Risk analysis of my Mutual Fund Investments (Beta Coefficient)

Introduction

I recently wrote about my plan to prepare for the next recession which, in my opinion, is due soon. While thinking about that, a question that came to my mind was: how will my mutual fund portfolio deal with the upcoming recession? To answer that, I wanted to do a risk analysis of the mutual funds that I am using to generate Passive Income Streams. I wrote about my implementation of passive income streams here.

The mutual funds and/or cash driving my passive income streams are listed below for reference. Before I do a risk analysis of my portfolio, we need to understand some terminologies. Lets dive into that next.

Investment Vehicles (Last Updated on 10/18/2014)
Risk Bucket Name Investment Vehicle 1 Investment Vehicle 2
Risk 1 (Cash in banks) Smarty Pig (online) Credit Union (brick & mortar)
Risk 2 (Bonds) VCAIX (ca munis) N/A
Risk 3 (Balanced Funds) VTMFX (has natl munis) N/A
Risk 4 (Dividend Investing) VDIGX (div growth) VHDYX (high curr div)
Risk 5 (Capital Growth) VTCLX (large+mid cap) VTMSX (small cap)
Risk 5 (International Funds) VTMGX (large blend) N/A

 

Risk of a mutual fund

When we talk about the risk analysis of a mutual fund OR the volatility of a mutual fund, we often compare it to the market as a whole. For example, if the market goes through a volatile phase, will the mutual fund also be volatile OR will it be stable OR will it reach inversely to the market?

Consider one example. In a recession OR a down market, most people will conserve money and not buy new cars. Most people will repair their current cars and postpone purchase of a new car to when the market is up.

  • If you own stocks of companies that manufacture new cars, when the market goes down, such stocks will also go down.
    • Greater risk in a down market, but greater reward in an up market
  • If you own stocks of companies that manufacture automotive replacement parts, then when the market goes down, replacement parts companies make money and hence such stocks will go up.
    • Greater risk in an up market, but greater reward in a down market.
  • If you own stocks of companies that provide water supply to people, such stocks remain calm when the market goes up or down.
    • Low risk, Low reward.

A metric used by many investors to compare a mutual fund/stock/portfolio to the entire market is called the Beta Coefficient.

Beta Coefficient

If you had asked me last year, I would have said that “beta coefficient” looks like a very geeky mathematical name i.e. something I had ignored often as too complicated. It is complicated math but I have found a nice and easy way to understand it. Lets define it my way.

Beta Coefficient of a mutual fund/stock/portfolio is a measure of the risk that shows up when the mutual fund/stock/portfolio is exposed to different types of market conditions like an up market, down market, recession, etc. 

Some common values of Beta Coefficient will help make it clearer:

  • A beta of less than 1 means that the mutual fund/stock/portfolio will be less volatile than the market.
    • The water company example above
  • A beta of greater than 1 indicates that the price of the mutual fund/stock/portfolio will be more volatile than the market.
    • If a stock’s beta is 1.5, it’s theoretically 50% more volatile than the market.
    • For example, the new car company stocks.
  • A negative beta indicates a counter-cyclical sector that moves inversely with the broader market.
    • The replacement auto parts company example.

My portfolio’s Beta Coefficient

I gave the search “VCADX beta coefficient” on google and google finance displays the beta coefficient for VCADX so easily that I repeated the same procedure for the remaining mutual funds in my portfolio and here are two tables.

Table 1: Income Portfolio

  • Mutual funds that primarily generate dividends, capital appreciation is secondary
  • 64% of my passive income streams portfolio is in this category
Beta Coefficient of my Income portfolio (updated 03/31/2015)
Investment Vehicle 1 year Beta 3 year Beta 5 year Beta 10 year Beta
VCADX (CA Munis) 0.93 0.93 0.96 0.93
VTMFX (Balanced fund) 0.69 0.73 0.72 0.76
VDIGX (Dividend Growth) 0.87 0.90 0.81 0.80
VHDYX (Current Dividend) 0.93 0.92 0.84 n/a
Average 0.86 0.87 0.83 0.83

 

Table 2: Capital Appreciation Portfolio

  • Mutual funds that primarily invest for capital appreciation, any dividends are secondary.
  • 36% of my passive income streams portfolio is in this category
Beta Coefficient of my Capital Appreciation portfolio (updated 03/31/2015)
Investment Vehicle 1 year Beta 3 year Beta 5 year Beta 10 year Beta
VTCLX (Capital Appreciation) 1.04 1.02 1.04 1.03
VTMSX (Small Cap) 1.32 1.13 1.19 1.18
VTMGX (International) 0.99 1.03 1.02 0.97
Average 1.12 1.06 1.08 1.06

Conclusion

Consider the Average beta values for both the income and cap appreciation portfolios:

  • Income portfolio
    • Average beta is less than 1 => my Income portfolio will be less volatile than the market.
  • Capital Appreciation portfolio
    • Average beta is greater than 1 => my Capital appreciation portfolio will be more volatile than the market.

