Ask The Expert with Larry Swedroe, May 2008 Issue

This is the 6th 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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Question from Randy, Credit Withdrawal

At this time municipal bond fund yields are relatively good…is there a risk in losing capital by investing in a tax exempt mutual fund portfolio which includes: tax exempt short, intermediate, long, limited and high yield funds? If so, please explain why. Thank you.

Randy, the answer is unless you own one month Treasury bills (considered the benchmark riskless instrument against which risk premiums are determined), there is always risk. And even with them, while there is no price risk, no liquidity risk, and no credit risk (at least for Americans), there is still some inflation risk.

Most people don’t know this but for the period 1933-1999 they provided a slightly negative real return, and that was before taxes. And in more recent times, from 1973-82 they provided a negative real return of -0.2. The only truly riskless instrument, not considering taxes, is TIPS, if you buy them with a maturity to match the holding period and hold to maturity.

With municipals there is certainly credit risk. Some munis have historically performed quite well in terms of credit risk. Triple A rated munis have had virtually no defaults. And even single A munis are 90 percent less likely to default than single A corporates. So they are relatively safe. But that doesn’t mean there is no risk. For example, we now have very difficult times for many municipalities and some are in serious trouble (i.e., Vallejo, California nearly defaulted this year). The reasons are bad fiscal management (excessive pension obligations to municipal employees that have gone underfunded) and the weak economy that is causing revenues to fall, sharply in some cases. Real estate taxes falling as home prices fall, sales taxes falling as consumer spending weakens, and capital gains taxes paid will be way off as the stock market has performed poorly.

So credit risks are rising. That is one reason why yields look “attractive.” The high yields are not a free lunch. (There are other more complex reasons related to the credit/liquidity crisis.) There are also some sectors of the muni market that have historically performed poorly, including health care related bonds, industrial development related bonds and housing related bonds. The problem with mutual funds is you cannot control what they buy.

In addition to aforementioned risks you also have term risk, if the maturity of the bond doesn’t match your maturity. If the maturity is shorter than your spending need, you have reinvestment risk. If it is longer, then you have price and inflation risk.

And finally you have to differentiate between the underlying credit risk of the issuer and the credit risk of any credit enhancer (e.g., AMBAC, FGIC). Investors are finally waking up to that risk.

My book, The Only Guide to a Winning Bond Strategy You’ll Ever Need, goes into more detail on all of these risks. And it will help you not only with munis, but with the full spectrum of bonds.

A few important points to consider. With Treasuries you don’t have credit risk so no need to diversify and thus no need to pay a fund manager (other than convenience) since you can buy direct. But with munis, you do have credit risk and thus need to diversify. For most individuals the best way to do that will be with a fund. But that creates all sorts of problems like maturity risks, there may not be a state specific fund for your state, and there is opaqueness as to the underlying credit ratings (you will never know what the fund really holds, only the overall rating which will be based on the credit insurer, not the underlying rating). Morningstar shows the credit ratings of the fund so you can track that.

An alternative is to buy individual bonds at the auctions (so you don’t get hosed by a broker adding big spreads) and then hold to maturity. But I would only do that if you have a large portfolio so you can diversify the risks, owning say 10 or more bonds. I would also recommend never buying anything but AAA or AA bonds and if it is an insured bond I would only buy it if the underlying rating is no more than one notch below the insured rating. And I would also limit any credit risks (below AA underlying) to the very short term and no more than small percent of the portfolio (say 10%).

Bottom line is this, if you buy a well run fund (meaning low costs and stays with very high credit rating) and you stick with short to intermediate term, you will be investing in a very low risk (but not no risk) investment. Be very careful of funds with high yields. They are getting those yields by buying risky investments. Typically you will see that with higher expense funds (as they try to offset their higher expenses).

One final note — I would avoid high yield funds of all kinds. And that is not just for municipals. Junk bonds are just that, junk. I cannot see any role for them in a portfolio. What investors fail to understand is that with junk corporate bonds you really are buying a hybrid instrument (see my Bond Book for more details).

