that will last and grow for another thousand years. Suppose company B is a solid non-dividend paying company that will last and grow for another thousand years. What advantage would you have in owning company B your entire life? Your paper net worth would be high, but without selling you wouldn't be able to do anything with that potential money (yes, you can sell calls on your shares or use them as collateral, but I consider this a part of selling because that's what these transactions can lead to).

Suppose there's a major crisis and the stock markets are closed for an extended period. You will find it exceedingly difficult to sell your shares (and likely for a much lower price) if you suddenly need the money (you'd have to find a buyer, and then either transfer your stock certificates to him or enter into a contract to do so at a later date). Company A, on the other hand, will continue sending you checks. At such a time, I'd bet potential buyers would be more interested in company A than B.

Though seemingly likelier now, an extended market closure isn't that probable. But a market bust would still hurt company B owners more than A owners. Investors typically look to the future to decide how much to pay for a company's stock. They're usually willing to pay more than the company's book value. Two common measures are share price multiples on earnings and discounted future cash flow. During good times, investors are willing to pay more for earnings and cash flows. In bad times they're often very stingy. A company can double its earnings while its stock price and share counts stay the same. The P/E ratios (forward and trailing) just contract (in this example by 50%). A company can keep increasing its earnings while potential buyers, pessimistic about the future, can be willing to pay less and less. With company B this probably means that you have to wait for investors to get more optimistic before you want to sell. With company A, it means the dividend payments you receive will probably be higher.

The stock market is to a large extent a Ponzi scheme. Future buyers have to pay more than past buyers for participation to be worthwhile. In a certain sense, it can't be sustainable. As we saw with the housing bubble, it took more and more money for homeowners to get the same percentage return (and down payments as a percentage of purchasing price kept going lower and lower). For example, buying an asset for $2,000 and selling it for $4,000 requires finding a buyer willing to pay $2,000 extra for one to get a 100% return. That buyer has to find someone, call him C, willing to pay $4,000 extra for him to get a 100% return. C has to find someone willing to pay him $8,000 extra for him to get a 100% return. It doesn't take long before some future buyer, call him Z, can't find anyone willing to pay him double what he paid. Z and, more likely than not, prior owners, have to settle for lower percentage returns. For example, let's say some buyer, F, paid $400,000 for the asset. Whereas C doubled his money when he found a buyer willing to pay $8,000 extra than C paid, if F finds a buyer willing to pay $8,000 extra, he'll only make a 2% return. F has to find someone willing to pay $40,000 extra just to get a 10% return.

Eventually, the potential returns are so low and potential losses are so high that there are no willing buyers. No asset can forever increase in value.
This makes dividend paying stocks worthier investments. While like any other asset these stocks can't go up forever, they pay you regularly. Their earnings don't have to increase indefinitely, they only have to remain stable.

What I'm taking away from all this is that non-dividend paying large cap stocks are worse investments than large cap dividend payers and small cap non-dividend payers. Small cap dividend payers are probably the best lifetime stock investments. When buying non-dividend paying companies, we take a gamble on future buyers' willingness to pay more than we do. When we buy dividend payers, we make the same gamble, but we also take into account how much we will be paid in the meantime. If a stock will pay me $x a quarter for the rest of my life, what do I care if future buyers are willing to pay less for the stock than I did (as long as $x does not decrease substantially due to inflation)?

Depending on how we distinguish investing from gambling, I think the latter approach is more worthy of being called investing than the former.

Disclosure: I don't have any positions in any securities mentioned above. It would be nice, though, to own a good number of BRK-A shares. Although if this were the case, I'd have already exchanged them for cash.


How Did We Get Here? A Summary of the Credit Mess

The tech bubble burst in March 2000, just as many individual investors were deciding to put their money in the stock market amid financial media calls for 6,000 on the NASDAQ. The ensuing recession claimed many jobs, reduced corporate spending, increased unemployment, and destroyed NASDAQ investors' portfolios. The situation was made substantially worse by the terrorist attacks on September 11, 2001. Many people gave up on the stock market and decided to invest in real estate.

