Your Personal Finance Pro http://yourpfpro.com Personal Finance for Young Professionals Wed, 16 Jan 2019 15:26:45 +0000 en-US hourly 1 31591919 Are Preferred Stocks a Good Investment? http://yourpfpro.com/preferred-stocks-good-investment/ http://yourpfpro.com/preferred-stocks-good-investment/#comments Mon, 26 May 2014 13:11:52 +0000 http://yourPFpro.com/?p=4326 Even though this blog has seen nearly a 30% increase in readers since the beginning of the year I actually don’t receive many questions from readers anymore. Maybe it’s because my posts are so intimidating or maybe there is another reason. Either way, I always welcome reader questions since I can usually turn them into […]

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Are Preferred Stocks a Good Investment?

Even though this blog has seen nearly a 30% increase in readers since the beginning of the year I actually don’t receive many questions from readers anymore. Maybe it’s because my posts are so intimidating or maybe there is another reason. Either way, I always welcome reader questions since I can usually turn them into a blog post. Please contact me if you’re interested in submitting a question.

This week’s question comes from reader PR and he asks:

What is your take on preferred stocks as a way to increase income due to their supposedly paying a higher dividend? There is a fund PGX I heard about.

I can completely understand where reader PR’s question is coming from. Today’s low interest rate environment means that investors can no longer get the same rate of return they’ve gotten accustomed to with products like government debt and high quality corporate bonds. Many investors nearing retirement(or already there) are turning to alternative investments in order to squeeze more yield out of their fixed income. And that’s where a fund like PGX steps in.

PGX is actually an ETF that holds the preferred stock of many different companies. It has a 6.45% SEC Yield and a reasonable expense ratio of .5%(not good, but not horrible either). It is well diversified among many preferred stocks but let’s take a look a closer look at what this ETF actually holds.

What are Preferred Stocks Anyways?

Technically, preferred stocks are classified as stocks but they’re more akin to a hybrid stock and bond combination. A preferred stock gets priority in receiving dividends and precedence over common stockholders(after bond holders and other creditors though) in the event of a liquidation of corporate assets(like in a bankruptcy). But in return for this preferential treatment, the stock is normally issued at a fixed price paying a fixed dividend.

The price of the shares are also subject to interest rate risk and the risk of the stock being called. If interest rates go up, the price of the shares will go down. If interest rates go down, the shares can be called at par(ie $10 for a $10 share) and replaced with new preferred stock at a lower rate. This is called asymmetric risk since you’re taking on the risk of a long duration product if rates rise while also capping potential gains(with a put to call) if rates were to fall.

Normally, we would expect symmetric risk from a fixed income product like government debt since a 1% increase in interest rates would result in approximately the same change as a 1% drop in interest rates. That’s not how preferred stocks work though.

Alternative Investments Don’t Usually Add Up

I’m actually surprised that I haven’t seen more questions about preferred stocks popping up now that the dividend investing fad has died down a little bit. Investors are always looking for more yield but the thing you have to keep in mind is the stock market is damn efficient. If preferred stocks are paying a 6.45% yield, there’s a reason why: they have real risk.

I review a lot of alternative investments looking for that one diamond in the rough but the math just never seems to add up. Although the yield may be higher on preferred stocks than bonds, the two asset classes have almost nothing in common. Sure you could get a 6.45% return by investing in PGX but don’t be surprised if the volatility is more like that of the stock market.

The graph below actually illustrates how PGX(orange) underperformed bonds(green) during the past 6 years and even did worse than the stock market(purple) during 2008-2009 financial crisis. So basically you’re investing in a fund that has higher volatility than equities and a lower return than bonds. Doesn’t make much sense does it?

Are Preferred Stocks a Good Investment?

Keep it Simple

I like investing in things that I understand. Preferred stock isn’t the most complicated thing out there but it’s not that simple either. Generally, when I don’t fully understand how an investment works, there are probably lots of smarter people on the other end of that deal waiting to take advantage of me and my money. Investing in what you know isn’t the sexiest investment style but it usually makes the most sense.

