Finding portfolio gaps for a balanced portfolio

Since the end of 2016 is almost here, I wanted to see if there are any gaps in my investment portfolio used to produce passive income. If I did find some gaps, then I want to close them out to have a better balanced portfolio. I did some research and found that there are a few ways to find gaps in your portfolio.

Vanguard Portfolio Watch

If you have a Vanguard account and have all your investments in Vanguard, then Vanguard provides a tool called Vanguard Portfolio Watch. This tool will give you recommendations like the following:

  • OK: Your investments in foreign stocks add diversification to your portfolio.
  • CAUTION: The proportions of large-, mid-, and small-capitalization stocks in your portfolio differ from those of the market.OK: Your portfolio is tax-efficient.
  • CAUTION: Your portfolio emphasizes value stocks which puts you at risk of under-performing the market when growth stocks perform well.
  • CONSIDER: Holding more foreign bonds can potentially increase the level of diversification in your portfolio. Allocating up to 20% to 50% of your bond portfolio to foreign bonds is a reasonable amount to capture the diversification benefits.
  • CAUTION: Sectors indicated with a red arrow vary substantially from the benchmark weightings.

You can use the above analysis results to identify gaps in your portfolio and then invest accordingly. If you want to just see the effect of adding a new investment to your portfolio, you can use a tool called Portfolio Tester….also provided free by Vanguard.

Personal Capital Investment Watch

Personal Capital is a wonderful free tool that anybody can use for tracking their investments, spending and a whole bunch more.

  • The one feature I really like is that it breaks down all the funds in your portfolio into the following categories, JUST by taking the names of the different funds like VDIGX, VTCLX, etc. For example,
    • Large cap, mid cap, small cap split
    • Cash and bonds split
    • Alternatives (real estate, etc)
    • US and International split
  • Personal capital pointed out a weakness in my portfolio diversification w.r.t. lack of investment in Alternative Investments like Real estate, hedge funds, commodities, etc. Hence I started looking at how to add a real estate dimension to my portfolio.
  • I wrote about how I found this portfolio gap here.

This tool has something called Investment watch and that is what I use often to see the composition of my portfolio. Take a peek at it and see if it is useful.

Correlation Analysis

Whether you have none of the previous two ways OR you have it and still want to still find portfolio gaps, Correlation Analysis is a super-wonderful way to do it.

  • Two mutual funds (or stocks or any of the asset classes) are correlated means that the investments behave similar to each other i.e. they both reach the same way in the same market cycles…both go up OR both go down. Lets use the following tool to find correlation co-efficient (Asset Correlation Tool)
    • Example 1:
      • Correlation coefficient of VDIGX and VDAIX is 0.98 (98%)
      • This means that VDIGX and VDAIX behave 98% similarly
    • Example 2:
      • Correlation coefficient of VDIGX and VTMGX (International) is 0.77 (77%)
      • This means that VDIGX and VTMGX behave 77% similarly
  • Two mutual funds are not-correlated means that the investments behave differently in diff ways i.e. both react differently in the same market cycle….if one fund goes up, then one goes down. Lets use the following tool to find correlation co-efficient (Asset Correlation Tool)
    • Example 1:
      • Correlation coefficient of VDIGX and VCADX (CA MUNIs) is -0.13
      • This means that VDIGX and VCADX behave totally opposite to each other i.e. they have negative correlation.

A portfolio is a balanced one if it has assets in it that are correlated in different ways i.e. all the assets should not behave the same way. If we are in a bull market, some assets should go up and some may go down….if we are in a bear market, the same should hold true. If you think this does not make sense, go watch this awesome video titled Asset Allocation: Building a Better Balanced Portfolio The video is a long one but worth the time…and quite entertaining too 🙂

Tool for Correlation Analysis

A wonderful and free tool (no login required) for Correlation Analysis of your portfolio is a tool called Correlation Tracker. I chose the option where I type in all my portfolio values and I get a recommendation of different SPDR funds/etfs that correlate positively (same behavior) and correlate negatively (different behavior).