As the economy continued to stagnate, the Federal Reserve, chaired by Alan Greenspan (who has now sort of admitted he made a mistake), slashed rates down almost to 1%. The rates were kept at these low levels far too long, experts now say. Low interest rates on mortgages made houses more affordable, and demand for real estate increased. As demand and prices grew, mortgage lenders started changing their business models. Traditionally, a mortgage lender (bank, credit union, etc) would lend money for a home purchase and would hold that loan until it matured (usually for 15 or 30 years). This is called the originate to own model.

Since business was good, banks started shifting their strategy to an originate to sell model. Banks began to sell their mortgages to third parties (these third parties often sold them to fourth parties, and so on), freeing up capital to fund new loans. Mortgages started to become a mass produced product. While lenders made a small profit on every loan they sold, they started to make a lot of money on the volume of their mortgage sales.

With the originate to own model the lender cares deeply about the credit quality of its borrowers. Since the lender holds the loan until maturity, it makes no sense to lend to someone who is likely to default. With the originate to sell model, on the other hand, the lender has no incentive to be careful because any defaults are the purchaser's problem. In fact, since earnings on this model depend on the volume of sales, the lender has every incentive to make its lending practices as lax as possible. With many mortgages being sold less than a week after they're originated, lenders did just that.

The boom in mortgage selling led to and was reinforced by rising housing prices. Two out of every five new jobs created in the middle of the decade were housing related. (You may recall your friends and neighbors becoming mortgage brokers.) As fraudulent practices almost always develop in booming industries, housing was not immune. Lenders started approving pretty much anyone who could sign their name, with little or no attempt to verify employment status, etc. Fraudulent home appraisers started overvaluing homes. Speculators, thieves, the unintelligent, and people who were swindled, started purchasing homes with no money down for ever increasing prices, paying interest only.

The now nationalized Fannie Mae (FNM) and Freddie Mac (FRE) certified (insuring purchasers against some potential losses) some of these loans, making it easier to bundle and then securitize them, to make mortgage backed securities (MBS). Securitized loans were then sold to yield hungry banks, investment banks, and so on. But there was a problem. Fannie Mae and Freddie Mac only certified prime (the most credit worthy borrowers) mortgages, making it difficult to bundle and securitize subprime (borrowers with poor creditworthiness) mortgages.

In 2004, the retards in Congress (led by the Democrats--please note that I dislike both parties equally) came to the rescue. They started clamoring for Frannie Mae and Freddie Mac to certify subprime mortgages on a widescale. More people with low incomes, they argued, should have access to homes they cannot afford. Since Fannie and Freddie were making money on it, it did not prove difficult to have them assure subprime mortgages. When Republicans started to worry about questionable practices at the two government sponsored entities, the Democrats fought back. (See Maxine Waters praising subprime loans at the 5:30 mark.)

Lenders immediately started trying to get more subprime customers. Some firms specialized in subprime lending. People with low incomes (which is correlated with low levels of education) and others with terrible credit were swindled (many, of course, knew exactly what they were getting into but were greedy) into buying homes they could not afford. They were given adjustable rate mortgages, initially at teaser rates of 2 to 3%, that were later to reset to as much as 9% or more.

Now that subprime mortgages had Fannie and Freddie backing, it was easier to bundle and securitize them. It's obvious that subprime mortgages are riskier than prime mortgages. The geniuses on Wall Street took that into account when they thought of collateralized debt obligations (CDOs). CDOs were made by combining lots MBSs. These were then sliced into tranches, and the credit rating industry (Fitch, Standard and Poor's, Moody's) issued credit ratings on them.

The smart people who participated in this were trying to make as much money as they could before everything collapsed. The stupid bankers and risk modelers, on the other hand, thought there wasn't much to fear, as housing prices would continue to go up forever. (Was Franklin Raines a moron or a thief? See video at 7:46.) The ratings agencies, which were paid by the issuers of CDOs had zero incentive to understand what they were rating and every incentive to please their clients. Suddenly garbage subprime debt became AAA (the highest credit quality, with little risk of default).

As the debt was often rated AAA or AA and carried a higher yield than was otherwise available for safe investments in the low interest rate environment, yield hungry (and some risk averse) institutional investors like banks, investment banks, hedge funds, money market funds, and pension funds developed an insatiable appetite for CDOs. Some buyers, like hedge funds and investment banks, used borrowed money to make their purchases. For every dollar of assets some of these institutions had, they were buying over $20 or $30 worth of mortgages.