I’ve always kept an open mind to alternative investments but it seems like it’s always a better deal for the salesmen on the other side. I don’t mind doing the research and figuring things out for myself instead of listening to what someone else tells me about an investment. I use empirical data(like the chart above) and investment theory in order to decide whether an investment makes sense. If professional money managers can’t even come remotely close to consistently picking winning stocks and predicting things like interest rates why would I ever think that I can?

So What’s an Investor to do?

If you couldn’t tell by now, I think investing in preferred stock is a bad idea. Too many people tend to compare things like dividend yield to the return of fixed income products like bonds and CD’s – they are not the same. But like I said earlier, I understand why investors are looking for more yield and preferred stocks may seem attractive on the surface.

This probably isn’t the answer that people want to hear but there’s really not a whole lot you can do right now. There will never be a magic investment that combines the high return of stocks and the low risk of bonds. If there did exist such a thing, you would be very late to the party.

Readers, do you own any preferred stock or preferred stock ETF’s? Have you ever considered investing in it or is this the first you’re hearing about it?

-Harry @ PF Pro

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Reader Question on Investing for Beginners: Betterment.com Review http://yourpfpro.com/reader-question-on-investing-for-beginners-betterment-com-review/ http://yourpfpro.com/reader-question-on-investing-for-beginners-betterment-com-review/#comments Thu, 31 Jan 2013 01:30:28 +0000 http://yourPFpro.com/?p=1748 Today, we have a reader question about the site Betterment.com.  If you have a question for me, feel free to send me an e-mail. Reader TA writes in: I’m wondering if you’ve heard anything about the Betterment.com site?  I’m interested in learning/starting how to invest, and this site looks like a good place to start […]

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Betterment.com Review

Today, we have a reader question about the site Betterment.com.  If you have a question for me, feel free to send me an e-mail.

Reader TA writes in:

I’m wondering if you’ve heard anything about the Betterment.com site?  I’m interested in learning/starting how to invest, and this site looks like a good place to start for a beginner.  There’s a lot of great reviews from other PF blogs, but was just curious if you had any opinions about it?

Betterment.com is a site that’s been around for a while and they offer a low cost investment strategy for beginners.  What I like most about Betterment is that they keep it simple and they don’t invest in anything too complex.  There are definitely some financial advisors out there who will put you into a bunch of crazy funds and tilt towards certain sectors in order to justify a 1-2% fee. But most of these antics won’t do anything to improve returns.

No 401k Option

One thing you should be aware of though is that Betterment only offers IRA/after-tax investment services.  You shouldn’t even consider Betterment until you’ve taken advantage of the company match in your 401(k).  After that, you need to compare the different investment options in your 401(k) and see if it makes sense to continue contributing there or open up an IRA with a separate company.  And remember, this money should be invested for the long term, stocks are not a good place to invest your car or house fund.  Even though interest rates are brutally low, be patient and work on your rate of savings if you’re young and anxious.

Simple Interface

The way Betterment is set-up, it requires very little day to day management.  You can sign-up, set-up automatic monthly deposits and forget about it.  Betterment will automatically invest your money and re-balance at appropriate times.  They will help you set your asset allocation at the beginning and you won’t need to worry about it after that.  If you’re a hands-off investor and don’t want to worry about anything, I think Betterment provides just what you’d need.

No Fee is the Best Kind of Fee

I hate paying fees, everyone probably knows that by now.  But these companies have to make a profit somehow right.  Here is Betterment’s fee structure:

  • 0.35% per year for investors with less than $10,000,
  • 0.25% per year for investors with $10,000 to $100,000, and
  • 0.15% per year for investors with more than $100,000.

For what they provide, these fees are pretty low.  What I like most about Betterment is that they promote buy and hold passive investing.  They won’t do anything fancy and they’re one of the best at what they do.  Getting started with them is pretty simple too since you can invest with as little as $100/month.  There’s a $3/month fee if you don’t contribute at least $100/month which I actually like since it forces you to invest your money.

