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In This Issue: What Ever Happened to the Risk Premium? Tips & Tricks - How Much Interest are You Paying?
What Ever Happened to the Risk Premium? If you read the financial press at all, you have heard the term “risk premium”. It has become fashionable in the last few years as the market has continued to grow at a rapid pace and prices paid for stocks have reached historic highs. The idea behind the phrase is a simple one - stocks are risky because profits are uncertain. Things that can’t be controlled - such as recessions, management blunders or the emergence of a new, strong competitor - can and do happen. To compensate for such risks, investors demand an extra return, or risk premium. This premium is measured against the safest investment option - the Treasury bond. As an example, you may pay $100 for a Treasury security that pays $6 of interest annually, but you won’t pay the same $100 for stock in a company that has $6 of profits, because the company’s prospects for continued returns are less certain than those of the Treasury security. If you buy the stock, you’ll typically pay less, because you want a higher return. Interestingly, when the perception of risk decreases, then so does the amount of the risk premium. In such an event, prices are likely to rise. This phenomenon has much to do with the market boom that started in 1990 and continues to this day. In this market many investors have become willing to accept lower-than-normal earnings on certain equities. In fact, a recent study indicates that on average, the risk premium demanded for stocks over Treasuries has decreased from 13% in the 1980s to 4% today. The reasons for this dramatic shift include the decline of inflation, new information technology, the globalization of world economies, better inventory control, and higher price stability. Nonetheless, the truth is that few investors have actually concluded that market risk is vanishing. Investors are bidding up prices because the market is going up and nobody wants to be left out. In economic terms, however, this confidence amounts to a perception that risk is falling. For the short-term investor such confidence may well be misplaced. Some of the very conditions that contribute to the growth of the market are potentially risk magnifiers as well. Globalization of the world economy poses dangers related to cultural differences and misunderstanding of other countries economic policies and practices. New technologies breed uncertainty and cause older technologies to disappear. Competition for market share erodes profits and leads to lower-than-expected long-term growth. Plus, faith in declining risk may inspire risky investing behavior. Whether or not the faith that American investors are putting in our economy is justified is unknowable in the short run. In a few years, we may have a better understanding of the events behind the rise in confidence that led to the increase in stock ownership from 19 percent in 1983 to 48 percent today. Then we will begin to see if risk has, indeed, decreased. The history of the stock market strongly suggests that the market is overpriced—meaning that risk premiums are way too low—and that fundamental long-term returns on stocks should approximate only 10% (dividend yield plus earnings growth). Yet returns in recent years have averaged around 18%. The entire difference can be attributed to speculation linked to the perception of declining risk. As history tells us time and time again, the market will return to historic norms over time, driven by the fundamentals. The lesson is clear for the long-term investor. Do not speculate. Select funds carefully, balance risk, and stay the course.
How often do you make changes in the way you allocate your 401(k) investments between funds? If it’s more than once a year, then you are following the long-established practice of overreacting to short-term fluctuations in stock prices. You are in good company. To get a flavor for how mutual fund investors react to market changes, consider the following:
The above probably seems natural and even logical, until you notice that it masks one of the great truths and paradoxes of the world of investing: when prices are high, investors jump on the bandwagon; when prices are low it is difficult to give stocks away. As Warren Buffet has pointed out: “a rising market is for sellers; a declining market is for buyers.” And yet, we persist in paying more attention to the process of investing than we do to the economics. As has been mentioned previously in these pages, the key to maximizing long-term investment returns is to carefully select an investment strategy—one that fits your life stage and tolerance for risk—and then implement that strategy through allocation of your investment dollars among a group of funds. By sticking with your strategy and resisting changes