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In This Issue: The Return to Value Investing; Implications for the 401(k) Investor How Well Does Dollar Cost Averaging Really Work? Maximizing Your Annual 401(k) Contribution Making Sense - Roth IRA versus 401(k)?
The Return to Value Investing; Implications for the 401(k) Investor With the decline in tech stocks that started in April showing no signs of letup, the pundits are looking for another horse to ride. Lo and behold, they are turning, yet again, to value stocks as the “new” most favored investment vehicle. So, Ben Graham and his bible of value investing (Investment Analysis) first written in the 30’s are back in favor. Actually, the concept of value investing never really went out of style. In the investing community, the debate over which investing approach (value or growth) produces the best long-term results has raged for decades. In the 1990’s, the argument has been fueled by the interest in, and performance of, the so-called “tech” stocks and the “dotcom” or Internet companies. For the 401(k) investor, the problem of choosing an approach has always existed, since most employer-sponsored plans contain one or more value and growth funds. Figuring out how to choose between them, or even how to allocate investments among them, can be difficult and confusing. To help make sense of the debate, let’s take a look at the terms value investing and growth investing to see what each means: Value investing generally describes a method of purchasing stocks that exhibit characteristics such as a low price-to-book value, a low price-earnings ratio, or a high dividend yield. Growth investing, on the other hand, refers to a strategy of accepting a high price relative to a company’s current earnings or book value based on the belief that the company’s future growth will justify the risk. While these two approaches seem to be at odds with one another, closer examination reveals that they actually are inextricably intertwined. Let’s listen to Warren Buffet, protégé of Ben Graham, legendary value investor, and chairman of Berkshire Hathaway, as he talks to stockholders on the subject: “Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive. In addition, we think the very term value investing is redundant. What is investing if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value—in the hope that it can soon be sold for a still-higher price—should be labeled speculation.” He goes on to say, “We select our marketable equity securities in much the way we would evaluate a business for acquisition in its entirety. We want the business to be one a) that we can understand, b) with favorable long-term prospects, c) operated by honest and competent people, and d) available at a very attractive price.” In short, when it comes to investing for long-term growth, one must distinguish between trading in the hope of short-term gain (a market-driven decision) and a strategy of buying based on underlying value (a decision that is independent of the market, and of price). In the world of the 401(k) investor, the employer has already done some of the homework and made some of the decisions. Generally, fund choices include both growth and value funds. But, we have seen that growth and value go together, so how do we choose between them? The key lies in understanding how much emphasis is placed on growth by each fund’s management. So-called growth funds place relatively more emphasis on Buffet’s second test (favorable long-term prospects) than on the other three tests. Value funds, on the other hand, place more emphasis on Buffet’s fourth test (a very attractive price) than on the other three tests. Generally speaking, investing for growth offers the opportunity for better-than-average long-term returns and higher-than-average risk of principal. Investing for value offers the opportunity for lower-than-average risk of principal in exchange for the prospect of moderate long-term gain. Managers of funds that consistently meet their investment targets over the long-term evaluate purchases based on all four criteria. It is the relative importance attached to each of the four that determines the style (growth or value). Given all of the interest in tech stocks, how should the 401(k) investor evaluate funds that invest in companies like Microsoft, Cisco, Dell, AOL, and Amazon.com? After all, these companies are trading at prices which certainly don’t meet Buffet’s fourth test. Do they meet any of the other three? Using the following table, let’s see how each stacks up:
Test #2: Cisco, Dell and Microsoft all meet the test of favorable long-term prospects. The jury is still out on AOL, but the company’s increasing dominance in the industry bodes well for its’ future. Amazon.com is in a battle with Barnes and Noble for dominance, and it’s anyone’s guess what the future holds. Test #3: As far as we know, each of these companies meets the test of being operated by honest and competent people. Test #4: None of these companies are available at a very attractive price, and one of them has never been profitable. However, by looking at this test in combination with Test #2, we can see from the table that companies like Dell and Microsoft are the more attractive buys. Further, by applying the concept of dollar-cost-averaging (which all 401(k) investors regularly employ) to the 52-week price range, we can see that the average price paid for Dell, Microsoft and Cisco would be substantially less than current levels, making them a bargain relative to AOL and Amazon.com. We can conclude from this examination that three of these companies (Dell, Microsoft and Cisco) pass the tests of the long-term investor and should reasonably be found in a growth-oriented fund. In addition, Microsoft would find itself welcome in a value-oriented fund as well, given its profitability and prospects for the future. Both AOL and Amazon are clearly too speculative, at current prices, to fit in any but the most aggressive growth funds. The 401(k) fund investor has the advantage of having experts (fund managers) working for him or her to help assess price/value relationships. Understanding their investment philosophy is key.