Based on the above numbers, I can conclude that when the next recession comes, my Income Portfolio should continue to generate approximately the same amount of income (give or take a few percent) because it is less volatile OR less risky that the overall market.

Appendix

Financial Independence Progress Report for Mar 2015

03/29/2015
Emergency Fund ($72K) 100.0% 100.0%
College Fund (80K) 33.20% 33.15%
Passive Income Streams ($4000 pm) $41.48 pm (03/2014)% $125.42 pm (03/2015)
Retirement Fund ($900K) 56.35% 56.55%
Roof for our Family($1 mil) 00.00%
Medical Fund 00.00%
Life Insurance Done (term life insurance payments initiated)

Main Takeaways

  1. Stock funds, in general, have not done well. 529 funds went down and Retirement fund barely moved.
  2. Passive income for March 2015 increased in comparison to Mar 2014. The main reason is an extra infusion of capital last year. But, I will take the money…however it comes.

DIGIT savings….Month 1 update

I started using DIGIT, a new way of squeezing out some extra cash from my bank account, exactly a month ago. I wrote about it here. My goal was to squeeze some leftover money after accounting for all the budgeted categories (expenses, savings and investment goals). Every time the savings account accumulates to a couple hundred bucks, my plan was to withdraw it and apply towards my Financial Independence goals.

That said, how is DIGIT doing? Very well 🙂

As of today, DIGIT has squirreled away $106 from my bank account. It started slower than I originally anticipated, but it seems to be learning fast and squeezing more money out of my account. This is good in two ways for me:

  • This is $106 I did know I could live without and
  • This is $106 that I would have spent on something less important than my financial independence goals.

So, go DIGIT! By next DIGIT update, I will talk about how I used this money towards my financial independence goals.

 

PS: If you want to sign up and try it out, go directly to Digit’s website here at https://digit.co/

If you do sign up at all, please do share your experiences, positive OR negative, via comments on this page. I would love to hear from you on how this works out.

Link to Yahoo Article: http://finance.yahoo.com/news/29-old-invented-painless-way-170000170.html

How to prepare for the next recession?

For the past few months, I am seeing some excesses in the market that has brought back memories of past boom+bust cycles. For example,

  • A 2bed/2bath condo sold for a neat $1mil,
  • A 3bed/2bath townhome list for $850K and sell for $1.2mil…I am not joking about this 😐
  • I saw many people jumping in to buy $70K cars
  • I saw people bid more than $100K over the list price to buy a very old home
  • ……

The above observations remind me of previous boom cycles and I felt that it was time to revisit lessons learnt from past boom+bust cycles. Hence this post. Hope it is useful for you. If you have lessons of your own to share, please do so…it would be much appreciated.

Boom+Bust cycles

I have faced two official recessions OR you can say a few bubble-pops in the last two decades of my life.

  • Economy was doing well..here comes the dot-com bubble pop in 2001
    • This was officially a recession
  • Economy was doing well..here comes the market tank due to the Iraq war
    • This was officially not a recession, but job losses were the same…..
  • Economy was doing well..here comes the real estate bubble pop in 2008
    • This was officially a recession

Before each recession, there is a period of bubble formation OR economic prosperity….pick your poison 🙂 One could go back in US economic history and one would find the same repeated pattern of BOOM and BUST cycles.

  • 2004 to 2007: Boom time; Bubble pop in 2008-2010
  • 1994 to 2000: Boom time; Bubble pop in 2001-2003
  • 1983 to 1991: Boom time; Bubble pop in 1992-1994
  • ……..

The current Boom cycle has been on from 2010 onwards…I.e. we are more than due for a Bust real soon…..can we benefit from this knowledge? If you are interested in how I plan to benefit, please read on.

What did I see or not see during these cycles?

