A Key to a Lasting Retirement Portfolio

Posted on February 27, 2015 | AAII Journal

If you’re retired—or nearing it—ensuring that your retirement investment portfolio lasts your lifetime is critical. And that’s not easy because by nature the stock market is volatile. What if a market downturn takes a bite out of your investment portfolio?

While you cannot completely control the market’s impact on your portfolio, there are things you can control that can also make a significant difference in how long your portfolio may last. One: your withdrawal rate from your portfolio. The amount you take can directly impact how long your assets could last in retirement.

But what about in difficult markets? At Fidelity, we still believe in inflation-adjusted withdrawal rates of no more than 4% to 5% a year for individuals who retire at age 65. That’s because we did the analysis using our Retirement Income Planner and an inflation-adjusted withdrawal rate of more than 5% steeply increased the risk of depleting retirement savings during an investor’s lifetime. We also ran some further analysis to determine the influence of different market environments.

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The Individual Investor’s Guide to the Top Mutual Funds 2015

Posted on February 3, 2015 | AAII Journal

The returns realized by mutual fund shareholders in 2014 depended significantly on the categories they chose and, at least on the domestic equity front, whether they went with an active or a passive fund.

We bring this up because a significant part of a fund’s returns are influenced by the performance of the category it operates in. For example, the average energy fund plunged 18.0% last year. The culprit: oil. Oil prices fell from $105.37 per barrel on June 30, 2014, to $53.27 per barrel on December 31, 2014. Fund managers required by their funds’ objectives to invest in energy stocks in their portfolios could do nothing but sit and grimace.

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Few Investors Plan to Keep Allocations Unchanged in 2015

Posted on February 3, 2015 | AAII Journal

Last month’s Asset Allocation Survey special question asked AAII members what, if any, allocation changes they expect to make this year. Slightly fewer than three out of 10 (30%) said they don’t anticipate making any changes. About 16% intend to increase their allocations to equities, while 7% plan on reducing their exposure to stocks. Close to 15% intend to boost their bond allocations and just under 10% say they will boost their cash allocations.

A Comprehensive Approach to Covered Call Writing

Posted on January 14, 2015 | AAII Journal

Setting up a covered call portfolio using securities that generated significant dividend distributions was covered by Ben Branch, professor of finance at the University of Massachusetts, Amherst, in two wonderful articles published in the AAII Journal last year.

The articles ran under the titles “Assembling a Covered Call Portfolio on Dividend-Paying Stocks” (June 2014), and “Managing a Portfolio of Covered Calls” (July 2014) and can be found in the AAII.com archives. This article adds information to the key facts highlighted in Branch’s articles and presents another perspective as to how and why such a covered call portfolio can be constructed and managed.

Covered call writing is a strategy where individual investors can sell options against securities—stocks or exchange-traded funds (ETFs)—they already own to generate monthly cash flow. In its traditional sense, profits can be gleaned both from the sale of the option and from share appreciation if the option selected has a higher value than the current market value of the stock. (For example, an investor buys a stock for $48 and sell the $50 call option; this known as an “out-of-the-money” strike.) If the option selected had a strike price (agreed exercise price) the same as (“at the money”) or less than the current market value (“in the money”), the maximum return would be the time value component of the option premium only.

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How Much Is Needed to Start Investing?

Posted on December 22, 2014 | AAII Journal

What is the minimum dollar amount needed to start investing? It is a question some members ask us and likely one that many others have, especially those who are new to investing.

Technically, you are only limited by the minimum amount required by a brokerage firm or mutual fund company to open an account. ShareBuilder, an online broker, has no required minimum account balance. More than 50 mutual funds included in our annual mutual fund guide have minimum purchase requirements of $100 or less, including funds offered by Fidelity, AssetMark, USAA and Oakmark.

Pragmatically, you should weigh the dollar amount you have available to invest against the actual costs of creating a diversified portfolio. Brokerage commissions for buying and selling stocks and exchange-traded funds (ETFs) increase significantly on a percentage basis as the dollar amount invested decreases. Mutual funds, conversely, charge a flat percentage fee. Commission-free ETFs, which are offered by some brokerage firms (including Charles Schwab, Fidelity and TD Ameritrade) are even more advantageous from a cost standpoint.

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Annuities Now Allowed in Target Date Funds

Posted on December 10, 2014 | AAII Journal

Deferred annuities are now to be held by target date funds within qualified defined-contribution plans, such as 401(k) plans. The inclusion of annuities allows target date funds to provide lifetime income to employers holding such funds.

Target date funds alter their allocations by their date. Far-dated funds use an aggressive allocation strategy and the allocations gradually grow more conservative as a target date fund approaches its target date. The changes are designed to match the investment needs of various age groups.

Currently, widely available target date funds do not have an age restriction. This presents a difficulty for insurers, because it makes pricing an annuity contract difficult. Insurers prefer a restricted age group for making actuarial assumptions. By restricting specific target date funds to older employees, however, a retirement plan would run afoul of the discrimination clause in the tax code. The tax code bans qualified plans from discriminating “in favor of highly compensated employees.” To the extent that older employees have higher salaries than younger employees, restricting access to investors within a specific age group by a target date fund could cause problems.

The tax code does allow the Internal Revenue Service some flexibility in establishing guidelines for qualified plans, and the agency used this flexibility to create a special rule. Target date funds in qualified plans can now restrict the age of their shareholders if certain conditions are met. The series of target date funds offered within a qualified plan must all have the same manager and use the same generally accepted investment theories. The target date funds available to older employees can include deferred annuities, as long as those contracts don’t provide a guaranteed lifetime withdrawal benefit (GLWB) or a guaranteed minimum withdrawal benefit (GMWB). Fees and expenses must be determined in a consistent manner and the target date funds can only hold the employer’s securities if such securities are publicly traded.