Question from Dan via Cash Money Life

Standard retirement investing typically includes a large percentage of your portfolio going towards stock mutual funds, often index funds. Investing in these funds is an assumption that over the long-run, the stock market will go up, and thus your account value. Over the entire history of the stock market, the market overall has had an annual return of over 10%, amidst short-term peaks and valleys. Can we still make this return assumption in today’s world?

Looking at the current state of the world, specifically the U.S., we have international out-sourcing of jobs, technology, and knowledge; an ever-expanding bureaucratic federal government; the rise of China as an economic superpower and the potential rise of India; a huge national debt alongside a dollar with decreasing value; and a volatile terrorism situation based on an ideology that sees the destruction of this nation as its duty. Can we be certain that the stock funds we buy today will increase in value over the next 30 years? Should we invest in international funds?

First, stocks are risky, no matter the horizon. If you doubt that, just ask a Japanese investor. In 1990 the Nikkei was trading at around 40,000. Today, almost 20 years later, it is around 13,000. The reason stocks have provided high returns is because they are risky. The high EXPECTED returns are compensation for taking that risk. There is no guarantee about those returns going forward, or there would be no risk.

Second, one of the most important lessons about investing that I try to educate people about is that they should not make the mistake of confusing information (e.g., facts, data, opinions) with wisdom or knowledge you can use to generate excess profits. All the issues you state are well known by investors and thus already built into prices.

The only information you can benefit from is information no one else knows. And if you know it (or read it in Money or heard it on CNBC) then you can be sure it is not a secret, and thus you should ignore it. As difficult a concept as that is for most people, it is the most important thing you can learn about investing. I suggest you read my new book, Wise Investing Made Simple. It contains several stories that explain this concept in detail. But bottom line is this, ignore all such pontifications as they are just noise. The market knows it and in its collective wisdom has already built it into prices.

Third, the way most financial economists forecast future returns is to use what is known as the Gordon Constant Growth Dividend Discount Model. It based on the simple mathematical fact that the return of the market comes from these sources:

• dividends,
• growth of dividends (or earnings, they are same in the long term),
• inflation, and
• the change in valuations or P/E (what you might call the speculative return)

Roughly the historical return you cite of 10% has come from about 4.5% in dividends, about 2.5% in growth, about 3% from inflation. So we can observe the current dividend yield of 2%. A reasonable assumption is that growth will be the same going forward on average as it has been for 100 years. So add 2.5% to that and that gets you the expected REAL return.

And the inflation forecast we can roughly estimate by taking the 10 year Treasury yield (about 3.9%) and subtracting from it the ten year TIPS yield (1.5%) and you get 2.4%. That leaves you with a forecast of about 7%, not the historical rate of 10%. That assumes that P/E ratios stay the same. If they expand the return would be higher and vice versa. Unfortunately, many people will be disappointed by this and find themselves without sufficient retirement funds if they don’t plan properly.

Finally, as to your question on international funds, I recommend that investors have an international allocation of at least 30% of their equities, and preferably 50%. They are excellent diversifiers of U.S. economic and political risks and also your labor capital, assuming you are employed. All of my books on equity investing go into detail as to why you should diversify globally. And my new book on Alternative Investments (Bloomberg publishing in October) will have a chapter on them and how to invest in them.

Question from Mark

Hello Larry. I own a house with my sister and am being bought out. I will be getting about $115,000 dollars that I would like to invest, with minimal risk. I have done a lot of research and most definitely want to diversify this investment. What do you think about EQUITY INDEXED ANNUITY QUOTES? What other suggestions can you provide? I am 36 years old and most definitely want to grow this amount. Thanks in advance.

Soon as you hear the words equity indexed annuity run as fast as you can. They are all products designed to be sold and not bought. My next book, The Only Guide to Alternative Investments You’ll Ever Need: The Way Smart Money Diversifies Risk, The Good, The Flawed, the Bad and the Ugly, covers 20 alternatives. EIAs are in the UGLY category and that is being generous. I would suggest you get the book when it comes out in October. (Can pre-order now on Amazon).