in your allocations, except to rebalance your percentages once every year or so, you give yourself the best possible chance of gaining the maximum from the underlying economics of the market in the long-term. Market timing has no place in the strategy of the long-term investor. And yet, most investors ignore such sound advice. In fact, investors’ growing short-term orientation can easily be seen by comparing differences in fund portfolio turnover from the 1960s and 1970s, when it was about 8%, to today when turnover is running at about 31%. The holding period for investments in the 60s and 70s was about 12.5 years. Today the holding period has dropped 75% to less than 3 years. For the long-term investor, the economics of the companies that one invests in are the significant issue, not the unpredictable, unknowable and largely irrational behavior of the markets in the short run. In the end, the value (and market price) of a stock is determined by only two things: dividend yield and earnings growth. Neither of these factors are in the least influenced by short-term swings in the market. As John Bogle, founder of the Vanguard Group of mutual funds, is quick to point out in discussing turnover as practiced by mutual fund managers: “Now controlling one-third of all stocks, fund managers are largely trading, not with other investors, but with one another. Thus, each trade balances out for fund shareholders as a group. It is a zero-sum game. But, importantly, money is left on the table for (benefit of) the dealers executing the trades, meaning that the activity becomes a negative-sum game…A recent study by Morningstar found that few managers were able to improve returns significantly through portfolio turnover, but that on balance, the tiny increases in return that turnover may have engendered were gained only by buying riskier stocks.” One can readily conclude from this that emulating the professional fund manager is not necessarily a wise choice. Perhaps more to the point, such research as that above only adds to the notion that the 401(k) investor should add low fund turnover to the list of criteria used to select investments. For the 401(k) investor, the idea remains to focus on those things that can be controlled. This means, ignore the short-term direction of the market because it is something you cannot control. Focus instead on risk, cost and time, all of which you can control. Begin investing early, because this gives you the most time to build a successful portfolio and to overcome market risk. Pay close attention to the cost of investing - transaction cost, investment advice, portfolio management and administration. Keep these costs at a minimum in order to put the most money to work for you. Making the most of your investment program is not difficult. There are only a few simple rules to follow. John Bogle, in his recent book “Common Sense On Mutual Funds” sets them out as follows: Invest you must. The biggest risk is the long-term risk of not putting your money to work at a generous return, not the short-term—but nonetheless real—risk of price volatility. Time is your friend. Give yourself all the time you can. Begin to invest in your 20s, even if it’s only a small amount, and never stop. Even modest investments in tough times will help you sustain the pace of compounding and will become a habit. Compound interest is a miracle. Impulse is your enemy. Eliminate emotion from your investment program. Have rational expectations about future returns, and avoid changing those expectations as the seasons change. Cold, dark winters will give way to bright, bountiful springs. Basic arithmetic works. Keep your investment expenses under control. Your net return is simply the gross return of your investment portfolio, less the costs you incur (sales commissions, advisory fees, transaction costs). Low costs make your task easier. Stick to simplicity. Don’t complicate the process. Basic investing is simple—a sensible asset allocation to stocks, bonds and cash reserves; a selection of middle-of-the-road funds that emphasize high-grade securities; a careful balancing of risk, return and cost. Stay the course. No matter what happens, stick to your program. [This] is the most important single piece of investment wisdom [out there]. Not every 401(k) investor has a wide range of choices within their plan. However, it is important to follow the above rules as best as possible within the available fund choices. To take full advantage of the rules, supplement your 401(k) program with investments in taxable funds once you have maximized your plan contributions. Follow the same rules for taxable investments as for your 401(k) plan. Remember that the temptation to engage in market timing plus too-frequent shifts between funds can have a negative impact on a long-term investment strategy. These are the two biggest enemies of the 401(k) investor.
