Investing & Markets

Personal Finance Series | Part 5 of 6

“God is able to make all grace abound to you, so that in all things at all times, having what you need, you will abound in every good work” (2 Cor. 9:8)

By COL Ray E. Porter III, USA (Ret.)

I am convicted by the thought that the Lord has blessed me and that I have an obligation to share. Scripture does not tell me to sit and wait, but to use His blessings of intellect, education, energy, opportunity and heart to be that good steward who multiplied the talents (Matt. 25:14-21).

Paul is clear and strict in telling the Thessalonians to work and support the ministry (2 Thess. 3:6-12). I know many of you find more good works than your tithe can support, so to get beyond tithing and on to gifting you need to multiply His blessings. This is the purpose of investing, and the better we do it, the more we can give back to His work.

The investment menu is extensive, but your choices are generally made from a short list based on your need for return and your tolerance for risk. The common spectrum runs from low yield, highly safe term instruments such as bank savings, mutual money markets and certificates of deposit (CD) to less predictable, but potentially more lucrative, equities (stocks) and equity mutual funds. Bonds are generally in the middle, offering more potential return than money markets at a greater risk.

Within mutual funds there are wide variations in risk and return and combinations of bonds and stocks. I want to defer discussion of bonds, and instead, tell you there are mutual funds with combinations of bonds and stocks called either Balanced with a fixed allocation or Asset Allocation where the allocation changes with market, or anticipated market conditions. A simple risk scale would show risk increasing from pure term through different mixes and peaking with all equities. But how about return: What can you expect? There is no direct answer so you need a system to understand the “norms” of recent equity market experience.

The simplest system I’ve seen for reducing millions of bits of data to twenty columns on a pre-screened list of funds is that offered by Sound Mind Investing (SMI). Austin Pryor combines fundamental Christian principles with risk and return performance data to organize funds into four categories. He uses the Morningstar database to present us with a monthly list of hundreds of funds (reduced from 7,000) for our consideration by category for stages of life. Their website offers great educational material, but detailed investment advice requires membership. I recommend everyone visit the home page to see what is available.

The SMI system organizes equity mutual funds into four categories drawn from the Morningstar’s nine. The criteria are size and investment style. Companies are Small or Large, and are “value or growth.” Value mutual funds seek companies currently out of favor which are bought cheap with the expectation (hope) of recovery: Chrysler, when the government had to bail them out, drugs when the Clinton administration attacked them in 1994, and recently tobacco. Growth funds pay top dollar for companies with records of strong annual growth and expect it to continue. Amazon, Texas Instruments, Pfizer, and Visa are examples of “blue chips.” (Morningstar adds a blended category and a medium size category for its nine.)

SMI then measures performance over a number of periods up to three years and expense of buying/owning and computes risk and return scores based on standard deviations from the performance of the S&P 500 Index (discussed as an investment below). These scores are expressed in relation to 1.0, the performance of the S&P500.

For example, Austin Pryor highlighted Weitz Value fund with risk of .8, or eighty percent of the S&P 500, and performance of 1.2, or twenty percent better then the S&P 500.

Average annual returns and risk scores when applied to the four categories give you a relative understanding of each.

Note that no category has a return score better than its risk score. In fact no category beats the standard. The S&P 500 is the standard for risk at 1.0 and its eighteen percent return for the decade is the return standard of 1.0. Understanding this is a good start point for making selections for your portfolio. You are seeking individual funds that have historically (three years) beaten the standard. You start looking for those funds within the category(s) that fits your investment needs. Austin Pryor’s Quarterly Review provides data on a couple hundred funds in each category. Monthly, he provides Recommended Funds and guidance for people at his four levels of investing.

There are many other ways of categorizing funds. You will see funds described as Aggressive Growth, Sector, Global, International, Regional, and more. If you were seeking the highest possible return, you might buy high-risk investments such as Aggressive Growth or Sector mutual funds. Think “dot.coms,” internet/telecommunications and biotech/human genome sciences. Many such investments tripled and tripled back in 2000. Stocks opening at $10 run up into the high $100’s only to finish the year in low single digits.