  • I punched in all my mutual funds that generate passive income for me. They are: VCADX, VWIUX, VTMFX, VWELX, VDIGX, VDAIX, VHDYX and VTMFX.
  • Funds that correlate positively:
    • SPDR Select Sector Fund – Industrial                            XLI        Correlation = 0.882
    • SPDR Select Sector Fund – Consumer Discretionary XLY       Correlation = 0.874
    • SPDR Select Sector Fund – Technology                         XLK        Correlation = 0.805
  • Funds that correlate negatively:
    • SPDR Select Sector Fund – Utilities                                XLU        Correlation = 0.311

The last one (XLU) surprised me. The main reason I own so many different Vanguard funds is to diversify risk by acquiring different asset classes and within each asset class, have multiple managers competing for my money. But, a correlation coefficient of 0.311 for XLU indicates to me that my portfolio has a gap with utilities.

Verifying what the Correlation Tool said ….

To verify the gap of utilities in my portfolio, I tool 4 of the stock Vanguard funds I own (VDIGX, VDAIX, VHDYX, VWELX and VTMGX) and plugged them into Vanguard’s fund compare web page: Vanguard Fund Compare.

Fund          VDIGX     VDAIX      VHDYX      VWELX       VTMGX
Utilities     0.00%     2.81%        8.01%         4.23%         3.10%

The above is a clear clear vindication that the percentage of utility stocks in my passive income portfolio is low. The maximum is 8% but that fund does not have the most money. So, the correlation analysis tool correctly predicted a gap of investment dollars in Utilities in my portfolio.

Conclusion

Granted, utilities is not the most sexy of the stock picks, but it is a rock solid foundation on which passive income streams of many other people are built upon. And more importantly, it balances out my portfolio by adding an asset that correlates less with all my existing mutual funds.

I found one Vanguard utilities mutual fund (VUIAX) but minimum is $100K 🙂 No way that I have that kind of money. But there is a corresponding ETF called VPU. I just invested one share in this ETF….hopefully, I can save some more money and add a few more shares to my portfolio. I am happy to have added an asset that has only 30% correlation (0.311) with my existing funds. Wish me luck for some awesome passive income for years to come via this new asset vehicle called Vanguard Utilities ETF (VPU).

Dollar Cost Averaging…my way :-)

I was reviewing the performance of my portfolio for 2015 when I realized that I had used Dollar Cost Averaging (DCA) quite a bit this year. The markets have fluctuated wildly in the last few months and my anticipation is that it will be the same in 2016 as well. Dollar Cost Averaging (DCA) is what I used to smooth out the fluctuations in 2015. I have a couple different ways of implementing DCA…so, I thought it would be nice to write about it and see if my blog friends have any input.

DCA Type 1

My path to Financial Independence is to generate multiple passive income streams using a diversified set of mutual funds (link). For example, VCADX, VTMFX, VDIGX, VHDYX , VTMGX, VTCLX and VTMSX. Investments into the different funds are automated and are withdrawn on the first of every month. Regular investments, irrespective of the short term market fluctuations was my initial plan for DCA.

But, I realized that when the market went through downward dips, my DCA plan was found a bit lacking. For example, if the dips were spread across many days in the month, my DCA plan of investing at the beginning of every month would miss out on loading up quality investments at lower prices.

So, I spread my mutual investments into two pieces for each mutual fund, and spread across many non-overlapping days in the month. Since Vanguard does not charge me a fee to invest into mutual funds, I felt that this spread captured the market ups and downs better. For example

  • VCADX           9th and 28th
  • VTMFX           6th and 27th
  • etc

DCA Type 2

But, I saw one more pattern in the  market. Market dips in the downward directions were followed by upswings the next couple of days. For example, if DOW dropped 300 points on one day, it is rare to have a similar drop on the next day as well i.e. consecutive market dips were rare. On the days the DOW (or S&P) dipped badly, there were opportunities to invest in my chosen high quality mutual funds at a lower price.