  • For the 2001 bubble pop, I had no idea this was coming…I was a finance newbie and really did not even know what 401K meant. But, I did see a lot of job losses around me, close friends getting hurt bad and I myself barely scraping through..more luck than anything else….it was a very stressful time.
  • For the 2008 bubble pop, I could see it coming and did take some decisions like moving to a more stable job, creating an emergency fund, etc. But, I did not predict the severity of the recession….again, it was a lot of job losses around me and it was again a very stressful time. I was fighting so hard to retain my job and stay afloat that benefiting from it did not come to my mind.

But, since I was no longer a financial newbie, I was fortunate to be around people who, on hindsight, proved to be financial geniuses. I was not smart enough to financially benefit form the lessons at that time, but I plan to do so in the next recession. Here are some examples of a common patterns I saw during the boom+bust cycles.

  • A person I know dumped $150K into the stock market, in the worst of the 2008 bust cycle and by 2014, he had more than doubled…infact almost tripled his investment. At that time, I thought he had nerves of steel to do that but on hindsight, he was just making use of the recession. He has now officially retired and working part time just for the social connections.
  • A person I know, a financial newbie, bought a home in 2008, under pressure from family since a baby was on the way. She really hated the idea of buying and came up with all financial reasons not to…but, a relative who happened to be a real estate agent convinced her otherwise and  even dropped the commissions for the purchase. Her house is now $500K past the purchase price and she stopped working to spend time with the baby. She now looks like a financial genius and the relative loses no chance to rub it in.
  • A couple of people I know bought houses at the peak of the boom cycle in 2000, 2004 and 2007. They went through a lot of suffering with undervalued houses…especially with the threat of job losses hanging over their head. It took many many years to break even and some have not yet done it still.
  • Job loss means loss of two important things as well: Health insurance and Life insurance.
    • COBRA insurance premiums for a family of 4 can cost as much as $1900 per month
    • No job => no life insurance => no protection for family

What did I learn from these cycles?

The lessons I learnt can be broadly classified into the following points:

  • When you see excesses in the market, then it is a forewarning of an upcoming recession.
  • If your only source of income is shaky, then it is hard to take risks and benefit from the recession/bust cycle.
  • Big items (houses and cars) should always be purchased in a recession or bust period. A mistake make in either of the two can take years and years to recover from…especially the house.
  • Make yourself very valuable to your company….but at the same time, be prepared to interview for a job at any time

My plan for the next recession

An often heard sating is: Attack is the best form of defense. For the next recession, I plan to attack it with a goal to benefit from the recession, rather than take it lying down. Based on the lessons learnt from past recession cycles (previous section), here is the action plan I have implemented since April of last year.

  • Lesson: When you see excesses in the market, then it is a forewarning of an upcoming recession.
    • Action plan:
      • Watch for excesses in the market
    • Results:
      • I am already seeing the excesses in the housing market and luxury items.
      • Now, I am sure we are entering the first stage of a bust cycle.
  • Lesson: If your only source of income is shaky, then it is hard to benefit from the recession/bust cycle.
    • Action plan:
      • Create an emergency fund.
      • Develop passive income streams and take out the reliance on income from work
      • Remove reliance on life insurance from the place I work.
    • Results:
      • Starting last year, I have designed and implemented a Passive Income Plan
        • On average, it will pay me roughly $500 per month.
        • Of course, this is not enough to replace my income. But, it does take care of food expenses for the family.
      • I have a 12 month Emergency Fund to take care of any temporary loss of income
        • When the income source is shaky, it is hard to take a risk like buying a house.
        • But, if you can survive for a year without a source of income, the confidence to take a risk is very high.
        • Hence the one year emergency fund.
      • I bought Life Insurance coverage to protect my family.
        • Until last year, my life insurance was provided through my work.
        • But now, life insurance is independent of my work…so, even in a loss of income scenario, my family is protected.
  • Lesson: Big items (houses and cars) should always be purchased in a recession or bust period.
    • Action Plan:
      • Have patience to wait for the next recession to buy
      • Create a good down payment fund that is big enough to reduce the monthly payments
      • Learn how to evaluate a house
    • Results
      • The highest amount of pressure to buy a new car, a new house, etc comes from peer pressure. I can take it, but my family has a hard time dealing with it. I have managed to convince them to stick with my plan until now…they have sacrificed a lot over the last couple of years. Now, I have to deliver on the house at least in the next recession.
      • I have reduced my investments a bit to start accumulating $300 more per month into my home down payment fund. When the recession strikes, I will be ready with my home down payment.
      • I am learning how to evaluate a house for purchase by doing the following:
        • Watch home inspection videos on you tube
        • Watch how pricing is done by reading articles on the net and videos as well.
        • Watch how to not get fooled by real estate agents.
          • A staged house sends warning bells ringing in my ears now….
          • For example, I found a common trick of using undersized furniture (bed, chairs, etc) to make the room look bigger.
          • Damn…these real estate agents are good huh 🙂
  • Lesson: Make yourself very valuable to your company….but at the same time, be prepared to interview for a job at any time
    • Action Plan
      • Be rated near the top 20% in your company
      • Constant Preparation to make yourself ready to take a job interview on any day.
    • Results:
      • I have been working very hard to produce more things at work…but it has been slow digging. Likewise for my interview preparation.
      • But, now that I have plans in execution for all the other lessons, I will concentrate on this action plan for the rest of this year.