If you do not need high rates of return or cannot tolerate a high rate of volatility and risk, you might focus on insured term investments averaging around six percent, or various bond or blended funds. SMI evaluates Balanced and Asset Allocation funds that generally return .6 of the S&P 500 for about .6 risks. However a recent Quarterly Review highlighted two funds with .6 risk/1.1 return and .8 risk/1.1 return.

The right answer for most families avoids extremes, combining both term and equity investments. To make these judgments you need to have defined goals and understand what money does over time (TVM) as discussed in articles 2 and 3. Your research should then gain an appreciation for recent norms of equity and market performance, such as reported in SMI or Morningstar.

“Commit to the Lord whatever you do, and your plans will succeed” (Prov. 16:3).

Over the years investment may exceed expectations allowing reduction to risk, or they may under-perform your planning factors requiring adjustment to goals or more aggressive investments. All fund performance data is historic and not necessarily a prediction of the future, but it is a guide. It is not very reliable for any one- to two-year period, but has been fairly consistent for 3 or more years.

There are other categories of funds and many focuses by the various funds. A diversified portfolio may include lower risk bond, types of income and blended funds or more aggressive international funds. There are also funds focused on sectors such as Biotech of Computer Software.

Morningstar is the definitive research source for mutual funds. They list forty-eight categories of funds: twenty-eight equities and twenty bonds including nine domestic funds which are a combination of size: Small (<2B), Medium, and Large (>8B) capitalization, and orientation: Value, Blend and Growth. This 3 x 3 matrix will encompass most pure equity funds of interest to the average investor. Your choices are first, which category (based on risk/return) and then, which fund (based on performance). Morningstar’s spreadsheet lists over 1,700 mutual funds down the page and ninety-six bits of data across the page. Far too much data to manage, but their various tools can be very useful.

“Be sure you know the condition of your flocks, give careful attention to your herds . . .” (Prov. 27:23).

Many libraries carry the Morningstar Reference book (magazine) with a full page of data, analysis, and verbal discussion of each fund. This information is also available in an online subscription (expensive, so check in larger libraries). It is a useful tool where you can enter criteria (your choice of ninety-six columns) and get a data sorting. This can reduce 1,700 funds to eight or eleven that are worth additional research on their individual Morningstar pages. Finally, they offer parts of these capabilities free at Morningstar.com. If you spend fifteen minutes on any of their funds, you will probably know more about that fund than some you own–which should cause you to ask why you bought it and should you keep it.

Less technical is their Star Rating for three-, five- and ten-year periods where the Morningstar Risk score is subtracted from their Return score and grouped (one to five stars) as top ten percent, followed by 22.5%, 35%, 22.5% and bottom ten percent. This system is easily grasped by the military, which also recognizes rank based on number of stars. A five-star fund is one that over the rated years is in the top ten percent on a risk/return basis.

Which funds to buy, how long to hold, how many to buy? Thinking about the portfolio theory charts in article 2 helps you develop a strategy. You are seeking appropriate risk/return, and diversity. For many, this will mean owning five to seven mutual funds and avoiding having more than twenty to twenty-five in any one fund. These are long-term investments, so you let time work for you. You don’t change funds often and you don’t need to own funds in the top ten- percent or the ones so heavily advertised as top in their category every year.

A reasonable goal is having all your funds in the top half most years. If one fund significantly under-performs the market for several years, you should consider switching unless it was bought as a “Value” in an-of-favor sector that you expect to recover soon. The sell decision is the hardest for us to make. We don’t often sell winners, so the ones you need to sell are the ones where you have to accept a loss or admit a mistake. Still, in investing, it is smarter to admit an error than compound it by continuing to sub optimize your portfolio.