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Selecting a Valuation Method to Determine a Stock’s Worth

Posted on December 9, 2014 | AAII Journal

Investing is about earning a financial return. Valuation is at the heart of investing—you need to find a stock selling at an attractive price relative to its intrinsic or underlying value, otherwise your prospects for a financial return are poor.

Wait, you say, that sounds like value investing and I am a growth investor. We feel this dichotomy is unnecessary. All investing is about identifying companies for which we expect to earn a handsome financial return. Why would we want to buy companies selling above their intrinsic value? We might be willing to buy them if the current price is equal to the intrinsic value, as a fair financial return would be expected. However, ideally we would prefer to find companies where the current price is well below intrinsic value. Whether you are a value investor or a growth investor, you are likely concerned about the price you are paying relative to intrinsic value (including the company’s growth prospects). All investors should therefore assess the value of the company using some valuation method and compare that value to the current market price. Doing otherwise is to speculate, not invest.

All valuation methodologies are not created equal and no single method applies to all companies or works in all market conditions. Some valuation methodologies are more appropriate in certain circumstances and not in others. In this article, we examine different valuation methodologies and provide guidance for selecting the method most appropriate in particular circumstances.

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The Individual Investor’s Guide to Personal Tax Planning 2014

Posted on December 5, 2014 | AAII Journal

We start this year’s tax guide with some good news: You may have a smaller federal tax bill in 2015.

The Internal Revenue Service (IRS) adjusted several line items to account for inflation. This indexing increases the dollar amounts defining each tax bracket and the dollar amounts for various exemptions and deductions. The net result is that less of your income may be taxed. Plus, if you are just above the breakpoint for a tax bracket this year, the adjustments could potentially put you into a lower tax bracket in 2015.

The amount of any federal tax savings will vary by taxpayer. Some of you may actually pay more, particularly if your income is higher in 2015 or if there are certain exemptions or deductions that you no longer qualify for. A new penalty for not having health insurance is now in effect as well. Still, many taxpayers will get a savings next year. Wolters Kluwer, CCH estimates that a married couple with total taxable income of $100,000 will pay $125.50 less in income taxes in 2015 than they will on the same income in 2014, assuming they file a joint return. An unmarried person with income of $50,000 will pay $62.50 less in 2015 than he or she will in 2014. Keep in mind that these are just estimates. The numbers also exclude the impact of state and local taxes.

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Christine Benz’s checklist for rolling over your 401(k)

Posted on October 22, 2014 | AAII Journal

If you are changing jobs or are close to retirement, you will be considering what to do with your 401(k) plan assets. Even if you ultimately decide to leave your investments in your former employer’s plan, you should investigate your options to ensure you are making the best choice. Morningstar’s Christine Benz created a checklist of steps to take.

Check your account value: Account balances above $5,000 open the door to many options, including leaving it with your former employer (if the plan allows you to do so) or rolling it into an IRA or your new employer’s 401(k). If your account balance is below $5,000, your former employer can legally remove you from its plan. Balances below $1,000 can be cashed out.

Determine whether you want to stay within the 401(k) confines: This decision will be partially determined by your former and/or current plans’ guidelines. If you are allowed to do so, you will need to weigh the pros and cons. Employer retirement plans offer some protections and can give you access to fund options not available outside the 401(k) structure. Alternatively, moving your account outside of the 401(k) structure gives you more choices.

When making this decision, compare the costs and fund selection of the 401(k) plan(s) against the options available to you through an individual brokerage or mutual fund account. If you like the 401(k) structure and have the option of either staying with your former employer’s plan or moving it to your new employer’s plan, you will need to compare and contrast the two. Also, look at your options for rolling over to an IRA account, which can be held at the brokerage firm or mutual fund company of your choosing.

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Weight by Fundamentals, Not by Price

Posted on October 15, 2014 | AAII Journal

Robert “Rob” Arnott is the chairman and chief executive officer of Research Affiliates. He has published many research papers, served as the editor in chief for the Financial Analysts Journal and pioneered several unconventional strategies, including the Fundamental Index approach. We spoke recently about his quantitative approach to managing stock portfolios.
—Charles Rotblut

Charles Rotblut (CR): Given your background in quantitative analysis, what suggestions could you give individual investors regarding stock characteristics and ratios that lead to better returns?
Robert Arnott (RA): The characteristics that historically produce the best returns are value measures. A higher yield does deliver a higher return and a lower price-earnings ratio delivers a higher return. One of my favorites is a lower price-to-sales ratio. While largely ignored, it does deliver a higher return.

To me, the more important opportunities are not so much in individual stocks as they are in portfolio construction. Typically when you buy a stock, the size of your investment in that stock drifts up and down with price—the higher the price, the higher the weight of the stock in your portfolio. That’s also the Achilles’ heel of market-capitalization-weighted index funds. So reweighting the portfolio to mirror the economic footprint of the business—something we call the Fundamental Index approach—weights companies by the fundamental size of the business and not by the popularity or price of the stock. This turns out to add a lot of value, partially because you’re trading against the market. As the stock’s price soars, if the underlying fundamentals aren’t soaring, if the company isn’t actually getting bigger, then a Fundamental Index portfolio will prompt you to sell some of what you own.

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