But bottom line is this, they are high expense complex products with the complexity designed in the favor of the issuer. They are also highly tax inefficient, converting long term capital gains into ordinary income and losing the benefit of being able to harvest losses. And for any foreign investments you lose the foreign tax credit. Unfortunately tens of billions of this garbage is sold every year to investors who simply don’t have the knowledge to make the right decision. They are exploited by the sales forces of the marketing machines of insurance companies.

As to the alternatives, I could write a book on that. In fact, I have written seven now. I would urge you to read The Only Guide to a Winning Investment Strategy You’ll Ever Need. It will explain MPT and the EMH and how individual investors can put the knowledge about how markets work to work for them.

But here is the short version, you need to first write an investment policy statement that lays out your goals and then ends with an asset allocation plan (the book shows you how to do all this). The plan should identify your specific ability, willingness and need to take risk (there are tables to help you do this). Then you should implement the plan by building a globally diversified portfolio of index or other passively managed funds that are low cost and tax efficient. And make sure that you have your asset location right (to the extent possible put your bonds in tax advantaged accounts and equities in taxable as a preference). Then make sure you rebalance regularly and also tax manage the portfolio.

And if you cannot do this for yourself (and the hardest part is staying the course, ignoring the noise of the market and the emotions they cause), then hire a Registered Investment Advisor that is fee-only to help you develop the plan and then stick with it. The book also provides a guide to finding a good advisor.

Question from Pinyo

Over the past few years, I have diligently contributed to my retirement plans consisting of 401k and Roth IRAs. Currently, my retirement asset is about 90% of my assets (excluding our primary residence). Is there such a thing as saving too much for retirement? Is there some sort of guideline to help me balance between retirement savings and “living” that you can suggest? Thank you.

Pinyo, the only purpose of investing is ultimately consumption (of some kind). By investing (instead of consuming today) you are transferring consumption from the present into the future. The only reasons to do that are that you expect (not guaranteed) to earn a sufficiently high rate of return to compensate you for delaying the gratification of spending today and also you want to have a certain amount to spend in the future.

The answer to your particular question depends on your own situation. If you have already built a
sufficiently large portfolio to meet your future spending needs, adding more to that fund might be too “costly.” The cost is the lost value of the gratification you get from the spending today.

A good rule of thumb is that you should have a portfolio that is about 30x what your spending needs will be (in today’s dollars). So once you reach that goal your choices being greater. You can spend more today (and enjoy your spending) and still be relatively secure in your retirement, or you can continue to save more and get even more secure (and sleep well) and also know that it is likely that you will be able to spend even more in retirement. No right answer. It is clearly an individual decision.

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Past Issues of Ask The Expert

• 04/2008 - Ask The Expert with Larry Swedroe, April 2008 Issue
• 03/2008 - Ask The Expert with Larry Swedroe, March 2008 Issue
• 02/2008 - Ask The Expert with Larry Swedroe, February 2008 Issue
• 01/2008 - Ask The Expert with Larry Swedroe, January 2008 Issue
• 12/2007 - Ask The Expert with Larry Swedroe, December 2007 Issue

About Larry Swedroe

Larry Swedroe is a principal and director of research at Buckingham Asset Management, LLC, an SEC Registered Investment Advisor firm in St. Louis, Missouri (www.bamservices.com). He is also principal of BAM Advisor Services, LLC, a service provider to investment advisors across the country, most of whom are affiliated with CPA firms. However, his opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management or BAM Advisor Services.

Before joining Buckingham in 1996, Larry served as senior vice president and regional treasurer at Citicorp and vice chairman of Prudential Home Mortgage. Larry is author of The Only Guide to a Winning Investment Strategy You’ll Ever Need (updated and re-released in 2005), as well as five other books. Most recently, he authored Wise Investing Made Simple (2007).

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.