Every month, there used to be some leftover money in the budget for unused items. For example, if we did not use the entertainment portion of the budget completely OR if my kids school was off leading to less frequent visits to the gas pump, etc. I decided to pool up the leftover money and keep the cash ready. When ever the DOW dropped, I pushed the money into one/many of my investments. Here is the algorithm I followed:

  • DOW drops 100                                   Invest $100
  • DOW drops 200                                   Invest $250
  • DOW drops 300                                   Invest $500
  • FTSE 100 drops 100                         Invest $200

Since I invest in mutual funds, the smart reader may ask how do I know what the NAV will be before the marker closes on that day? An ETF or a raw stock trade will guarantee as close to the instantaneous market price as possible…a mutual fund cannot. Here are some lessons I learnt assuming the Market closes at 100pm Pacific Standard Time

  • DOW dips 100 at 900 am, I invest $250 and DOW rises by 200 by 100 pm i.e. I invested $250 at a higher price than what my intention was.
  • DOW dips 300 at 1100 am, I invest $250 and DOW rises by 200 by 100pm i.e. DOW is still down -100 and my investment pays a lower price.

The reader might have guessed. My basic idea is that “higher the DOW dip, the earlier in the I can invest and still come out with a lower NAV price than the previous day”. I.e.

  • If DOW is only down 100 points, I buy late say around 1200 pm.
  • If DOW is down 300 points, I buy earlier say around 1100 am.
  • Any investment after 1230pm or so is moved to the next day.

This method of DCA has proven very beneficial to me to acquire quality assets at much lower prices…inspite of using mutual funds. Some people might say that I am using market timing and it is bad. But, since my investments are quality investments, chosen conservatively, I do not lose even if I paid a higher price because my purchase timing did not meet my expectations.

Conclusion

As per my 2015 Goals (link),  my Passive Income Streams goal for 2015 was $16000 with a stretch goal of $24000. Using a combination of DCA types 1 and 2, I have managed to exceed the stretch goal also with a total investment of $28,000 approximately. Believe it or not, I did not know that all the DCA Type 2 investments would add up to so much more money at the end of the year. This indirectly means that my budget is tuned for the worst case money consumption and some more fat can be extracted from it. But, hey, who is complaining  😉

VDIGX….an investment decision validated.

When I was travelling last couple weeks, I got time away from the day-to-day chores of family life. I kind of enjoyed this break….ssshhhh….don’t tell this to my wife 🙂 I used that time to read up on different articles related to my current investments. When the markets went down, I wanted to feel good about my investments!

One of my investments is in VDIGX (Vanguard Dividend Growth funds). I have talked about various dimensions of this fund in this blog.

  • My original rationale on picking this fund is documented here. Don Kilbride, the manager of VDIGX, is a recognized name in the industry and has done a wonderful job with VDIGX.
  • VTSMX is Vanguard Total Stock Market fund. I compared VDIGX vs VTSMX here. I wrote that both VDIGX and VTSMX have their rightful place in my portfolio.
  • I definitely see a recession coming and wrote about it here. As part of that, I did a Risk Analysis of all my investments here. VDIGX had the second lowest Beta Coefficient of all my investments….only VTMFX (a tax managed balanced fund) did better. A low beta coefficient means that my investments will be less volatile than the market i.e. income stability will be much better.

In addition to what I thought about, some other smart people have thoughts on VDIGX too. I read one such article from Morning Star while travelling and I really liked the content enough to post a link here.

This article argues that a fund may not provide the greatest current yield (usually, this implies less risk) but if the fund holds quality holdings, it will provide a more stable income stream and potentially lead to more capital growth in the longer term. Read more directly from Morning Star link above…it is worth it.

PS: There is good marks for VHDYX (Vanguard High Dividend Yield) also…this makes me more happy because I have invested in this also. Wish me luck for continued good success in picking good investments.

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

The Power of Investment Income

…through long term cap gains and dividends. If earning $73,800 per year (married filing jointly) or $36900 (filing single) and PAYING NO TAXES interests you, then please do read on for an interesting story. I will explain why lots of financial independence(FI) bloggers use investment income as a vehicle for their FI journey.

Many years ago, I remember Warren Buffett mentioning that he pays a lower tax rate that his secretary. I never really figured out what he meant until I started exploring financial independence myself and started investing in stocks myself. To understand his statement, one needs to understand some part of the income tax code….I know, not a popular topic, but knowing a little bit of the tax code can save you lots of money in taxes!! So, bear with me.

