Buy Now Or Buy Gradually Over Time?

A reader asked a question in the comments to my previous post Bought REITs Again. I'm answering it in a new post because the question is quite common.

"If you were to set up a new IRA and pour some cash into it (200K), would you go ahead and dive right in or wait and time? For example, VTI is way down now, so is EEM and other ETFs. Would you consider gradually moving in (say 10% each month?)"

Let's take a look at two scenarios.

Scenario A, if I have $200,000 in an IRA already invested in the funds and asset allocation I like, would I sell all of them for cash now and re-establish my positions gradually over the next 10 months? I would not and most people probably will not either. The funds are fine. The allocation is fine. There is no reason to redo it.

Scenario B, if I'm setting up a new IRA with 200K in cash, would I dive right in or buy gradually over time? What's the difference between Scenario B and Scenario A? Just a few mouse clicks and some small brokerage fees if any. If I use the $200,000 cash to buy the same funds right away, I'll be in exactly the same position as in Scenario A. Therefore I would buy the funds now and keep the funds.

This has nothing to do with whether the funds I will buy have been up or down lately. It all depends on what your answer is in Scenario A. If the answer for Scenario A is hold, to be logically consistent, the answer for Scenario B must be buy now. If the answer for Scenario A is sell and re-purchase over time, the answer for Scenario B must be buy over time. If the answer for Scenario A is sell half and re-purchase half over time, then the answer for Scenario B is buy half now and buy half over time.

The decision is based on the fact that money is fungible. In an IRA with no tax implication, cash, mutual funds, and ETFs can convert to one another at minimum or no cost. Here's the TFB Buy Hold Parity Theorem: :-)

Hold = Buy + Transaction Cost

It means that if you are going to hold an asset if you already have it, you should also buy it if you don't have it, unless the transaction cost is too high.

The logically equivalent corollary is:

Will Not Buy = Sell - Transaction Cost

It means that if you don't have an asset already, and you will not buy it or not buy as much, then if you already have the asset, you should sell it or sell down to the level you would otherwise buy immediately, unless the transaction cost is too high.

Unsure About Socially Responsible Investing (SRI)

I read this question in a recent issue of the Yoga Journal magazine:

"I don't want to support tobacco companies or environmental polluters, but my broker claims that socially responsible investing will cost me. How can I persuade my broker to make investments that align with my values?"

The official answer from the magazine pointed out how the reader should go about investing in socially responsible funds. Unfortunately the magazine doesn't have the article online. I'd like to address some other issues not covered by the answer in the magazine.

First of all, this reader owns the investments, not her broker. If she wants to invest in a certain way, she doesn't have to persuade any broker. The broker can give his or her opinion but the investor gets to make the final decision. Don't be afraid. It's your money.

Second, if socially responsible investing (SRI) is good for the world but it costs you, should you still do it? Sure. We can't expect something good for nothing, can we? When push comes to shove, that's the real test for our commitment. Are we ready to make personal sacrifice for the health and for the environment, or are we just paying lip service? If you want to do something good, be prepared to pay one way or another. If the cause justifies the cost, by all means do it.

Although I identify with the goals of socially responsible investing, I'm unsure about its effectiveness, especially when SRI comes in the form of avoiding investment in certain industries or companies. I'm not sure if we necessarily make the world a better one if we just don't buy certain stocks. Buying a tobacco company's stock doesn't make the tobacco company produce more cigarettes. In most cases (except in IPOs), the stock just changed hands from one investor to another. The company didn't get a penny more. It is still doing what it has been doing. If people who don't like cigarettes all shy away from tobacco stocks, only people who don't object to cigarettes will own those stocks. That will probably make the company become more aggressive in making and marketing cigarettes. So I'm not sure how not buying tobacco stocks is going to help reduce tobacco use in this world. On the contrary, if people who want to be more socially responsible own the tobacco stocks, they can elect like-minded directors and make the companies change their practice. Wouldn't that be more effective?

Personal Finance Quiz, September 2007

Here are some of the questions from visitors to this blog who looked for the answers using a search engine. Without searching, which ones can you answer? Regular readers should be able to answer most of them. Oh, may be not the last one. Let's see who can answer them all.

Q. Are FHLB bonds taxable?

Q. Is Fidelity TIPS fund good?

Q. Is Netflix factored into CPI?

Q. Are 403b contributions exempt from social security tax?

Q. Are charitable donations allowed in AMT?

Q. What Chinese IPO's were issued in May of 2007?

Q. Is expense ratio included in yield?

Q. Do Vanguard money market funds invest in subprime loans?

Q. What does it mean to buff a company?

Q. What if I lie on my life insurance application?

Q. What happens if you don't pay your mortgage?

Q. What is generation x up to now?

Risks in Money Market Funds

Reader Kim asked, referring to my post Which Vanguard Money Market Fund? in April,

"In light of the current sub-prime meltdown, some people are questioning whether they should move out of Vanguard Prime MMF into something safer, like Vanguard Treasury MMF. Your blog helps calculate return under different scenarios but leaves off the risk aspect.  Would it be of interest to you to add in some additional calcs. to quantify the risk v. return aspect to give a better picture on each fund?  I am very interested in this issue because it is often neglected.  Thanks!"