How often to trade? SMI offers a spectrum from “Just the Basics” strategy with annual changes designed to equal “the market” and an “Upgrade” strategy with monthly advice and above market expectations. If you are doing your own study and making your own decisions, you need to be patient and focus long term. A more aggressive approach is regular weeding of the portfolio. An old Wall Street chestnut answers the question, “When to sell?” with “When you find a better investment.”

Another way to research mutual funds is through the many monthly financial magazines or their web sites. Most publish an annual performance report in February. Barron’s lists annual results on the second Monday in January and the Wall Street Journal during the first couple of publishing days of a new year. First you look up the funds you own and then look for funds recommended by multiple sources. If they fit your style and diversity requirements, a Morningstar or SMI search may be appropriate. I put together a spreadsheet with the funds which several of these magazines have recommended and compare about eight bits of data on each and then go to the Morningstar page. One warning. The covers of these magazines that advertise the “Top 10 Funds for Next Year” are advertisements designed to catch YOU.

Your research is very important and should be viewed within a larger frame of reference. Your goals are long term and so should your investment be. The market will always fluctuate and you want to be positioned to weather periods of downturn. Fidelity’s great fund manager, Peter Lynch, points out that many people have the head for investing, but not the stomach. We look back at the 1990s as a great up market, yet from July to October 1998, the NASDAQ fell twenty-nine percent while the S&P 500 and Dow dropped nineteen and seventeen percent respectfully. The year 2000 saw the NASDAQ fall fifty percent from an historic high in March to a point in early December. You don’t want all the eggs on that roller coaster basket.

Another risk is in believing advertising. There are hundreds of ways of classifying mutual funds and an infinite number of time periods. When a fund advertises it is number one, for a period, it mostly means within their parameters, they are number one. When a fund claims seventy-five percent one-year return, and 28.3% three-year return, it means one year in which their style or top holdings were in vogue and two years of five percent returns before that. Want to guess on performance for next year? Want to bet on it? I look at year to date, twelve-month and thirty-six-month periods for performance and consistency.

Is there a place for individual stocks? We have discussed mutual funds because that is the right place for most people. With stocks you are taking greater risk, you need more research and more constant supervision of the company, the industry and the economy. You do have more control and can minimize your tax liability since you control selling for capital gains. (Most mutual funds generate high turnover–average eighty percent a year–and by law must distribute gains to you–usually in December).

Diversity is harder to achieve with stocks, as you need sufficient assets to buy stock in eight to ten companies. Individual stocks are more volatile than mutual funds and with less diversity, any one stock slide can noticeably hurt your entire portfolio. You may not quickly pick up on the fall of one stock and you will probably hesitate selling until it is a loss, then you hate to admit it and sell. Mutual fund managers are supposed to do all this for you and may be able to anticipate changes in sectors of the market.

Still, a serious investor may find it advantageous to invest primarily in stocks. More common is a situation where an individual investing primarily in mutual funds, buys a few individual stocks. They may be of particular interest or in an area of personal expertise. If these stocks would constitute only a small percentage of one’s total equity allocation, then you wouldn’t worry so much about diversity. Either way, each investor should consider which type of investment best fits their level of expertise and time available for management.

One type mutual fund compensates for several common fund disadvantages. Index funds are not “managed” like other funds, where highly paid managers are backed by economists and hundreds of people doing company research. They simply buy a published index: no analysis and no stock picking. The Standard & Poor’s 500 Index is the best known, containing the 500 largest American corporations accounting for eighty-five percent of the value of U.S. stocks. Index funds have low turnover, only exchanging stocks when the index changes, and thus are very tax efficient, average .19% in fund expenses vice 1.38% for the average fund and require little research.

However, because they are not managed, they may underperform in a down economy, but the largest Index S&P 500 fund returned 17.68% (Barron’s 10 Jan 2000) during the 1990s (18.21% with dividends reinvested) and 17.28% for the last three years (98-00). Many people consider a major index fund as a core holding around which other funds are selected for diversity and risk management. They are ideal for inclusion in long-term education and retirement accounts.