Types of Income

There are many types of income a person can earn. Some types are listed below:

  • From working for somebody
    • Salary
  • From owning stocks and bonds
    • Long and short term capital gains
    • Dividend Income
  • From owning real estate
    • Rental income
    • REIT funds income
  • From cash
    • Interest income from banks

Types of Income according to IRS

The tax man has a different notion of income. The tax man sets the amount of taxes based on the different notions of income. So, let us understand the types of income a tax man sees.

  • Ordinary Income
    • Salary
    • Short term capital gains (from selling stock owned less than a year)
    • REIT income
  • Ordinary Dividend Income
    • Owning non-qualified stocks that pay a dividend
  • Qualified Dividend Income
    • Owning qualified stocks that pay a dividend
  • Long term Capital Gains
    • from selling stock owned more than a year

The simple definition of Qualified dividends means income from corporations that meet a specific criterion like incorporated in the US or in a country that has a tax treaty with the US, stocks owned more than 60 days prior to the ex-dividend date, etc etc. There is a link at the bottom of this article for details. But, dividends from most US corporations are Qualified dividends.

Tax Filing Status

The tax man also specifies a filing status based on the different social definitions attached to a person.

  • Single
  • Head of Household
  • Married
    • filing jointly
    • filing separately
  • Qualifying Widow or Widower

IRS Tax Rates for the types of Income

Since the tax man sees income differently than you and me see it and different filing status, the tax rates are different for the different types of income. For 2014, let us consider the following table for two of the most common filing status types.

Tax Rates Single Married Filing Jointly / Qualifying Widow or Widower
Ordinary Income Long Term Capital Gains and Qualified Dividends Taxable Income over to Taxable Income over to
10% 0% $0 $9,075 $0 $18,150
15% 0% 9,075 36,900 18,150 73,800
25% 15% 36,900 89,350 73,800 148,850
28% 15% 89,350 186,350 148,850 226,850
33% 15% 186,350 405,100 226,850 405,100
35% 15% 405,100 406,750 405,100 457,600
39.6% 20% 406,750 457,600

The most important rows to consider are the rows in BLUE color. Two things stand out in the blue rows

  • 0% tax rate for
    • Long term capital gains
    • Qualified dividends
  • 0% tax rate until…
    • $73800 for married filing jointly
    • $36900 for single filers

What the above powerful statements tell us is that if *ALL* of your income comes from long term cap gains OR from qualified dividend, you will pay ZILCH to the tax man i.e. you get to keep what you earn!! How beautiful is that!

Back to Warren Buffet and his secretary…

You did not think I forgot about him did you 🙂 According to some news articles, Warren Buffet himself declares that he pays a 17.4 percent rate on taxable income. Note that he earns millions of dollars in income, but the first $73800 is tax free. His secretary apparently pays 8-9 points above him i.e. her average tax rate is atleast 25%. How is this possible? This is possible because of this:

  • Warren Buffett
    • most income is Investment income
    • Taxed at lower rates
    • First $73800 of investment income is tax free
  • His Secretary
    • most income is Salary income
    • Taxed at a much higher rate (from the table about, it is 25%)

Conclusion

Most financial independence bloggers, when they achieve financial independence and retire early, expect to get income from two sources

  • Stock investment
    • selling stocks and realizing long term capital gains
    • qualified dividend income
  • Rental income

If you are in the stocks category, like I am trying to be, aim for a good chunk of income from Investment income and get to keep all of the income until $73800 (married filing jointly) or $36900 (single filers).

It would be good to diversify the income streams and get some rental income as well. But, that is not my chosen path yet because of lack of hard $cash$.

Go Investment Income!!

Links

VDIGX vs VTSMX: Which is a better investment?

VTSMX is a total market fund. VDIGX is a Dividend Growth fund…primary a large blend (value+growth) fund. In a recent discussion that I participated on MMM foum, I did some analysis on where VDIGX is w.r.t. VTSMX and learnt some new things. Based on that, the answer is: it depends 🙂 Hey, don’t try to kill me for this…I will try and justify my answer!

Is VTSMX (total market index) better than VDIGX?

1.