For a time everything was grand. Thanks to rising housing prices, some lenders like Washington Mutual had negative default rates. That is, when borrowers defaulted WaMu was able to make a profit when the mortgaged properties were foreclosed. Amid this surreal environment banks decided to up the ante by creating structured investment vehicles (SIVs). Banks started selling their mortgages to the SIVs they created.

This moved the mortgages off their books and freed up capital to issue more loans or buy more mortgages from other issuers. SIVs allowed banks to pretend their capital reserves were much higher than they actually were. That is, banks used SIVs to get around pesky laws preventing them from leveraging too much.

You may wonder where the SIVs got the money to buy subprime mortgages from their sponsoring banks. That's right, they borrowed! They issued asset backed commercial paper and sold it to investors like money market funds. The subprime debt SIVs owned paid a higher interest rate than the SIVs paid the money market funds. Thus, SIVs made money on the difference between the interest they received and the interest they paid out, enabling them to buy more subprime mortgages and sell more debt to money market funds and other investors. As housing prices rose and default rates were low or negative, everyone seemed to be a winner.

But there was a nagging feeling in the backs of mortgage purchasers' minds. There was some risk here, wasn't there? Ever the prudent bunch, they decided to buy insurance on their MBSs by purchasing Credit Default Swaps (CDS). Companies like AIG (AIG) made a good business of leveraging their assets many times over to sell CDSs. For example, a mortgage purchaser would pay AIG $200,000 to insure $2,000,000 worth of mortgages. AIG promised to pay the mortgage holder if borrowers defaulted on the mortgages. Soon, sellers of CDSs were insuring debt worth dozens more times than their assets.

Eventually everyone was buying and selling CDSs, and now no one really knows who owes whom how much when there's a default. Hopefully most of the outstanding CDSs offset each other, but the market for them is as big as the world's economy: $45 trillion. If you were upset that AIG wasn't allowed to fail, you should consider whether you really want to find out what would happen if this house of cards were allowed to fall.

Because of the rising housing prices, low rates, MBSs, CDOs, SIVs, etc, everyone from homeowners to hedge funds had the incentive to overproduce and overleverage. As demand went ever higher, homebuilders built houses as fast as they could. People who already owned homes bought extra houses, or refinanced their current mortgages and started using their homes like ATMs (credit cards is probably a better analogy).

For example, someone who had $200,000 left on their mortgage discovered that his house was worth $400,000. He'd go to the bank, get a $400,000 loan, pay off the $200,000 he owed on the first loan, and use the remaining $200,000 to buy crap he didn't need, like an extra gas guzzling car, another house, stocks, cell phones, computers, etc. All the while, he'd pay only the minimums on his credit cards and mortgage. (Around two years ago I was amazed to see that suddenly half the people on my block had BMWs in their driveways. I thought about buying an ultra short ETF, but as the market was galloping up, I got caught up in the optimism and didn't do it.) As houses became more and more expensive, fewer and fewer people had enough for a downpayment, so more and more mortgages covered 100% of the home purchase. Most of these mortgages, like subprime mortgages, came with low teaser rates that were later adjusted upwards.

All this borrowing and spending created lots of jobs here and abroad, and fueled the world's developing economies. We buy a lot of their oil and junk products. Asian countries, like China, India, and Korea, started running greater and greater trade surpluses. They were flooded with dollars. They took this money and started to buy US mortgages, increasing demand for MBSs and creating incentives for lax lenders to lend even more. We borrowed and bought their crap. They used the proceeds to buy our debt. It was a kind of perpetual cycle. All asset classes were inflating, from real estate to stocks to commodities.

Then reality asserted itself. Interest rates on adjustable rate mortgages started reseting. Suddenly people, who were living from paycheck to paycheck and paying only the minimums, were faced with mortgage bills two or three times as high. Instead of having to pay $2,000 a month, all of the sudden they had to pay $4,000 or even $6,000 a month. These people started defaulting.

As defaults grew, foreclosures increased. As foreclosures increased, the supply of houses on the market grew. Lenders also started to become a little more wary. Fewer people started getting mortgages. This decreased the demand for houses. As supply grew and demand decreased, housing prices started falling. Now people who owed $600,000 on a house worth $580,000 and declining decided it wasn't worth it, and walked away. Defaults increased. The supply of houses grew greater and demand decreased. As refinancing became more difficult, consumers facing mountains of debt started spending less. Employers, especially in housing related industries, started making job cuts. The situation started reinforcing itself.