Investment Options

I really like Betterment’s investment options and I actually hold VTI myself in one of my retirement accounts.  Anytime you see companies like Vanguard or iShares, the fees should be pretty low.  Here’s the breakdown of what funds you’ll be invested in(the average expense ratio of these funds is ~0.17%)

Stock Portfolio

  • 25% Vanguard Total Stock Market ETF (VTI)
  • 25% iShares S&P 500 Value Index ETF (IVE)
  • 25% Vanguard Europe Pacific ETF (VEA)
  • 10% Vanguard Emerging Markets ETF (VWO)
  • 8% iShares Russell Midcap Value Index ETF (IWS)
  • 7% iShares Russell 2000 Value Index ETF (IWN)

Bond Portfolio

  • iShares Barclays TIPS Bond Fund ETF (TIP)
  • iShares Barclays 1-3 Year Treasury Bond Fund ETF (SHY)

How Does Betterment Compare?

Betterment is one of the best companies out there offering low cost investment options for beginners but there is another simple way to re-create what they do.  The alternative is to open an account with Vanguard and invest in one of their target retirement funds like Vanguard Target Retirement 2050 Fund (VFIFX)(adjust the fund to whatever year you plan on retiring).  This fund will invest in a very comparable asset allocation to Betterment and the expense ratio is only 0.19% while Betterment’s ER is around 0.52%(the average ER of the funds Betterment invests in is .17%).  If you have less than 10k invested with Vanguard there is a $20 annual fee, but thatt’s waived as long as you choose e-statements.

The simplicity and low cost funds make Betterment a good starting point for beginners, but it’s clearly more expensive than Vanguard.  Fees will play an important role in the performance of your portfolio as your balance grows but in this case a .33%(.52-.19) difference on $10,000 is only $33.  Still, I’d go with Vanguard since they offer a comparable product at less than half the cost.  Eventually, your accounts will grow and at that point you won’t want to be paying an ER of .52% so why not start with a company like Vanguard now?

Readers, have you ever used Betterment’s services?  Do you think it’s a good starting point for beginning investors or should they start somewhere else?

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Asset Allocation Guide: Why to Invest in International Index Funds http://yourpfpro.com/asset-allocation-guide-domestic-vs-international-mutual-funds/ http://yourpfpro.com/asset-allocation-guide-domestic-vs-international-mutual-funds/#comments Fri, 31 Aug 2012 04:43:28 +0000 http://yourPFpro.com/?p=1079 If you followed the market from 2000-2009, you’ll know that US stocks got hammered.  Investing in international stocks wouldn’t have saved you from a period like that, but it could have helped.  International stocks provide some much needed diversification and tend to reduce your portfolio’s overall volatility.  In fact, since international funds make up 60% […]

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Kuala_Lumpur_Petronas_Towers_international_asset_allocation

If you followed the market from 2000-2009, you’ll know that US stocks got hammered.  Investing in international stocks wouldn’t have saved you from a period like that, but it could have helped.  International stocks provide some much needed diversification and tend to reduce your portfolio’s overall volatility.  In fact, since international funds make up 60% of every asset in the world market, a market weighted portfolio would hold 40% US Stocks and 60% International Stocks.  A portfolio without international stock is too US-biased to provide adequate diversification.

If you’re in a lifecycle fund like 2040 Target Date ETF(TDV) then you’re already invested in international funds, 24% to be exact.  But if you’ve decided to cut down on expense ratios and manage your portfolio yourself, you need to understand why and how much to invest in international stocks.  I started working on my annual rebalance and it got me thinking about my international allocation.  Currently, I’m 90% stocks, 10% bonds and within my equities, I’m at 60% domestic, 40% international.  I had the number 40% written down and highlighted but I could not remember why.  In my quest to find out, I found some great information on the boglehead’s forum and a very helpful Vanguard paper.

Vanguard Conclusions

Luckily for everyone, I did read through that boring paper so let me give you the summary so you won’t have to read it and halfway through you’ll feel like gouging your eyes out.  Vanguard found that “although finance theory dictates that an upper asset allocation limit should be based on the global market capitalization for international equities (currently approximately 58%), we have demonstrated that international allocations exceeding 40% have not historically added significant additional diversification benefits, particularly accounting for costs and that a 20% limit is a reasonable starting point.”  Now what the hell does that mean?  Basically based on past performance, Vanguard found that a 20-40% allocation(as part of your equities) towards international stocks would give the highest returns while minimizing volatility.  Allocations over 40% did not provide a diversification benefit nor a greater return.