Comparing VDIGX vs VTSMX in Morningstar over a 10 year period, here is what I get when I plot the growth chart: Link. According to this chart, I see two wins for VDIGX:

  • VDIGX seems to outperform VTSMX
  • VDIGX seems to have a smaller loss than VTSMX in the 2008 downturn.

2.
Comparing VDIGX vs VTSMX in Morningstar over a 5 year period, here is what I get when I plot the growth chart: Link. According to this chart, I see one win for VTSMX:

  • VTSMX seems to outperform VDIGX

Note that this is a total return comparison for a fixed amount…i.e. total return == dividends+capital gains.

3.

Just to cross verify this result, I went to Vanguard site itself and compared the two funds. The above conclusions seem to hold up. In the last 3-5 yr range, VTSMX is better; in the last 10 yr range, VDIGX is better.

4.

Past performance is not a predictor of future performance, but Wellington family (VDIGX manager Don Kilbride comes from here) has a good reputation. So, assuming there is some meaning in past performance, here is what I see:

  • In the Bull market of last 5 years, VTSMX has performed much better.
  • In the market dip of 2008, VDIGX seems much better
  • In the dip+bull market over the last 10 years, VDIGX seems to come out ahead.

Is VDIGX a better fund for a taxable account than VTSMX?

Lets me see what the answer is to the second question of VDGIX/VTSMX for a taxable account. Coming down to brute force numbers, here is the dividend distribution for the last year.

VTSMX
Distribution    Most Recent
Type            Distribution    Record Date    Reinvest Date    Payable Date    Reinvest Price    Distribution Yield    SEC Yield
Dividend       $0.25800    12/18/2014    12/19/2014    12/22/2014    $51.75    —    1.76%  B
Dividend       $0.21100    09/22/2014    09/23/2014    09/24/2014    $49.58    —    —
Dividend       $0.19000    06/20/2014    06/23/2014    06/24/2014    $49.49    —    —
Dividend       $0.19200    03/21/2014    03/24/2014    03/25/2014    $47.08    —    —
——–
$0.851
tax = $0.851 * 15% = $.12765

VDIGX
Distribution    Most Recent
Type                Distribution    Record Date    Reinvest Date    Payable Date    Reinvest Price    Distribution Yield    SEC Yield
Dividend            $0.21800    12/19/2014    12/22/2014    12/23/2014    $23.37    —    2.10%  B
ST Cap Gain    $0.07300    12/19/2014    12/22/2014    12/23/2014    $23.37    —    —
LT Cap Gain    $0.24700    12/19/2014    12/22/2014    12/23/2014    $23.37    —    —
Dividend            $0.19900    06/19/2014    06/20/2014    06/23/2014    $22.18    —    —
Dividend            $0.02300    03/20/2014    03/21/2014    03/24/2014    $21.40    —    —
ST Cap Gain    $0.01200    03/20/2014    03/21/2014    03/24/2014    $21.40    —    —
LT Cap Gain    $0.01600    03/20/2014    03/21/2014    03/24/2014    $21.40    —    —
——–
$0.788
tax = $.703*15% (div + long term cap gains portion) + .085*33% (short term cap gains)
= $.10545 + 0.02805
= $.1335

Here is my conclusion:

  • Just based off of the dividends and capital gains distribution over the last year, VDIGX pays a bit more tax, assuming short term cap gains max bracket of 33%.
  • Note that the .31% expense ratio also is a downer for VDIGX.

Based on the taxes paid over the last year, VTMSX wins this round.

I have VDIGX in my taxable account portfolio for the past year…it seems like I invested in a lossy investment, but understanding the context of my investment is probably important as well. Let me tackle that next.

Why do I invest in VDIGX and not VTSMX then?

I split my retirement into two kinds of retirement:

  • Early Retirement funded by Passive Income Streams from my taxable account
  • Real Retirement funded by my tax-advantaged accounts like 401K, IRA, etc.

Details on the funding design for my retirement are in this post.

In my tax advantaged accounts (401K and IRA), almost all the money is invested in Vanguard Target Retirement Funds. Each of the target retirement fund invests in VTSMX. So, I have enough money riding on a total stock market strategy.