One of the perennial debates in the investing world is when, why and if anyone should be investing in bonds. This is particularly true for those people investing in 401(k) plans and who, by definition, are long-term investors. With the oft-quoted statistic in mind that stocks have returned an annualized 11% over the last 70 years versus bonds return of 5%, what’s the argument about? In particular, hasn’t the experience of the last 5 years (stocks up 26%, bonds up 7%) been enough to stifle the debate? Apparently not. If your 401(k) selection options include bond funds, the following information will be of interest. For the long-term investor, the presence of bond funds limits risk—a definite advantage in today’s’ investing environment. Plus, when interest rates are low, bonds can beat equities returns as well. According to some studies, over the past 10 years (1990-1999) a mix of 25% Treasury bonds and 75% large-cap stocks would have reduced risk by 20% while amassing 90% of the return of stocks alone. While this is clearly a reason to consider having some bond funds in your portfolio, there are some fundamentals you need to keep in mind in order to manage your expectations. First, when a bond fund buys bonds, it is lending money to the issuer—a corporation, or local or federal government. In return the bond fund gets a promise to pay a fixed amount or rate of interest plus repay the face amount of the bond. But bonds, like stocks, trade on the open market, which means that their price fluctuates relative to interest rates in order to balance their yield to Treasury bonds (see the article on risk premium elsewhere in this issue). Second, there is the matter of default risk, which careful fund selection should minimize. You need to know how your plan’s bond fund(s) rate. Your 401(k) plan administrator should be able to give you this information. If not, you can ask the mutual fund company for a prospectus. Third, there is interest rate risk, which means that when interest rates go up, bond prices go down, and vice versa. See the table following this article for an example of how this works. By buying bonds through a fund, you avoid having to worry about valuing your investment in bonds that may not trade every day plus the fund manager will see to reinvesting interest payments. Finally, you can invest small amounts in a bond fund and not be subject to large price fluctuations. How Bond
Price Changes as Interest Rates Change
Tips & Tricks - How Much Interest are You Paying? If, like most Americans, you are paying for your insurance on a monthly, quarterly or semi-annual basis, you may be paying a much higher interest rate than you think. To figure how much you pay on a monthly payment schedule, divide your monthly payment by the annual premium. If the result falls between .085 and .0875 you are paying between 4% and 11% interest. Worse, if your results fall between .09 and.095, you are paying between 19% and 34%. Check it out. If you are interested in saving for the short-term—say for a car, college tuition or to start a business—your best vehicle may be taxable funds. As with other investments, it is a good idea to diversify, even when the investments are relatively low-risk. Consider a 40/30/30 mix of money market, short-term bond and intermediate-term bond funds which can improve your return over a straight money market fund. The often quoted 10-11% long-term return on equities is definitely not a birthright. The facts are that for stocks held 10 years or less, the probability is that 47% of the time they will return less than 10%. Even for stocks held 40 years the probability is still 26%. Bond funds can moderate this risk, showing an historical probability of beating stocks 21% of the time over ten years and 15% of the time over 40 years. Add bond funds to your portfolio.
Did you know that a new law could make it possible for you to reduce your mortgage costs by $100 a month or more? In July, the Federal Homeowners Protection Act went into effect. This law mandates that private mortgage insurance (PMI) agencies automatically terminate a policy once a mortgage loan balance declines to 78% of the original property value. The law applies automatically for all new mortgages. The effective date for existing mortgages is January 2001. Mortgage insurance is common because with the average cost of a home these days being $165,000 and 20% of that amount being $33,000 (the average required down payment), many folks simply can’t afford the down payment. If you put down less than 20% of the purchase price when you bought your home, your lender probably required you to take out PMI. If you are not sure whether you are paying for mortgage insurance, check your loan amortization schedule which tracks payments, principal balance and PMI costs, or ask your lender. If you qualify for termination of your mortgage insurance, contact your PMI provider right away. Consider applying the amount saved directly to your mortgage balance each month. Here’s why: Assume you have a $100,000, 7.5%, 30-year fixed mortgage. Your total interest cost over 30 years will be $151,700. Now, if you apply that $100 you saved each month on insurance toward principal, your total interest will decline by a whopping $56,300 and you will pay off your 30-year loan in only 24.5 years. To figure exactly what the impact would be on your mortgage costs, visit www.bankrate.com and click on “Calculators” at the top of the page. Input your mortgage and insurance specifics and the calculator will print you an amortization schedule with all the details.
Indexes Prime Rate - 8.25% Fixed Mortgage 30 Year - 7.57%, 15 Year - 7.20% Home Equity Loan 8.92% Automobile Loan 8.35% Internet Sites Dow Jones Average History
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