Ask The Expert with Larry Swedroe, January 2008 Issue

This is the 2nd issue of the Ask The Expert column by Larry Swedroe. You can see Larry’s full biography and important disclaimer below. If you are interested in having your question answered by Larry, please send me an email via the contact page.

Now, let’s get to the questions and answers (please note that the emphases and links are mine).

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1. Is it best to get out of debt before you start investing?

From Lynnae @ Being Frugal

The issue is actually fairly complex, though some parts of the question are easy to answer.

• First, if you have any credit card debt you should not be investing. Pay that off first as the cost almost certainly exceeds any reasonable expectation of return on prudent investments. So pay off all of your credit card debt every month before you invest.
• Second, if you have any fixed income investments (e.g., bonds, CDs), you should likely sell them and pay off your debt as the return on those investments is likely to be less than the cost of the debt (unless you have a subsidized student loan).
• And I would also pay off any debt before investing in stocks and the reason is that you will not be receiving the full risk premium for taking the risk of owning equities. So you are taking stock risk but not getting stock returns (net of the cost of the debt).

Let me explain.

The cost of the debt you have is almost certainly higher than the risk-free rate of return (the return on one-month Treasury bills). Other investments like stocks have higher expected (but not guaranteed) returns. The higher expected return is called a risk premium. And it is called a risk premium for a reason; you are taking risk. How large a premium is a reflection of the degree of risk. So longer term Treasury bonds have provided a risk premium of about 2% a year above the return on one-month T-bills. That is a premium for taking what is called term risk (related mostly to inflation). Stocks have earned about 7% a year above the return on T-bills. And riskier small and value stocks have earned further risk premiums. Thus, the market has historically priced stocks to provide that size and value risk premium.

Now let’s take an example. Say treasury bills are at 4% and we expect stocks to return 10%. That is a risk premium of 6%. But if your debt costs you 8% then your risk premium is only 2%. You are taking risk that the market prices at 6% and earning just 2%. That does not make sense to me. Now it is a bit more complex since you should look at after tax returns. So you should adjust the cost of the debt to reflect the true after tax cost (assuming the interest is tax deductible) and adjust the equity return to reflect the lower capital gains rates (assuming it is in taxable account).

Another important issue relates to mortgage debt. Many people make the mistake of not thinking of the mortgage on their home as debt when it comes to their asset allocation. Mortgage debt should be treated the same way as any other debt in terms of analyzing the costs versus the expected return on any investment.

And finally, there is the issue of the need to take risk. If your financial plan requires you to earn a high rate of return then you may need to carry a home mortgage and take the risk of investing in stocks (instead of paying down the mortgage). But you then should be sure you also have the ability and willingness to take that risk as well. My book, The Only Guide to a Winning Investment Strategy You’ll Ever Need, has a chapter on how to build a portfolio, specifically addressing the issues of ability, willingness and need to take risk. I provide specific tables that are easy to use to help you figure out the right asset allocation for you.

I would add one last point. While stocks have historically earned about 10% a year, providing that large risk premium, most financial economists believe that going forward the return to stocks will be somewhat lower, more in the range of 7-8 percent per annum.

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2. I wanted to get your opinion on currency hedging - is it worth the cost over the long run?

I live in Canada and this year our currency went on steroids and obliterated every non-Canadian investment from the point of view of a Canadian. Currency hedging (i.e., buying currency-neutral funds, ETFs, etc.) doesn’t seem to cost that much and the payoff can be pretty big in a year like 2007.

Also, how much should age factor in? i.e. if you are 22 then maybe currency shouldn’t be an issue since you aren’t going to retire for a while but for someone like myself who wants to retire in about 15 years, not sure how much I should worry about it? And if you are retired…then maybe currency hedging makes the most sense?

From Mr. Cheap @ Quest For Four Pillars

That is a great question and more important to someone in Canada than it is for someone in the US. The reason is that Canadians are more impacted by exchange rate changes than Americans are because trade is larger percent of GNP. Here is how I would suggest you address the issue.

First, I would create an investment policy statement that includes your asset allocation. I think the best way to address the issue is to make sure your investments are globally diversified and unhedged. So the way to do that is to include a large percent of international (non-Canadian) investments in your equity holdings. For Americans I typically suggest 50% international.

In your situation I would consider an even higher figure (Canada is a much smaller percentage of world trade), perhaps 70%. Then for your fixed income investments keep them in investments that are not likely to be damaged by inflation. So that means either some type of inflation adjusted security or relatively short-term bonds.

International investments should play an important part in everyone’s portfolio as they diversify the economic and political risks of their home country.

Few other quick points. First, age should not matter here. Second, currency hedging costs are relatively low but I don’t think that you need to engage in that. You can get the hedge by investing internationally with your equity holdings.

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3. I’ve read your book Wise Investing Made Simple, and understand, I am an investing novice. I don’t really understand a whole lot. I do understand what an index fund is, however, give me a list of mutual funds and I have NO idea which are index funds unless they have the word “Index” in the title. For example, my Roth IRA is invested in a Vanguard Target retirement fund. Is that an index fund? No idea.

So my question is: how do I find out that something is an index fund other than having the word index in the title? I thought they all did but some of your example funds in the book do not and I realized I am
missing something.

Also, could you explain P/E ratio again? I re-read that several times, but I I am still confused.

From Jaimie @ I’ve Paid For This Twice Already…

Let’s begin with the fact that what we really want to do is own passively managed funds. A passive fund is one that does not engage in any market timing or security selection efforts. All index funds are passively managed. They buy and hold all the stocks in an index such as the Russell 2000. And they hold them in market cap weighting — so the S&P 500 Index is not an index of 500 equal holdings. The largest stock might make up 5% of the index, and the largest 50 might be 50 percent.