A balanced portfolio traditionally also includes bonds or similar term holdings. It is common for investment firms to publish recommended allocations based on expected market conditions. For example, sixty-percent equities, thirty-five percent bonds and five-percent cash. While bonds normally underperform equities, their greater predictability, guaranteed income and safety are considered an important balance to the risk and uncertainly of equities. During the last five years of the 90s, the Lehman Brothers Aggregate Bond index gained 6.5% annually vice the S&P 500’s twenty-two percent return. The year 2000, however, is the exception which proves a point as the LBAB index returned 9.14% while the S&P 500 lost 10.1%.

Investors can also choose from a large variety of risk and rates of returns from within the term investment community. Bonds carry risk and it is easy to identify. For any given term length, the higher the rate, the higher the risk. They range from hyper-safe U.S. Treasuries returning about six percent to High Yield bond funds (marketing term for junk bonds) paying up to thirteen percent.

Most bondholders should buy them within a bond fund for diversity and ease of management. Municipal bonds, with their tax-exempt status, may have a place in high-income portfolios. U.S. Savings Bonds have some college savings and tax deferral advantages, but generally weak rates of return. Most people I know with military type pensions (with annual COLA’s) do not feel the need for allocating more than ten to fifteen percent to bonds, but it is a sound strategy for some. Remember; do not take more risk than you need.

Investing is a long-term proposition. The risks of trying to move in and out of the market are too high for the average investor. Quality balanced investment over time has long been the key to reasonable return at acceptable risk. Historic returns since 1926 are: Treasuries 3.7%, Bonds 6% and equities 11%. Time reduces the effects of volatility so that any strategy other than long term, involves more risk.

A dated, but relevant, study showed that during 816 months between 1926-93, one dollar grew to $683, but if you missed the single best month, return dropped to $461. Take out the best forty-eight months (six percent of the time), return dropped to $6.83 (Ibbotson & Associates). The only losers were on the sidelines. Long-term investors win over the long term, no redundancy intended.

Let’s revisit our case study family and see what they consider appropriate for their goals. First, Captain Steward wants three months’ pay available in easy access (liquid) money. But not wanting to sacrifice return, he checks the money market mutual funds (MMMF) listed regularly in financial newspapers or magazines and finds a major company fund with $1000 minimum investment that is paying 6.51% (Dec 00 Kiplinger’s Personal Finance) vice a national average of six percent. He puts the $10,000 in long-term savings and will seek a higher return on the $200 per month he is adding to that fund.

During the 90s, Growth mutual funds returned twenty to twenty-two percent, but since the Great Depression, the long-term average has been in the ten- to twelve-percent range. As his monthly deposits accrue he plans to invest in one Growth & Income fund and one Large Capitalization Growth fund. He may well exceed the eight-percent return so that at some point the average of these investments with the $10,000 at 6.5% will give him the desired eight percent, possibly more. He knows he can adjust as he goes: this is just a plan.

For his Short-term account he does not have the luxury of time to ease the risk, so he starts with another top-rated MMMF. As the account grows, he reviews different rates of return and selects among two- to three-year Certificates of Deposit yielding around seven percent. He stays away from equities because of the risk over any short period. If the fund outgrows his short-term needs, he starts adding new money to his long-term account for better returns.

College is his next concern. His plan calls for earning more than term investments are paying and given his time frame of fourteen years he decides to accept the risk and volatility of mutual funds. He will use a “One Source” (Charles Schwab (C)) type account where he has a money market mutual fund and can buy a variety of no load mutual funds from different fund families. The money fund pays six percent while he decides on a couple of no-load–maybe Large Blend–Mutual funds that for the past ten years have returned an average of 13.4%. If he fell behind or expected cost went up, he would shift to more aggressive Growth funds.