For my taxable account, I invest in a different strategies, with two separate buckets/funds for each strategy…to spread the risk a bit more. The strategies I have invested in are:

  • MUNIs…VCAIX…federal+state tax free
  • Balanced fund….VTMFX…capital appreciation + national munis…federal tax free + some state tax free
  • Dividend Investing: current dividends (VHDYX) and Dividend growth (VDIGX)….100% qualified dividends (15% tax) + AMT free
  • Capital growth large and small cap (VTCLX, VTMSX)..does generate some capital gains
  • International (VTMGX)…does generate dividends…almost 100% qualified dividends (15% tax), gets some foreign tax deduction. And hopefully, some capital gains.

So, VDIGX takes the place of a dividend growth fund in my portfolio in my taxable account. The advantages that I considered before investing were:

  • 49 stocks appx…less diversification…but a longer term approach…almost a buy+hold strategy…i.e. limits short term capital gains
  • good fund family…Vanguard/Wellington
  • Considered a solid fund for a down market
  • Appx 10% is foreign market…so, some diversification across geographies (VTSMX has 0% foreign stocks)
  • A little better return than bonds, but a little less risk than capital appreciation/growth stocks.

So, would I change my VDIGX fund investment? Not now for two reasons:

  • It is a portfolio diversification for me in the dividend growth bracket…all companies in VDIGX are not in the index.e.x, 10% is foreign inv unlike VTSMX.
  • It is a less volatile fund…a good fund to keep during market dips…if you consider the last 5+ years of bull market, then a market dip is logical in the next year or two. Lets hope VDIGX earns its expense ratio 🙂

VDIGX vs VTSMX: Which is better?

VTSMX seems like a good fund to hold for its low expense ratio and the tax efficiency of an index fund. If you do not mind drops in value during a market dip and can hold it through the dip, pick VTSMX.

VDIGX is a more conservative fund, with better performance during a market downturn w.r.t. VTSMX and a comparably less performance in a bull market than VTSMX. If you want something better than a bond fund return with a little bit of additional risk, pick VDIGX.

Hope that shows that both VDIGX and VTSMX can be winners in the right circumstances.

Bonds and Interest Rates

There is a lot of stuff on the internet that deals with understanding bonds…many of them are either too technical OR too simple. How do I know this? I know because reading just one leads to a lot of unanswered questions and doubts. So, I decided to see if I can simplify them to a level where one can understand with just a single read. This level of over simplification will put me on top of the murder list for most financial experts, but please bear with me and let me know if I am egregiously wrong in any of the simplifications and I will correct them.

That said, it is time to learn some bond terminologies.

Bond Terminologies

Let us discuss a few of the terms you will find in almost all articles on bonds in the internet.

Types of bonds (lowest risk and hence lowest reward first)

  • Treasury bills or T-bills
  • Government bonds
  • Corporate bonds
  • High Yield bonds
  • Emerging market bonds

Bond Parameters

  • Purchase price
    • Price paid to buy the bond 🙂
  • Coupon or Interest
    • The periodic (yearly, half yearly, etc) interest payments paid to the bond holder
  • Yield
    • A fancy term used to describe the return provided by a fixed income investment like a bond
    • Yield = Coupon(Interest) / Purchase price of the bond
  • Maturity
    • After what time period will the bond principal be returned back to the investor (me).
    • When I buy a bond, I am loaning the bond purchase price amount to somebody (us govt, municipality, company)
    • For the duration of the maturity period (say 10 year bond), I get periodic coupon/interest payments.
    • At the maturity date, I get money I loaned out back.

Example:

  • Lets say that purchase price of bond X is $1000.
  • The  guaranteed Coupon or Interest is say $60 per year
  • The yield will then be $60/$1000 = 6%
  • Bond X has a yield of 6% earning $60 interest/coupon per year.

Bond Rating

We talked about Bond X in the previous example. We said that the guaranteed coupon/interest is $20 per year. The only exception to the guarantee is if the bond issuer defaults on the payment. For example, some bond issuers in Detroit have defaulted on the bond interest payments and declared bankruptcy. To gauge the credit worthiness of a bond, there are some rating agencies (big ones are Standard and Poor’s, Moody’s, Fitch ratings)  that classify different bonds into the following rating bands:

  • AAA: Prime
  • AA  : High Grade
  • A    : Upper medium Grade
  • BAA: Lower medium Grade
  • BA  : Non-investment grade speculative
  • B    : Highly speculative
  • CAA: Substantial risks/Extremely speculative
  • CA  : Default imminent with little prospect of recovery
  • C    : In Default
  • D    : In Default

Obviously, AAA is the best and D is the worst in the scale above.