The MBS market began drying up as defaults rose. Some investors started demanding higher yields. Other investors, like pension funds, discovered that the subprime debt they bought wasn't AAA after all. They are not allowed to purchase or hold debt that is below a certain quality (usually AAA or AA). With the MBS market going down, lenders started lending even less. The situation reinforced itself further.

Pretty soon, no one wanted to buy MBS or CDOs at all. Banks were left holding billions in potentially worthless mortgages. It became harder for even prime borrowers to get financing. As fear spread, companies and municipalities started having a hard time borrowing to fund their operations, leading to layoffs and reductions in spending. Banks, now worried about their capital reserves and fearing their rivals might go under, pretty much stopped lending, even to each other. That's sort of where we are now.

As everyone delevers, we're in for a painful recession. Our economy, and the world's to the extent the world depended on American consumers buying imported junk, for the last five years or so (we can probably say the last 10 years) has been fake. It was based almost exclusively on credit. Almost half of the jobs created this decade were housing related. This new employment fueled growth in other industries. But everywhere, pretty much everything Americans bought was bought with borrowed money. We had a negative savings rate. Now that it will be harder to borrow, what will fuel future economic growth?

One thing about the future is rather clear. If we manage to get out of this crisis and go back to business as usual, our next boom will peak lower and our next bust will bottom deeper. We have to find a way to live within our means, with more saving than borrowing.

Pretty Good CD Offer from Citibank

Citibank (C) started advertising a 4% six month CD. That's pretty good considering the national average for six month CDs is around 3.06%. If you've renounced stocks or have savings deposits you don't need for six months, Citi's CD is not a bad place to go (stay within the FDIC limit, though).

The offer seems to indicate that Citi is strapped for cash more than its large rivals, like Chase (JPM) and Bank of America (BAC). This could mean that the stock will head lower. If you're of that opinion, you might consider buying medium or long term puts (I'd do it at the 10 strike).

Here's a plan that might be appealing if you're considering the CD and want to speculate "for free." Calculate how much interest the money you want to buy the CD with will earn over the next six months where you're presently holding it. Then calculate how much it'll earn in the CD. Find the difference between these, and then look at the puts you might want to buy. If the difference between the interest earned on the Citi CD and the earnings where money currently held is equal to or greater than the value of the puts, buy the Citi CD and buy the puts. It's like you're getting the puts for free. If the stock continues to drop, you'll make more money.

That's probably not very clear, so here's a general formula and an example.

This is for money you don't need for the next six months.

Money currently held in account A will earn $x in interest over the next six months.

Money in the Citi six month CD will earn $y in interest over the next six months.

A medium or long term put(s) (at whatever strike you think is best) costs $p.

First, if $y is greater than $x, you should strongly consider buying the CD.

Second, if you want to take a risk and if $y - $x is equal to or greater than $p, you might want to buy the put(s). This way, if Citi stock goes up and the put becomes worthless you'll be no worse off six months from now than if you just kept your money where it is presently. If Citi stock goes down, you'll be better off.

Example: Over the next six months, let's say you'll earn $400 in interest on money you don't need for the next six months. Let's say if you move that money to the Citi CD, you'll earn $750 when the CD matures. That's a $350 difference. It's probably worth it to move your money into the Citi CD.

Now, if you're in the mood to speculate, you can take $350 from your brokerage account and use it to buy puts on Citibank. Should the stock fall, your puts will rise in value and you'll make extra money. Should the puts become worthless, six months from now you'll have earned a net of $400 on the entire enterprise, which is what you would've gotten had you done nothing at all.

Disclosure: At the time of writing I hold no positions in any assets mentioned above.


How to Start Investing

I've received a few emails recently from people who want to start investing but do not know where to begin. While this post is aimed at new investors, seasoned investors will hopefully get something out of it too.

