February 2013 S&P 500 Forecast Results

Financial Place Online provided a market forecast back in December.  The forecast was for the S&P 500 index to be above 1400 by 1 February 2013.  The good news is that this forecast came to be true.  The great news is that the S&P 500 is currently at 1513!   The primary concern though, is that the upward run has come too fast.  Very little of the underlying U.S. economy has changed in the last year.  The job market has modestly improved, but this is more than offset by fiscal uncertainty that may result in disaster coupled with a monetary policy that maintains the suppression of interest rates.

The 52 Week low for the S&P 500 was 1266.  Also, the index is up 100 points in the last month.  The price to earnings ratio (P/E) is a little above 17.  It is worth noting that the P/E ratio correlation to the stock market is weak as earnings growth is another factor which weighs heavily on the price of the index.  Forecasts for 2013 earnings growth are estimated to be anywhere from flat to 3%, hardly anything worth writing home about.

What may really be the cause of the run to over 1500, is the present 2.07% dividend yield.  Those who were invested in bonds found the S&P 500 dividend rate to be attractive since bond yields are low and interest rate risk is increasing.

The performance of the Financial Place Online balanced portfolio

The Financial Place Online balanced 401k portfolio example was developed based on a grouping of common Vanguard funds available to various 401k plans.  The asset allocation is as follows:

As compiled from Vanguard’s website, the performance record for each of these assets is impressive.

VanguardThe first thing to note here is the omission of the Developed Markets fund.  That fund has been recently established.  In its place, the MSCI EAFE index has been used, which is a more than reasonable assumption.  Each of the four funds have experienced strong performance in the past.  It is important to remember that past performance is just that; past performance.  What is important is what each of these funds represent.  As a combination, this portfolio covers ownership of the U.S. S&P 500 index, a stong mix of Real Estate Investment Trusts, the U.S. aggregate bond market (high credit rated bonds) and developed markets in Europe and Asia.  There will be profitability in the future.  You can be sure of that.  Businesses are all about increasing shareholder value, though some are better at it that others.  This portfolio is geared towards capturing as much of the total market profits as you can in as cost effective of a method as possible.

A balanced 401k portfolio

Graph GuyThis is one of the most frequent topics that comes up for discussion at Financial Place Online.  What makes for a balanced 401k portfolio?  While there are many different strategies that can be employed, the 401k account is structured differently than a normal investment account.  The 401k is a tax advantaged account, and that is its main and only advantage.  Very few 401k plans offer a great enough variety of funds to try some proprietary investment strategy that a financial advisor will try to cook up for their clients.  Even fewer 401k plans offer low-cost investment options.

The biggest determinant of what you get out of your 401k is what you put in to it.  Doing nothing with all of the great ideas in the world will get you nowhere in investments.  The second biggest factor of 401k success is just being in something other than “cash and cash equivalents”.  This means stocks, bonds, real estate, or even sector funds.  Whatever it is, just be in something.  Also, talk about it and enjoy it.  Have personal ownership for whatever you are in.  The final critical element for success is investing in low cost funds within your 401k.  The fund expense ratio will kill your account if it is high enough.  So much so, that if all of the options have an expense ratio above 1% and the S&P 500 index is the only fund available with a ratio below 0.35%, then be only in that fund.  It makes that much of a difference.  No manager will sustain performance long enough over time to make such a high expense ration worth it.  I see some funds (commodities hedging) flirt with a 2% ratio.  That’s just ridiculous.  Those people should be kicked out of Wall St.

For those who have good low-cost options and want to diversify in your 401k, here’s the Financial Place Online recommendation:

If you have a 401k administered by Vanguard, T. Rowe Price, or Fidelity, then congrats! You have a good bargain of a 401k program.

With that, let’s focus on a well balanced tactic for spreading across the following Vanguard funds, analyzed using their personal account costs.  Your 401k costs should be even lower.

  1. 25% Vanguard 500 Index Fund Admiral Shares (0.05% expense ratio)
  2. 25% Vanguard REIT Index Fund Admiral Shares (0.10% expense ratio)
  3. 25% Vanguard Developed Markets Index Fund Admiral (0.12% expense ratio)
  4. 25% Vanguard Total Bond Market Index Fund Admiral Shares (0.10% expense ratio)

The 25% rule:  Keep the current balance of each of these four account equal at the end of every 4 month period.  This is just often enough to make the changes, but no so much that it becomes too time consuming.  To balance, take your total account balance and divide by four.  Sell any fund that is above this number and use those proceeds to buy more shares of the funds that are below this number.

Automatic, rule based investing is really the way to go.  The costs of anything else goes straight into the broker’s pockets.  Simple 401k investing is something that you should not be paying any advisor for.  That’s why Financial Place Online will never charge for it.  Paid financial advice should be reserved for topics that are more complex, such as small business tax situations, or trust management; certainly not for education on 401k tips and tricks.

The next article from Financial Place Online will feature some analysis of past returns for this investment strategy as well as future expectations.

Compound interest and doubling your money

There are some basic rules of finance whose understanding is integral to the proper management of money.  The first rule has been to understand the concept of the time value of moneyInterest rates drive all things finance; from credit card debt and house buying to savings accounts and bond investments.  The concept of the time value of money is rooted in mathematics and can be cumbersome to commit to memory.  The good news is that there has long been a rule that is easy to commit to memory and serves as the 95% solution to figuring out how much an asset can make you or how much a loan can cost you.

The rule is called “The divide by 72 rule“.  If you already know of this rule, you’re ahead of many.  However, do you know why that rule works, or even whether it actually does or not.  Anything based math should not be taken on faith, but instead proved through relationships.  The 72 rule states:

To quickly calculate the time in years to double your money in an investment due to compounding interest payments, divide 72 by the annual interest rate.  For example an 8% interest rate would take (72/8) 9 years to double the money invested.

This can work with interest rates that are compounded annually or even in shorter terms, so long as the annual effective rate is used in the calculation.

Rate Rule of 72 Annual Delta %
1% 72.0 69.7 3.2%
6% 12.0 11.9 0.9%
11% 6.5 6.6 -1.5%
16% 4.5 4.7 -3.8%
21% 3.4 3.6 -6.1%
26% 2.8 3.0 -8.3%
31% 2.3 2.6 -10.5%
36% 2.0 2.3 -12.7%

>>>The above table shows a comparison between the rule of 72 and annually compounded interest rates.  Notice that the error is low for interest rates that we commonly calculate.  The formula for the time to double your money is Time=ln(2)/ln(1+rate), where the time is in years and the interest rate is expressed as a percentage.  The divergence at higher interest rates from the rule of 72 is cause by the rule of 72 actually being tied to the formula for continuously compounding interest.  This is where interest is always compounding upon itself.  The formula for doubling you money in this case in Time=ln(2)/rate.  This formula tracks perfectly with a rule of 69.3 as shown below.  The reason that 72 is used is because “head math” with 72 works easier as 72 has plenty of multipliers (1,2,3,4,6,8,12…and so on) that are common interest rates.

Rate Rule of 69.3 Annual Delta %
1% 69.3 69.3 0.0%
6% 11.6 11.6 0.0%
11% 6.3 6.3 0.0%
16% 4.3 4.3 0.0%
21% 3.3 3.3 0.0%
26% 2.7 2.7 0.0%
31% 2.2 2.2 0.0%




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