His Retirement account will become his largest asset during the next thirty-two years; the length allowing him to let the dynamic of time reduce the risk of equity holdings. He starts with one S&P 500 index fund, one Large Cap Growth fund and one Mid Cap Growth fund. As assets grow he will consider adding to diversity with ten percent slices of an International fund or an aggressive growth or sector fund. There is no limit on this objective, so he can continue to add aggressive funds as he meets other objectives. But he never wants to risk goals already obtained so he can also adjust risk down as he nears the objective.

Nothing in this example is a rule. They are reasonable judgments for their situations. You can take more or less risk, you can spend ‘too much” on college to the determent of all other areas. You can consume more today and sacrifice security and flexibility in the future. To the extent you have a disciplined savings habit and the more you understand the options, you will be able to shift investments and new cash flows to adjust to what your accounts have experienced and changed needs. You decide to deviate, but it should be a decision, not a default, and it should be from a plan.

Finally, a brief comment on accounts and brokers. The evolution of the One Source type account by Charles Schwab in the early 80s practically solved the problem of having multiple accounts with different fund companies. If you buy mostly mutual funds, do your own research and want ease of management, one of these (different names from various companies) is ideal and also offers the advantage of allowing individual stock trades at discounts over full service brokers.

The full-service broker offers investment advice and a number of valuable services, which might make sense in accounts over $300-400K. The biggest challenge is finding an individual account executive you are comfortable with and who will meet your needs. Personal referral is a good way to find one. Do you need full service? You either need to develop the expertise requisite for individual stock investment and spend the time on personal management or pay someone to do it. With funds, most of us do not need brokers.

There are other options in the form of advisor/investment/insurance firms. Many people have benefited from early involvement with these sales representatives since they started investing earlier than they might otherwise have: they were doing something rather than nothing. With discipline and a little study you can avoid the high charges and loads, and be the ones deciding what is the best investment for your family (a popular high-load contract fund pushed by one of these firms is Fidelity Destiny I which for a three-year period ending 9/30/2000 returned fifty percent of the S&P 500 for ninety percent of its risk). Still, if you are comfortable with their cost/performance ratio and do not want to spend personal time on management, they may be the answer for you.

This has been the briefest introduction to only a few of the hundreds of type investments. I refer you to more study at almost every investment firm website and then more research–starting with what you now own. Also determine what your asset allocation is and decide if it is what is right for your situation and plan. If you are out of balance, gradual change is usually prudent, carefully assessing tax liability (add new money to under-funded areas). Once you are prepared, implement your plan. Today is the best day to invest that you will ever see. It is better than tomorrow, but not as good as yesterday.

“For we are God’s workmanship, created in Christ Jesus to do good works, which God prepared in advance for us to do” (Eph. 2:10). We honor him with our investments if our motives are His work. “Dishonest money dwindles away, but he who gathers money little by little makes it grow” (Prov. 13:11). Scripture often counsels patience and it is true in investments. Merrill Lynch reminds us it is difficult to grow rich quickly, so plan to grow rich slowly. Proverbs 10:22 tells us it is the blessings of the Lord that makes rich…and 1 Timothy 6:7 tells us we can take nothing from this world. Success in investing may be measured in dollars, but we will be judged as stewards, by how we share and use His assets. The final article addresses how to live as good stewards.

About the author: COL Ray Porter, USA (Ret.), is a longtime OCF member and former Council member. He created and taught an elective course on personal finance at the Army War College in the late 1990s—widely regarded as one of the most popular elective courses during his tenure. After retirement from active duty in 1997, he spent several years teaching personal finance and stewardship for churches and military units throughout the U.S. and Germany.

Editor’s note: While some of the specific examples in this series may not be updated according to the latest tax codes or financial data and markets, the principles of stewardship and personal finance still hold true today. The advice and insight in this article alone should not be used to make personal financial and investment decisions. Always consult a financial advisor or accounting professional before making any decisions with regards to your personal finances and investments.