Vanguard_International_Asset_Allocation_20_40

Missing Out?

Since 60% of the world’s stock investment opportunities are outside of the United States, it makes sense to include them as a part of your portfolio.  If you fail to include international stocks, you’re missing out on a lot of potential.  You’ll find the following companies in international markets:

  • 8 of the 10 largest automobile companies
  • 8 of the 10 largest diversified telecommunications companies
  • 7 of the 10 largest metals and mining companies
  • 7 of the 10 largest electronic equipment and instruments companies
  • 6 of the 10 largest household durables companies

Income Dependent

So what’s the allocation we want?  I think 20% is much too low because the market cap is closer to 60%.  In addition, since we live in the United States, we are very dependent on our economy already.  It seems to me that holding US bonds and US stocks and getting paid by US companies is not diversified.  A move closer to market cap makes sense because your salary is so dependent on the US economy.  Although, if you’re closer to retirement, then you are less dependent on the US economy since you have less working years left.  In this scenario it might make sense to shift back towards US stocks to stay diversified.

Don’t Go International Crazy

There is a tendency you should avoid though, over-weighting emerging markets.  Just because you know India and China are growing faster than the rest of the world doesn’t mean you should go crazy and invest a ton of money there.  Believe it or not, other people have realized this too, and a long time ago.  Even though it’s obvious that the growth of these two countries will far outpace the US’ growth in the next 100 years, that growth should already be reflected in the price of their stocks.  So in my opinion, there’s no need to tilt too heavily towards emerging markets unless you think they will exceed their projected growth pace.

Personally, I decided to keep my international allocation at 40% and US allocation at 60%.  I think that the US economy is on the decline, but that doesn’t mean that all US large cap companies are in trouble.  As the population of China and India grows, so does their demand for American products, services, etc.  Take Apple or any other US large cap company for example, let’s say that 30% of their 2011 revenue came from outside of the US.  That would mean that 70% of their revenue came from the US, so Apple/US large caps domestic allocation is actually 70% x 60% = 42%.  Instead of a 60% US allocation, I’m actually at 42% in this scenario since many large cap companies do business abroad.

It’s hard to say what the right number is for the future but we know that in the past it was somewhere between 20 and 40%.  But as the world becomes a global economy and countries start sharing resources and trading more frequently, the lines between domestic and international equities start to get blurry.  For now I’m happy with 40% because I think it takes into account enough of the world market where I can receive diversification benefits and the capital return of US companies.

Readers, have you looked at your asset allocation lately?  How much do you have invested in international equities?

-Harry @ PF Pro

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My Tax Efficient Investing Plan http://yourpfpro.com/my-tax-efficient-investing-plan/ http://yourpfpro.com/my-tax-efficient-investing-plan/#comments Thu, 02 Aug 2012 05:34:48 +0000 http://yourPFpro.com/?p=941 If the Mayans are wrong and Dec 21, 2012 doesn’t bring the end of the world, taxmageddon is still headed our way in 2013.  Income taxes are slated to go up for every single tax-paying American unless congress and Obama act.  Regardless of whether you’re for or against the proposed tax increase, it’s causing a lot of […]

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taxmageddonIf the Mayans are wrong and Dec 21, 2012 doesn’t bring the end of the world, taxmageddon is still headed our way in 2013.  Income taxes are slated to go up for every single tax-paying American unless congress and Obama act.  Regardless of whether you’re for or against the proposed tax increase, it’s causing a lot of uncertainty among investors.  This tax increase would return the capital gains tax to ordinary income rates, greatly affecting investors and their retirement accounts.

The budget deficit is growing every year, so it seems pretty reasonable that there is only one direction taxes can go, and that’s up.  With that in mind, it’s important to know how your money is taxed going into retirement accounts and how it might be taxed coming out.  Capital gains taxes can have a significant impact(just ask Mitt Romney) over a long horizon.  There are different theories as to the most efficient fund placement but I like to keep it simple.