Before you start investing, you need the following things:

  1. An emergency fund of at least $1,000 that you will continue putting money into regularly, so that this fund will be worth at least half a year's expenses as soon as possible.
  2. Health insurance and disability insurance.
  3. Little (or better yet, no) debt.
  4. Money that you won't need for at least 5 (or better yet, 10) years.
Once you have done 1 through 3, you are ready to start investing with #4. For many people this means $50 or $100 a month that can be set aside for investing. Perhaps you already have $500 or $1,000 ready to invest (that's #4 money).

How Do I Start Investing with $1000?

Getting Started

Before you go shopping for stocks, ETFs, or mutual funds, you have to figure out what asset mix is best for you. Your ideal asset allocation depends primarily on your age (or the time between now and when the money to be invested will be needed), goals, and risk tolerance. Your risk tolerance is, basically, the degree of losses you can bear before freaking out and selling everything. The greater the risk, the greater the potential gains and losses. The lower the risk, the lower the potential losses and gains. The closer you are to your goal, the less risk you should take.

Diversification among and between different asset classes lowers the risk and decreases the volatility of a portfolio. For example, owning 10 stocks should provide a smoother return than owning one stock. The one stock can go out of business. In a one stock portfolio this would result in a total loss. In a 10 stock portfolio, the other 9 stocks would still be worth something, so the loss wouldn't be nearly as great.

While owning a number of stocks is less risky than owning one stock, a ten (or twenty or thirty, etc) stock portfolio is not a diversified investment. This is because stocks as an asset class have a type of risk that cannot be mitigated by owning more stocks.

To be adequately diversified, then, you need to own more than one asset class. Different asset classes include stocks, bonds, commodities (e.g., agricultural products, precious metals, and petroleum), real estate, and cash. (Each of these asset classes can be diversified to a lesser or greater extent. For example, there are small cap, mid cap, and large cap stocks, as well as various economic sectors like financials, energy, consumer staples, etc. There are various kinds of bonds, both in terms of safety, duration, and tax consequences. There are many different kinds of real estate. Hotels, for instance, are different from residential homes and malls. Even cash can be held in different forms and locations--CDs, under the mattress, in a savings account, as a foreign currency, in bank A rather than bank B, etc.)

Asset allocation determines the portion of your portfolio that each asset class takes up. Your ideal asset allocation should help reach your goals with as little risk and portfolio volatility as possible.

Determine Your Risk Tolerance

The first step, therefore, is to determine your risk tolerance. There are a number of decent tests online (some are better than others). You should answer the questions as honestly as possible. The best ones I could find are listed below. If you know of or come across a better one, please leave a comment or email me.





Figure Out the Best Asset Allocation For You

Asset allocation is a topic that makes most people who are interested in personal finance salivate. There are generally two types of asset allocation:

Strategic or target asset allocation is a passive investment strategy that involves figuring out the appropriate mix of assets in your portfolio, and then sticking to it for the long run (changing it gradually to take on less risk as your time horizon gets shorter). Let's say your original asset mix is 50% stocks and 50% bonds, and a year after you start investing your portfolio's composition is 60% stocks and 40% bonds. If you're putting new money into the portfolio, with strategic asset allocation you would put money into bonds first, so that they would once again take up 50%. If you don't put in new money, on this strategy you would sell some of your stocks and purchase bonds with the proceeds, so that your asset mix would once again be 50% stocks and 50% bonds.

Tactical asset allocation involves trying to get a higher return by, for example, underweighting assets that you think will do poorly in the (near) future and overweighting assets that you think will outperform in the (near) future. That is, whereas in target allocation you leave your optimal asset mix alone (or change it over time to reduce risk as you approach your goal), with tactical allocation you are frequently adjusting your asset mix to make bets on the near term. So, for example, you can add more money to commodities and reduce your holdings in financials if you think the former will outperform while the latter will underperform.

As beginning investors should not be trying to time the market or otherwise increase their risk by being overly active in the management of their portfolios, I think the target allocation approach is the best one for beginners. Moreover, I think you should not sell anything that you buy. Rather, rebalance your portfolio (keep your asset mix on target) with new money, which you should be putting in regularly. This way, you will always buying more of the asset classes that are performing worst. The worse they perform, the more shares you'll buy, increasing your potential future returns (buy low, sell high). And by avoiding the assets that are doing well, you'll be less likely to buy more of them when they are too expensive.

There are many resources asset allocation, some of which are listed below.