Interest rates increases and effects on Bonds

Many many articles on the net talk about this statement “Interest rates and bond prices have an inverse relationship. When interest rates fall, bond prices usually rise and when interest rates rise, bond prices usually fall.”. What the hell does this mean? Let us take some examples and see what it means to a non-financial person.

Let us take the story of two bonds: Bond X and Bond Y.

Bond X

  • AAA rated, 6% yield, purchase price=$1000, 10 yr maturity
  • yield = coupon/purchase price => coupon/interest = yield * purchase price = 6% * 1000 => $60

Bond Y

  • AAA rated, 7% yield (interest rates increased by 1%), purchase price is still $1000, 10 yr maturity
  • coupon = 7% * 1000 => $70.

So, we have two bonds, with the same rating and purchase price, offering different yields. Bond Y will pay $70 dollars every year for 10 yrs but Bond X will pay $10 less for the same 10 years. So, why would anybody buy Bond X? This is the reason why Bond X’s value will fall when interest rates rise as there is a newer bond that offers more interest/coupon money for the same purchase price.

Let us take this one step further.

  • The total return for Bond Y is: 10 years * $70 per year => $700
  • The total return for Bond X is 10 years * $60 per year => $600
  • For Bond X to compete with Bond Y, Bond X should also somehow lead to an equal return for the purchaser i.e. the $100 difference has to be made up somehow.
  • But, the coupon/interest for Bond X is fixed at $60 per year…so, the only other way to make up the $100 difference is to reduce the purchase price from $1000 to $900.
  • So, Bond X is now sold like below:
    • AAA rated, purchase price=$900, 10 yr maturity
    • yield = coupon/purchase price = 60/900 = 6.66% yield (up from 6%)
  • A rising yield is hence bad news for any bond as it  usually means that the bond price has been lowered forcefully.
    • I.e. if I had bought Bond X for $1000 and I am forced to sell it for some reason when the interest rate has risen by 1%, I am going to lose $100 for each bond that I bought at $1000.

Interest rates decreases and effects on Bonds

The opposite  happens when interest rate decreases….the older bonds provide higher interest rates than the newer bonds and hence they become more valuable i.e. their yield increases.

Let us take this one step further.

  • The total return for Bond A (older) is: 10 years * $70 per year => $700
  • The total return for Bond B (newer, 1% lower interest rate now) is 10 years * $60 per year => $600
  • Bond A offers a better deal than Bond B by about $100. So, when all we can get today (with a 1% reduced interest rate) is Bond B, Bond A will command a premium i.e. the purchase price for Bond A becomes $1100 instead of $1000.
  • So, Bond A is now sold like below:
    • AAA rated, purchase price=$1100, 10 yr maturity
    • yield = coupon/purchase price = 70/1100 = 6.36% yield (down from 7%)
  • A falling yield is hence good news for any bond as it  usually means that the bond price has been increased by falling interest rates.
    • I.e. if I had bought Bond A for $1000 and I am forced to sell it for some reason when the interest rate has dropped by 1%, I am going to gain $100 for each bond that I bought at $1000.

Important Note

Whether interest rates are falling OR raising, when it comes to individual bonds, the bond purchase price (i.e. the principal) is guaranteed to be returned to the bond purchaser if the bond is not sold until the maturity date.

Next

If we have understood the above basics, the next challenge is to understand what happens to Bond Funds w.r.t. interest rate changes. Note that the impact on Bond funds are different than just Bonds.

Bucket Approach to Retirement

There is a common question among those planning/approaching retirement and definitely among those already in retirement.

That question is:

  • How to withdraw money from the retirement funds?
  • How to invest the remaining money while in retirement?
  • How much to withdraw each year?
  • How to not not be too conservative and run out of money?

A recent article I read from Christine Benz (Morning Star, published around 2012) was very informative to me. I am enclosing a link to that article here.