If you have read this far, then you really are a patient soul. Hope this info was useful in some way. Any tips you can share, please do leave a note in the comments section.

Adversity: Forge a Meaning, Build an Identity.

All of us face adversity many times in our lives. Some adversity we are forced to go through, some adversity we try to avoid using many many ingenious ways. But, we all surely face adversity. Is there any benefit from adversity? Is it useful at all? I have often read that adversity will forge your character. During my own times of adversity, believe me I have had a few tough ones and will have some for the rest of my life, I do not think about character building….but I have always asked one question: what is the meaning of life? Is this adversity supposed to help me find meaning in some way?

Towards that end, I recently came across a wonderful talk on TED…a website with some wonderful talks by an amazing set of people.  This talk is from a person named Andrew Solomon, whom I had not heard about before this talk. The talk was titled “How the worst moments in our lives make us who we are“. The main thesis in the talk was to use Adversity to Forge a Meaning and hence Build an Identity. The examples given in that talk explains the thesis so beautifully that I felt it would benefit others as well. It is amazing how some people can frame the problem and the solutions so beautifully that it is beneficial to lots of others who do not have that gift. The talk is about 21 mts and worth every minute of it.

Hope it benefits all who watch it.

DIGIT savings update….

I wrote about DIGIT, a new way of squeezing out some extra cash a couple of weeks ago, here. After money flies away from bank account for all the budgeted categories (expenses, savings and investment goals),  there is still some dollars left over. This left over money varies every month…sometimes it is $50, sometimes it is $100. Instead of leaving it in there and spending for something else…believe me, the force is strong enough…I wanted DIGIT to squirrel away the left over dollars to a savings account. There is no interest paid for the money in DIGIT accounts (as of now), but that is okay for me. I do not plan on leaving the money there for a long time. Every time the savings account accumulates to a couple hundred bucks, I plan to withdraw it and invest it towards my Financial Independence goals.

That said, how is DIGIT doing? As of today, DIGIT has squirreled away $14.95 from my bank account. It is a bit slower than I originally anticipated, but it is learning my spending habits and hopefully, it will speed up the money savings. This is $14.95 I would have spent on something less important than my financial independence goals. So, go financial independence and go DIGIT.

 

PS: If you want to sign up and try it out, go directly to Digit’s website here at https://digit.co/

If you do sign up at all, please do share your experiences, positive OR negative, via comments on this page. I would love to hear from you on how this works out.

Link to Yahoo Article: http://finance.yahoo.com/news/29-old-invented-painless-way-170000170.html

Financial Independence Progress Report for Jan 2015

Starting this year (2015), I have changed the tracking method for Passive Income to real dollars per month in passive income rather than percentage values. I.e. I am taking the cumulative passive income received this year and dividing them by 12 months. I removed the percentage tracking because percentage increases may make me feel good, but it is real dollar amount increases that shows reality. Amount per month looks puny at the beginning of the year…but lets keep it real hey 🙂

01/31/2015
Emergency Fund ($72K) 100.0% 100.0%
College Fund (80K) 31.04% 31.46%
Passive Income Streams (target=$4000 pm) $30.36 pm (01/2014)% $46.41 pm (01/2015)
Retirement Fund ($900K) 53.91% 53.34% (lost a step)
Roof for our Family($1 mil) 00.00%
Medical Fund 00.00%
Life Insurance Done (term life insurance payments initiated)