CNN Money


Seeking Alpha


To see it in action, check out my model portfolio, which at the time of writing is down almost 28%, but is currently outperforming the S&P 500 by 1%.

The most important decision you'll make is about what portion of your portfolio is devoted to stocks, bonds, and cash, and as your portfolio grows, commodities and real estate.

With stocks (and to a certain extent bonds) you also have to decide what portion should be allocated to domestic companies and what portion should be invested in foreign companies. Traditionally, most financial professionals advocated keeping foreign stocks to a small portion of your stock portfolio (20% was around the maximum). Today there is a growing body of experts advising that you devote as much as 55% of the stock portion of your portfolio to foreign stocks. They argue that future growth will come from abroad. As you think about this, you should consider that many (particularly large cap) US companies derive significant portions of their sales from abroad while many foreign companies derive significant portions of their sales from the United States.

Here are some examples of asset allocations based on risk tolerance:

80-90% stocks
10-20% bonds

70% stocks
20% bonds
5% real estate
5% commodities

65% stocks
20% bonds
10% commodities
5% real estate

51% stocks
34% bonds
7% commodities
5% real estate
3% cash (CDs, money market, high yield savings)

20% stocks
65% bonds
3% commodities
5% real estate
7% cash (CDs, money market, high yield savings)

Deciding How You Will Invest

Once you've figured out your risk tolerance and ideal asset allocation, you have to decide which route you want to take: doing it on your own, or leaving it to a financial professional. These are not mutually exclusive. You can combine the two approaches. An important factor to consider here is costs.

There are three general types of ETFs and mutual funds:

1. ones that are based on a broad index (e.g., entire stock market, S&P 500, all stocks except US, all bond index, total real estate, etc),

2. ones that are based on more specific sectors, asset types, or valuations (e.g., health care stocks, short term treasury bonds, high yield corporate bonds, small cap value, health care real estate investment trusts, etc), and

3. ones that are based on a target allocation (e.g., starts out with 80% stocks and 20% bonds, and gradually reduces the portion of stocks and increases bonds). These are usually called Target Date Funds (and are based on the approximate date you want to retire). They are worth considering if your ideal asset allocation matches theirs.


Doing it yourself, at least at the beginning involves purchasing Exchange Traded Funds (ETFs). These are baskets of stocks and/or bonds that you can buy like regular stocks through a broker. Most ETFs are index based, and are thus passively managed. That is, their managers do not engage in stock picking. ETFs are a very easy and inexpensive way to get instant diversification.

The costs associated with ETFs are generally of two types: commission fees you pay your broker, and the management fees taken by the company that manages the ETF. To a certain extent, both these costs can be controlled by you by choosing a low cost broker and picking the lowest cost ETFs. Broker commission costs run from $0 to $30 a trade and above. ETF management costs run from 0.06% to as much as 2% or above, with most in a range of 0.2% to 0.6%.

If you opt for the ETF approach, I suggest you stick with those in categories 1 or 3.

Here is an example of a very simple low fee ETF portfolio made of ETFs like those in category 1:

40% US stocks (VTI)
30% International stocks (VEU)
30% Bonds (BND)

If you started out with $1,000, you'd put $400 into VTI, $300 into VEU, and $300 into BND.

Mutual Funds

Leaving your portfolio to a professional involves purchasing mutual funds. They come in pretty much the same varieties as the ETFs mentioned above. Except for the mutual funds that are index based (and are thus passively managed), mutual fund managers try to beat the market. That is, they try to select stocks and bonds that will do better than their benchmark index (usually the S&P 500 for stocks and the Lehman total bond index for bonds). This means two things: much higher costs than ETFs and index mutual funds, and the risk that the mutual fund manager is not very good. As most actively managed mutual funds underperform the market and charge higher fees than passive mutual funds and ETFs, you should stay away from them.

The best mutual funds for you to consider are those that are index based (category 1 above) and those in category 3 that are passively managed. Look for funds that charge no transaction fees and as little management fees as possible.

Here is an example of a very simple low fee mutual fund portfolio:

40% US stocks VTSMX
30% International stocks VGTSX
30% Bonds VBMFX

In choosing this strategy, you're essentially going the do it yourself route. In doing it yourself, you may ask, what's better, ETFs or mutual funds?