I left off the level of risks in the different Vanguard money market funds because I thought (and still think) that difference in risks is only theoretical. The Vanguard Treasury Money Market Fund (VMPXX) and the Vanguard Admiral Treasury Money Market Fund (VUSXX) invest only in Treasurys. They are the safest because the Treasurys are guaranteed by the full faith and credit of the U.S. government. The Vanguard Prime Money Market Fund (VMMXX) invests in high quality, very short term debt issued by corporations. It also holds Certificates of Deposit with banks both in the U.S. and overseas. See the list of holdings from the SEC filing as of May 31, 2007. The various tax-exempt money market funds invest in debt issued by state and local governments and their agencies. These are still safe because Vanguard only invests in issues with high credit quality.

If someone is really worried about these money market instruments defaulting, they should look at the stocks part of their portfolio because those companies would have to go bankrupt first before they default on their money market debt. If you invest in the stock market at all, don't worry about the money market fund. If there were massive defaults, you would likely lose a lot more money from the stock market than from money market funds. In such a scenario, money market funds would be the least of your concerns. 

I don't worry about the theoretical risk difference between the different Vanguard money market funds. However for many people the extra safety afforded by the Treasury money market fund comes for free. The Treasury Money Market Fund yields a bit less, but because the interest income on Treasurys are exempt from state and local income tax, its after-tax yield can be higher, or at least not that much lower, than that of the Prime Money Market Fund. When the Treasury Money Market Fund yields higher after tax, it's a no-brainer. Even if it still yields a bit less, the difference you give up for the peace of mind may very well be worth it. It depends on how much you have in the money market fund. For example if a Texas resident (no state income tax) in 25% federal income tax bracket has $10,000 in a money market fund, the difference between the interest earned from the Treasury and the Prime money market funds is $33 a year after tax. Although I'd be fine investing in the Prime Money Market Fund, if giving up $33 a year gives someone the peace of mind, I have no problems with it. We blow much more than $33 a year on many other stuff.

Avoiding the Worst Days and Missing the Best Days

Two readers commented about avoiding the worst days on my post about the meaningless stats on missing the best days. The stock market had some bad days since then. I think some might be interested in reading about avoiding the worst days.

First I want to emphasize that the whole point of my previous post was that it's IMPOSSIBLE to miss the best 10 days in 10 years. The odds are 1 in 2.8 billion billion billion, which is like winning the Powerball jackpot with a single ticket purchase back to back to back. By the same calculation it's equally IMPOSSIBLE to avoid the worst 10 days. But since they asked, I compiled some numbers for avoiding the worst 10 days in 10 years. So here you go, more meaningless stats.

The rewards for avoiding the worst days are equally as impressive as the penalty for missing the best days. Look at this chart:

 

$1 invested for 10 years turned into $2.24 if left untouched. If the best 10 days had been missed (IMPOSSIBLE), it would grow to only $1.40, barely beating inflation. If the worst 10 days had been avoided (IMPOSSIBLE again), it would become $3.67, a huge jump. If both the best 10 days and the worst 10 days were taken out, they would cancel out each other -- $1 would grow to $2.29, similar to the $2.24 number if left untouched. So don't worry about missing the best days or try to avoid the worst days.

The exercise did produce some useful insights. Between July 1, 1997 and June 30, 2006, which is the timeframe Schwab used in its article, the best 10 days and the worst 10 days for S&P 500 were: 

All together the best 10 days were up 60%, and the worst 10 days were down 39%. You see the best days don't necessarily fall in bull markets and the worst days don't necessarily fall in bear markets. 7 out the 10 best days happened in the bear market from 2000 and 2002, during which the S&P 500 index lost 38%. 4 out of 10 worst days happened in 1997 and 1998, when the S&P 500 gained 71%. 

The bottom line is that the stock market is volatile. Sometimes it goes up and down a lot. A good day on the stock market doesn't necessarily mean good times are ahead. A bad day doesn't necessarily mean good times are over. Ignore the noise.

Personal Rate of Return: Dollar Weighted Or Time Weighted

After reading my post about estimating overall personal rate of return, a reader Brian asked:

"I have a Fidelity serviced 401(k) and I had always wondered about how they calculated the personal rate of return. Do you know how/if other providers calculate personal rates of return? If I were to open a brokerage account, is there one company that does this better than others?"

Rates of return fall into two major categories: Dollar Weighted Rate of Return and Time Weighted Rate of Return. They measure different things and they should be used for different purposes.

Dollar Weighted Rate of Return measures how much your investment dollars returned on average. Use this measure when you want to see if your return is above or below your long term return objective. The method for calculating the Dollar Weighted Rate of Return is XIRR. You will need to know the beginning balance, the date and the amount of your every contribution (and withdrawal, if any), and the ending balance. With a computer, the calculation itself is not difficult but collecting all the data can be tedious.

