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Senior Partner at Lodestone Capital Solutions LLC - a Registered Investment Advisory and Full Service Insurance Brokerage Firm.
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  • Your 401k And Target Of Date Funds

    Recently friends have been asking me to help them with their 401k selections at their workplace. Most of them are pretty standard, a list of mutual funds, roughly 30-50 investment choices with percentage drop-down boxes and rebalancing options.

    While reading into some of the investment choices, I noticed that many mutual funds have what are called Target Date Funds. Dated 2020, 2030, 2040, 2050. Meaning if you were looking to retire by a specific date/year, you could put all your money into one of these funds and it would be properly allocated so that you would retire by that date. Sounds pretty simple and straightforward.

    But what if we take 5 minutes to dig slightly deeper. Below are 3 target date funds from T Rowe Price and their top 10 holdings. I picked T Rowe Price as it was listed in a friend's investment list and for no other particular reason. Many firms have Target Date Funds as well.

    (click to enlarge)

    Notice something? There is quite a bit of overlap in between these funds and that they just so happen to all be T Rowe Price funds inside this Target Date Fund. These belong (from left to right) the Target Date Funds for 2050, 2040 and 2030.

    This would make us think, if we are buying a Target Date Fund, which is pretty much a group of mutual funds and they all already happen to be with the same company, why can't we just buy the individual funds directly? Because we believe there is a fee associated with the Target Date Funds. Usually around 1%, the same as the mutual fund itself. So 1% for the underling fund, then another 1% for the Target fund holding all the underlying funds. Assume we had 1,000,000, we would pay 10,000 to the underlying funds, then another 10,000 to have them buy those mutual funds for us.

    Interesting... So if we really wanted to, we could buy the same exact percentages of funds as they have there ourselves and.... save 10,000 for about 10 minutes of work. Sounds like a pretty good deal to me.

    The real life example would be going to a candy store and buying 5 candy bars from the store directly. But if you were to buy the candy from the employee in the store, it would cost twice as much for the same exact candy.

    There is some merit in the argument that they do rebalance and adjust periodically the percentages of these holdings, but anyone can go online, dig up some value/blend/growth Morningstar matrix and create their own percentages that would not perform any worse than these and save the same on fees.

    Lodestone Blog

    Jan 02 6:15 PM | Link | Comment!
  • Portfolio Rebalancing

    Portfolios are rebalanced all the time. Many firms even have the neat ability to automatically re-balance portfolios for you. Along with diversification, people preach automatic re-balancing as a way to protect yourself. I can tell you that it is 100% true. It can and will protect you from earning higher returns in the stock market.

    It sounds good on paper. 20% bonds, 60% stocks, 20% commodities/alternative investments. Or if you would like to make it even more detailed:

    15% investment grade bonds, 5% high yield bonds, 20% small cap growth stocks, 20% consumer goods and 20% industrial/cyclical stocks combined with 10% in REITs and 10% in a hedge fund.

    Keep your investments spread out, and automatically re-balancing your portfolio will ensure your percentages stay spot on and correctly diversified right?

    So the only slight issue is that you are ruining your returns. We can just apply a bit of common sense and we will realize the issues with blind/automatic/frequent re-balancing. We will not even need a chart or graph or table this time. Think about what happens when you re-balance a portfolio.

    Say you have a portfolio of 10 investments, each one with 10%.

    In our first scenario, 5 of them go up 50%, 5 of them stay flat. You re-balance all of them so that they stay at 10% each. What you have just done is, take money out of an investment going up and reinvesting that money in a company that is going nowhere.

    Scenario 2, 5 of them go down and 5 of them are flat. You re-balance and dump more money into investments that are going down and taking it out of investments that are holding their value.

    For scenario 3, worst case, 5 of them go up and 5 of them go down. So you are taking money out of investments earning you a good return and dumping them into investments that are losing you money.

    Not to mention, each time the portfolio is rebalanced, transaction fees may and probably will apply.

    What would make more sense when selling and buying another investment, is if an investment has

    • reached it's estimated intrinsic value
    • become impaired, either bad capital allocation, change of management, poor corporate governance, etc...
    • lower potential return than another investment that has become known and actionable

    This way, you are selectively selling investments that no longer have the potential for good returns and allocating the money to investments that will offer the ability to provide greater returns.

    Most brokerages I have dealt with love automatic re-balancing and asset allocation. Especially if it is done monthly. With transaction fees on each buy and sell, having that done to every single client account for every single holding to make minor adjustments of 1-2% and then doing it 12 times a year? Brokerages would love you for it. While most only re-balance once a year, please keep in mind that automatic re-balancing may not be the best method for you.

    One caveat is that it may work in some indexing situations, but when buying and selling individual investments, it can lead to mediocre and depressed returns. More often than not you may be better off just leaving the investments alone.

    Lodestone Blog

    Lodestone Website

    Sep 25 2:40 PM | Link | Comment!
  • Inflation, Interest Rates And QE3

    QE1, then QE2 and now QE3. Here's a brief video that discusses this topic.

    I would like to just add a few things. First, I agree in that equities is where it is at. With bond prices driven to what they are now, the yields are so small and when, not if, they do raise interest rates, whether it be 1,2, or 5 years down the road, they will take a big hit. Pretty basic econ 101, interest rates down, bonds up, interest rates up, bonds down. With interest rates near 0, the only way is up and it is only a matter of time.

    In addition, with the fear of inflation, whether it is a legitimate worry or not, may exacerbate the situation. Granted I do not believe inflation will be a major concern. We have had it, it is integrated into our economics, it is happening and will continue to happen. But never say never.

    As for predicting what will happen. These people may be right or wrong, but more often than not, they are wrong. So the smartest thing to do is what was said around minute 23 of the video. If you buy undervalued companies with a large margin of safety, you can have decent returns in a sub standard environment.

    As a bonus, equities also have a built in inflation protection. Some more than others. Below is a rough example.

    Let us have another imaginary cola X company. Say it cost 3 dollars for a 6 pack. They earn a net profit of 1.50 per six pack sold. And there is exactly one six pack sold per share of stock. Meaning each share earns 1.5 dollars per six pack.

    Then we introduce inflation of 100%. Cola X is now 6 dollars a pack. Assuming all their margins stay the same, their profit will be 3 dollars per six pack. Or 3 dollars per share.

    Assuming Cola X originally traded at a P/E of 15 as does all of its competitors . The stock price would be 22.50 (15 x 1.5). Now that the earnings has doubled, to maintain the same P/E, the stock price would need to be 45 (15 x 3).

    The number will rarely ever work out like this, as this shows Cola X as a perfect inflation hedge or 1 to 1. Historically, it has been seen that it is closer to .5 or .6. Still pretty good with the additional potential for undervaluation and growth.

    Lodestone Blog

    Sep 17 7:23 PM | Link | Comment!
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