My Tax Efficient Investing Plan

1.  401k – Contribute up to the maximum employer match

2.  Traditional IRA/More 401k – It’s easy to contribute more to your 401k but if your plan is laced with fees, consider opening a traditional IRA.

3.  Roth IRA – Allows you to lock in tax rates now

4. Alternative Investments – Real estate prices are at an all time low

5.  Taxable accounts – I’m not a huge fan of taxable accounts for retirement investing and I’ll explain why

1.  401k Up to the Employer’s Match

I’m lucky because my company fully matches up to 6% of my 401k contributions, with an additional 2% vested after 3 years.  So as long as I stay with the company 3 years, I receive a 6% match and a 2% bonus as long as I contribute 6% of my salary.  Contributing up to your employer’s match is a no brainer, even if it’s only 2-3%; it’s a guaranteed return.  If my company didn’t match my contributions, I’d probably skip to step 2.

2.  Open a Traditional IRA or Contribute More to Your 401k

If your company doesn’t offer matching, then their investment options are probably pretty lacking too.  I’d go straight to a company like Vanguard and open a traditional IRA.  There you’ll get great service and some awesome ultra-low cost mutual funds.  For those of you that have high fees and limited choices in your 401k, a traditional IRA can be a good choice after you’ve contributed up to the employer’s match.  After you collect that free money, there’s no reason you have to stay with your 401k provider.  Opening an account with Vanguard will also make things easier if you want to rollover your 401k when you leave your employer.  Traditional IRA’s give you a ton of flexibility, you can invest in everything from gold and REIT’s to Lending Club.

If your 401k plan has low fees and a good selection, contribute more!  I’ve increased my 401k every time I got a raise over the past three years, and now I’m max’d out.  If you have an HSA, I’d also consider contributing here because it’s the only triple tax advantaged account.

3.  Open a Roth IRA

I always recommend Roth IRA’s because it allows you to diversify your investments from a tax perspective in addition to reducing volatility.  I think tax rates are going up and a Roth IRA allows you to lock in current tax rates unlike a 401k where you will pay taxes at your ordinary income rate when you withdraw after the age of 65.  If you read this blog for the next 30 years, you should have a wide array of passive income by then and your income will be much higher than it is now 😉

Unfortunately though, with a Roth IRA you have to contribute your after tax dollars so you don’t get the AGI reduction like with a 401k or a traditional IRA.  There are income restrictions for a Roth IRA too but if your AGI is less than $110,000 you can still contribute.  Alternatively, for those over the AGI limit, they can explore a backdoor Roth IRA.

4.  Alternative Investments

Now that I’ve max’d out my 401k, Roth IRA and HSA, I am saving all my after tax money for my next real estate purchase.  Real estate prices are still low and the interest rates are at an all time low.  Real estate is the only investment where you can put up 20-30% of the investment, but still receive 100% of the returns. Not only will you receive 100% of the returns, but you don’t even have to pay taxes on the capital gains from selling your property up to $250,000.

5.  Taxable Accounts

You should only consider contributing to a taxable account once you’ve exhausted all other options.  And trust me there are many!  Before you invest in taxable accounts, you can open a 529, buy tax free savings bonds, and more.  But I think real estate is the best after tax option since it can help you create steady passive income.  But if you’re insistent on after-tax investing make sure to invest in tax efficient stocks like ETF’s or low cost mutual funds.

Summary

A good retirement plan involves diversifying your investments in addition to diversifying the way they’ll be taxed.  Although I think taxes will be higher in the future, they could easily be lower and that’s why I have a wide array of very different investments in my portfolio.  Some of my investments pay tax now, some pay later, and some pay never.

Although every situation is unique, I recommend contributing up to the employer match, starting a Roth IRA, using your raises to increase 401k contribution, then starting tolook at alternative investments like real estate.  Although there are a lot of different opinions on this subject, this is the plan I’ve used and what I always recommend.  It’s worked great so far, and I’m happy to say I’m on track to retiring early while creating steady sources of passive income.

Readers, do you do some, all or none of this?  Are there any types of investments I’ve missed that are a sure thing?

-Harry @ PF Pro

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