Time Weighted Rate of Return measures how much the combination of your investment choices returned on average, without the influence of the size and timing of your own contributions or withdrawals. There's a subtle difference here. Time Weighted Rate of Return ignores the effect of the external cash flows, that is, the cash flows from you. Use this measure when you want to see how your investment choices taken together, including any changes you made to your investment choices, returned compared to other choices or an index. There are two primary methods for calculating the Time Weighted Rate of Return: Daily Valuation and Modified Dietz. Daily Valuation is more accurate. Modified Dietz is a close approximation. For practical purposes, there's not much difference between those two calculation methods.

The personal rate of return you get from a financial service provider like Fidelity or Schwab is usually a Time Weighted Rate of Return. If you want a Dollar Weighted Rate of Return, you will have to do it yourself.

Let's put these in an example. Say you had $10,000 at the beginning of the year and your investments did great in the first 3 months. Your $10,000 turned into $12,000 without you adding a penny. Now on April 1, you put in $20,000 more, but your investments stalled in the rest of the year, and you end the year with $32,000. So you made 20% on $10,000 in the first 3 months and you made 0% on $32,000 in the next 9 months. If you plug in these values in a spreadsheet and use the XIRR function, you get 8%. This makes sense because:

10000 * (1 + 8%)^1/4 = 10194
(10194 + 20000) * (1 + 8%)^3/4 = 31988

Pretty close except for rounding. If you didn't put in additional $20,000 on April 1, your return would've been 20%. That's how your investment choices did and that's how Fidelity or Schwab will report to you. There's a big difference between the 8% Dollar Weighted Rate of Return and the 20% Time Weighted Rate of Return because the cash flow in this example is unusually large. If we change the additional contribution on April 1 from $20,000 to $1,000 and have the end of year value at $13,000 instead of $32,000, the two returns would be much closer. The Dollar Weighted Rate of Return would be 18.6%, and the Time Weighted Rate of Return would still be 20%.

Finally, because financial service providers typically provide only Time Weighted Rate of Return, and because the actual calculation methods for Time Weighted Rate of Return (Daily Valuation and Modified Dietz) yield similar results, there is no reason to believe that one company does it better than another. 

For more information on Dollar Weighted Rate of Return, Time Weighted Rate of Return, Daily Valuation and Modified Dietz, if you are not afraid of math formula, please read this article from dailyVest:

• Personal Rate of Return/Investment Performance Calculation Methodologies & Assumptions

ESPP: What's In It for the Company?

After reading my post about ESPP, a reader David sent me an e-mail and asked

I've read a bunch of stuff about ESPP and while everyone talks about what a good deal it is for the employees who are able to participate, or the tax consequences of the various ways to sell the shares, no one talks about what is in it for the company offering the plan. Any ideas?

My colleagues and I find it hard to believe that our company would offer this without some significant benefit accruing to the company. The $25k limit makes it a drop in the bucket for the bigwigs. So perhaps there is some larger corporate tax savings?

I like this line of thinking. There are always two sides to a coin. Many times the issue becomes very clear when you consider the other side. I do that a lot, like who pays for credit card rewards, whether investing in payday loan companies is a good idea, and what's going on with the mail-in rebate prepaid debit card.

Back to the question David asked. There are two main reasons companies set up ESPP plans. Before 2005, companies were not required to book an expense for stock options and ESPP. ESPP and, to a larger degree, employee stock options, were cost effective ways to compensate employees. Companies compete for talents. They can pay their employees either in additional cash or via ESPP and stock options. Back then a company didn't have to book an expense when they let employees buy stocks at a discount as long as their ESPP plan met the requirement of section 423 of the tax laws. Employees got a profit at no cost to the company. If the company paid the employees the equivalent amount in cash, they would've had to book an expense and negatively impact their earnings.

Companies do get a tax deduction when employees sell the shares and realize wage income, but they would get the tax deduction anyway had they simply paid more cash to the employees. So tax deduction was not the reason companies set up ESPP programs. Not having to book an expense was.

ESPP plans also create employee loyalty. When employees own stocks in the company (if they didn't sell right away), they are more likely to work harder. In management buzz words, the employees' interests are "aligned" with the company. Although employees are allowed to sell right away, many don't because of the endowment effect -- if you give them cash they won't buy the stock but if you give them stock they won't sell it for cash -- or because they wanted to gamble for the favorable tax treatment.

The accounting rules changed in December 2004 when the Financial Accounting Standard Board (FASB) issued FAS 123(R). Now companies are required to book an expense for their ESPP unless the discount is no more than 5% and the program doesn't have a look-back[1] provision. As a result, many companies discontinued or scaled back their ESPP plans. Many of them reduced the discount from 15% to 5% and removed the favorable look-back provision in order to comply with FAS 123(R) and keep the ESPP off their income statement.

For competitive reasons, some companies chose to keep their program as-is at an increased cost. Count yourself lucky if your company still offers the 15% discount with a look-back feature. A 5% discount to the purchase price at the end of the period reduces the annualized return from about 90% to about 20%. It's still profitable, but it's not nearly as nice.

 [1] The look-back provision allows the employees to buy stocks at a discount to the stock price at the beginning date or the price at the end date, whichever is lower.