How Well Does Dollar Cost Averaging Really Work? One of the central notions about 401(k) investing is that by putting the same amount away each month, variations in the stock market are minimized and long-term gains maximized. This idea can also be applied to investing outside the 401(k) world with after-tax dollars. Statistically, this approach has been proven sound. Or has it? Anyone who has ever had a large amount of money from the sale of a home, or an inheritance, for instance, has had the worry of how to invest it. Should it be invested all at once, or in increments? In today’s volatile markets such choices are even more worrisome. Many folks hedge their bets by using dollar-cost averaging in order to buy more shares when prices are down and fewer when they are up. However, one school of thought, based on studies of the risk/reward probabilities of various hedging techniques, says that this is an expensive way to reduce risk. According to the studies, investing 50% immediately and stashing the remainder in a money market account produces the same return on average as dollar-cost averaging, but with less risk. At least that’s what these statistics say. In fact, the studies go on to conclude that by increasing immediate investment to 56%, the investor is rewarded with an additional half-percentage point return. Some financial advisors are recommending that dollar-cost averaging be abandoned altogether as a hedging technique. Their reason, voiced by David Colville at Insight Capital Research & Management in a recent Individual Investor article, is that, “We have never found a successful way to time the market, and that’s what dollar-cost averaging boils down to.” While this is an interesting and provocative point-of-view, the great body of evidence suggests that it simply doesn’t hold water. Dollar-cost-averaging has been with us as a successful hedging technique for many years. The studies themselves confirm that the technique is the benchmark against which to measure other techniques. Moreover, the studies emphatically do not show that investing a lump sum is a successful hedge against risk—in fact, by definition it is no hedge at all. The careful investor should examine the notion of risk presented in the studies to see if it squares with the real-world marketplace over the long term and how it is influenced by the investment selections themselves. If you, as an investor, subscribe to the notion that the marketplace is efficient and will ultimately price investments at their underlying worth, and you have a large sum of money to invest, then you should tuck this offbeat notion away as just another attempt to complicate what is, in fact, a simple and effective investing tool and employ dollar-cost averaging to protect your stash. How Dollar Cost Averaging Pays Off
Maximizing Your Annual 401(k) Contribution Are you
maximizing your 401(k) contributions? Many people think they
are. But, studies indicate that by “maxing out” most
people mean they are contributing only enough to maximize the
amount of the company match. Here’s why following that
strategy can leave folks far short of their long-term investment
goals.
* Assumes
salary of $30,000 There are several reasons why contributing the maximum amount possible makes sense rather than limiting your contribution to what the company matches: Number One: Contributions reduce taxable income during your working years. If you are in the 32-34% marginal tax bracket, this means that Uncle Sam contributes 32-34 cents of every dollar you put in your plan. The money that would have gone for taxes goes into your retirement fund, where it can compound its way quietly, safe from taxes, until you retire. Using the above chart as an example, you can see that Uncle Sam will pay a little over $1,000 of the under funded amount, leaving you to make up only $2,400. Number Two: If the investment vehicles in your 401(k) plan earn a historical average of 10%, that $3,600 you could have invested would be worth nearly $175,000 in 40 years. Figuring that your out-of-pocket cost would have only been $2,600, that could amount to a real return of over 14% per year. Number
Three: In the above example, if you actually do contribute
the additional $3,600 every year for 40 years at a 10% average
annual return, your 401(k) portfolio will be worth $1,900,000
more than if you contribute only enough to maximize the company
match. Doesn’t take a Phi Beta Kappa to figure out the best bet, does it?
Mortage rates are headed up once again. In early September, the 30-year fixed rate was 7.83%. But, this rate is still worth considering, particularly if you are looking to refinance from a higher rate. While re-financing is complicated and requires special attention, it is instructive to note that a half point reduction in interest rate is worth $35 a month off your payment on a $100,000 mortgage. Still, if you’re thinking about buying or re-financing, better act fast. The door is closing. Don’t let a fund’s name mislead you. You may think you own a balanced fund or a growth or growth and income fund, but the top performers from last year all took positions in tech stocks. Read the prospectus to be sure you know what your payroll deductions are buying. When you apply for a mortgage or car loan, lenders run a credit report to qualify you for the loan and establish a rate. Ironically, the more you shop around the lower your credit rating may be as each lender you shop runs an inquiry. If the lender sees other inquiries, he or she can’t tell if you got the loan, so assumes that you did and—voila!—your risk goes up. One way to avoid the problem is to check published rates on the Internet. By narrowing your selection to one or two lenders, and then applying only to them you may get a better result.
Making Sense - Roth IRA Versus 401(k)? The most important difference between a Roth Ira and a 401(k) involves (you guessed it) taxes. Participants in a 401(k) plan pay no income tax on contributions, but all contributions and earnings are taxed at ordinary income rates when withdrawn at retirement. No tax deduction is allowed on contributions to a Roth but, at retirement, both contributions and earnings may be withdrawn tax-free. Confused? Of course you are. Here’s a way to sort things out: If you are in the 34% tax bracket (28% Federal plus 6% California), it takes $1,515 of pre-tax earnings to fund a $1,000 Roth IRA. It only takes $1,000 to fund a 401(k) contribution, and $340 of that amount is subsidized by Uncle Sam and Governor Davis. Using this logic, it’s hard to understand why anyone would select a Roth over a 401(k) plan. In case you’re still not convinced, take a look at the math: If you invest $1,000 in your 401(k) at 10%, in a little over seven years your investment will be worth $2,000. If, on the other hand, you invest $1,000 in a Roth IRA, it will also be worth $2,000. So far, so good. Now, if you are in the 34% combined tax bracket when you withdraw from your 401(k) after seven years, the after-tax gain to you will be $2,000 less the sum of your after-tax cost basis ($660) plus tax ($680). The net gain on the 401(k) investment will be $660. The Roth investment will generate no tax on withdrawal, but the gain will be reduced by the combined amount of the pre-investment tax cost ($515) and the after-tax cost basis ($1,000). Thus, the net gain on the Roth investment will only be $485. The debate continues, but the best rule seems to be to take the tax benefit when it’s offered to you, because tomorrow (and lower tax rates) never comes.
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