The answer to this question depends on costs and how much money you're investing. ETFs have no purchase minimums, and typically have lower management fees, but you incur broker commissions every time you buy them. Unless you have a broker that allows you to buy fractional shares, you will not be able to buy an exact dollar amount worth of an ETF. (For instance, suppose you want to invest $500 into VTI. As I'm writing, it's trading at $48.66 a share. If your broker doesn't let you buy fractional shares, you can only buy 10 shares of VTI with your $500. This leaves $13.40, which is not put to work in the way you want.)

No transaction fee index mutual funds typically have purchase minimums (the lowest I've seen is $500 initial investment and $50 subsequent investment; the ones listed above each require a $3,000 initial investment), and slightly higher fees. However, once you've made your initial purchase you can invest smaller amounts (usually $50 or $100) whenever you want. You get to buy fractional shares, so the full amount of your money is put to work. Depending on how often you want to invest and how much your broker charges you to buy ETFs, mutual funds, even with their higher management fees, may be more cost effective for you.

Choosing a Broker

You should choose your broker based on:

  1. commission costs.
  2. availability of fractional share purchases (especially if you're starting out with a small amount of money).
  3. if you want to go with the mutual fund approach, make sure the mutual funds you want to buy are available through your broker (be sure to check if it's cheaper/easier to buy directly from the mutual fund company).
  4. availability of dividend reinvestment.
Essentially, your choice of broker should boil down to the availability of the mutual funds or ETFs you want to buy, and the costs involved in buying them. Try to find a broker that does not charge you account maintenance, minimum balance, or inactivity fees. Site layout, order execution, and trading tools should take a back seat when you're starting out. (These things matter, of course, but you don't really need them when you're starting out. If you later decide to be a day trader or something, you can always open an account with another broker if you're unsatisfied with your cheap broker).

Some brokers you may want to consider:

My Suggestion

If you decide to go with the ETF approach, I suggest Sharebuilder or SogoTrade. Both have low commission fees, and no minimum balance or inactivity fees. They also allow you to put all your money to work by letting you purchase fractional shares. If you don't care about fractional shares and have $2,500 ready to go, check out Zecco. At the time of writing (10/21/08), they offer 10 free trades a month when your account value is $2,500 or over (this may change at any time, however). (Note that if you intend to invest in an IRA or Roth IRA, avoid Sharebuilder and Zecco, as they charge annual custodial fees for retirement accounts. At the time of writing SogoTrade does not offer an IRA.)

If you pay commissions for ETFs, try to limit your commission to 1% of your trade. For example, if you pay $4 a trade, try to invest at least $400 (or $404, including the commission charge).

If you choose to go with broad index mutual funds, choose the ones with the lowest costs.

With either approach, once you begin investing, continue to do so regularly. As long as you have #4 money (money you don't need for a while), keep putting it in on a fixed schedule (once a week, once a month, etc) no matter what is happening in the market. You should be buying when people are jumping out of windows screaming the sky is falling, when everyone is optimistic about the future and thinks stocks are the best thing ever, and at any time in between. As long as you have #4 money, stick to your schedule.

Should people's attitudes and economic circumstances affect you, remember that there is more reason to stop putting money in regularly when people are optimistic than when they can't bear to look at their brokerage account statements. Always try to maintain your asset allocation when you invest new money--this means buying more of the assets that are doing worst. With an index ETF or index mutual fund portfolio, you should never sell anything.

If you opt to go with an ETF or mutual fund of the #3 variety (target date funds), pick the one that most closely matches your ideal asset allocation and that has the lowest costs. Be aware that most target date mutual funds are funds of funds. That is, their holdings are other mutual funds. As those other mutual funds are usually actively managed, remember the risk that the managers of those funds may not be very good. If you go with the #3 variety mutual fund, try to find one that has no transaction fees, low management fees, and is index based.

Individual Stocks

You may be thinking what role individual stocks (or bonds, etc) play. You should consider these as potential portfolio boosters that are to be used sparingly. The bulk of your investment money should be in index funds. Individual stocks should make up a small fraction of your portfolio. Use them only to boost returns. Consider them as side bets.

The best time to invest is whenever you have money that you don't need for at least five years. If this is your situation, get to it.