But you can also own passively managed funds that are not index funds. The fund family called Dimensional Fund Advisors runs many such funds. For example, they manage a microcap fund that basically owns the smallest 5% of stocks ranked by market capitalization. Now the fund is passively managed, but there is no index. The family of Wisdom Tree ETFs are also passively managed, yet there are no indices against which they are benchmarked. Each fund defines its ASSET CLASS (group of stocks with similar risk characteristics). By the way, my book, The Only Guide to a Winning Investment Strategy You’ll Ever Need, has a chapter on Index Funds, Passively Managed Funds and ETFs that goes into more detail.

As to your question on the Vanguard Target Retirement Fund what you need to do is to either read the prospectus or you can use the Internet to find out what the fund actually holds. Typically Target retirement funds are what are called Fund of Funds, meaning they own several different funds. The funds inside the Target fund can be index funds, actively managed funds, or both. So you need to do your homework. Morningstar’s site provides some good information as would I am sure Vanguard’s site.

Note that targeted retirement funds will be shifting their holdings, becoming more conservative over time (which is appropriate). For novice investors these are probably good investment vehicles as they are likely to keep you disciplined by rebalancing themselves for you.

P/E is the price-to-earnings ratio. So you take the stock price and divide it by earnings per share. Stocks with high P/Es are called growth stocks and stocks with low P/Es are called value stocks. Despite what most people believe, growth stocks have relatively low expected returns and value stocks have relatively high expected returns. Both Wise Investing Made Simple and The Only Guide to a Winning Investment Strategy You’ll Ever Need go into great detail explaining why this is so. This point about expected returns being related to P/E ratios is an extremely important one for investors to understand — yet most get it completely backwards.

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4. In the previous issue, you wrote: “I recommend that everyone should have at least 30% of their equities in international stocks, with as much as 50%, which is my own allocation.” Personally, I agree with the statement but I would like to hear your justification; especially when most “experts” recommends no more than 25%.

From Pinyo

If you believe that the markets are relatively efficient you should consider how the market allocates capital when deciding on your own allocation. Currently the U.S. stock market makes up less than 50% of the global capital markets for equities. Thus, in my opinion, U.S. investors should allocate about 50% of their equities to international investments.

There is another important reason for doing so, at least for those that are still in the labor force. Almost everyone I know, including most professional advisors, makes the mistake of not accounting for a very important asset when designing their investment policy. That asset is their human (or labor) capital. The reason they fail to account for it is that it is not a financial asset that appears on a balance sheet. Yet, it clearly is an asset that has value. That value is your future expected income. Since that income is probably correlated to US economic and political risks more than foreign risks it is important to consider diversifying that asset as well. That would argue for even a higher international allocation.

There are two main reasons investors fail to diversify appropriately. The first is that they confuse the familiar with the safe. The second is that cannot deal with what we call tracking error regret. Once you diversify, your portfolio’s returns will not look like the returns of popular indices like the S&P 500. You should not care about that, but people do. So when you have positive tracking error, everyone loves it. But the price of positive tracking error is that you will also experience negative tracking error.

When that happens investors panic and sell. And typically at the wrong time. So unless you can avoid that psychological problem you should probably keep your international allocation low. Either that or hire an good financial advisor to keep you disciplined.

5. Is now the time to go into TIPS full force if one is a money market only conservative investor. Also, if so, can non-IRA money also be invested if one is retired?

From Randy

The academic literature on TIPS comes strongly down on the side of them dominating the fixed income portion of your portfolio. And I believe that investment decisions should be made based on the academic literature, not people’s opinions that are not backed up by the “science” of investing. My book The Only Guide to a Winning Bond Strategy You’ll Ever Need has a section on TIPS that I believe you will find helpful. But here is a short summary.

1. TIPS are superior risk tools to nominal bonds because they basically eliminate the risk of inflation. The longer the maturity of nominal return bonds the greater the inflation risk. Inflation risk is particularly important to retirees who no longer can count on wage increases to stay ahead of inflation. By the way, TIPS also are a good hedge against deflation as well.
2. TIPS are superior to nominal bonds as diversifiers of equity risks. While nominal bonds have low correlation to equity risks (though the longer the maturity the higher the correlation), TIPS are one of just two asset classes that have negative correlation to stocks (the other being commodities). Negative correlation means that when one asset class has above average returns, the other tends to produce below average returns, and vice versa.
3. Probably the best way for an individual to access the asset class is Vanguard’s TIPS fund. However, you can save even the fund’s relatively low operating expense ratio by purchasing TIPS directly from the government at the regular auctions.

Generally, TIPS should be held in tax advantaged accounts because they are tax inefficient investments. So unless you are in the lowest tax brackets I would only hold them there and then use municipal bonds for any taxable dollars. However, if you are in the lowest tax bracket then the Vanguard fund would still be a good choice.

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His Books

• The Only Guide to a Winning Investment Strategy You’ll Ever Need
• What Wall Street Doesn’t Want You to Know
• Rational Investing in Irrational Times
• The Successful Investor Today
• The Only Guide to a Winning Bond Strategy You’ll Ever Need
• Wise Investing Made Simple
• The Only Guide to Alternative Investments You’ll Ever Need

Disclaimer

• Mr. Swedroe’s opinions and comments expressed are his own, and may not accurately reflect those of the firm, nor Moolanomy and its owner.
• Not all questions will be answered
• By submitting a question, you grant us the right to publish your question.
• The answer is given based on the information provided in your question. Please seek professional assistance for more personalized advice.

If you are interested in having your question answered by Larry, please send me an email via the contact page.

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