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Booknotes: Morningstar Guide to Mutual Funds

November 18th, 2008 at 01:16 pm

When I read a good financial book, I like to take notes for my future reference and for the benefit of others here who might be inspired to go read it. You can see my past entries by clicking on the Booknotes catagory.

I actually read The Morningstar Guide to Mutual Funds several months ago, and just came across my notes -- so the details may be a little rusty. It was well-written, but I find I have a mental block when it comes to reading about investing (very odd considering I'm a bookworm who averages about a book a week.) It took me several libary renewals to get through this one.

This book is the first one I've read that really focuses on the process of how to choose a particular fund, as opposed to generalities of what mutual funds are, and for that I highly recommend it. It explains how to use the information available on Morningstar's website to choose funds.

Questions to ask yourself to check whether you thorougly understand a fund:
* What does the fund own (style, catagory sector)
* How has the fund performed? (3,5,10 year returns, calendar year return, average annualized return, after-tax return)
* How risky has the fund been? (standard deviation, top 10 concentration, Morningstar risk rating)
* Who runs the fund? (fund manager's history)
* What is the fund family like?
* What does the fund cost? (loads, expense ratio)

Know what a fund owns:
* Understand the style box -- this tells you if the fund invests in small, medium, or large companies, and also whether it buys stocks because they are "on sale" (value - a good price compared to history for that stock) or are expected to increase in price quickly (growth) or a combination (blend).
* Check the sector weightings. This tells you how much the fund is investing in different kinds of companies -- say banking, industrial, or high tech
* Check the number of holdings (more stocks = less risk)
* Check the turnover rate (lower is better). If the fund buys and sells a lot, trading fees will decrease the return.

Performance -- things to look at when comparing funds:
* Annualized return
* After-tax return
* Compare the fund's return to the right benchmark

* large cap: S&P 500
* small cap: Russell 5000
* foreign: MSCI EAFE
* taxable bond: Lehman Brothers Aggregate Bond

* Also compare the fund's return to the Morningstar index for corresponding style box
* Look at the long-term history -- the 3, 5, and 10 year returns
* Note how long the manager has been with the fund -- good historical results may have come from a previous manager
* Look at the calendary year returns -- this will tell you if one exceptionally good year is making the other long term results look better than is warranted.

Analyze the Fund's Risk:
* Add up the % invested in the top ten holdings -- how concentrated is the fund in these stocks?
* Style risk: Large-value is the least risky, small-growth has the most risk
* Past volatility: look at the worst calendar year. If it happened again, would you be willing to ride it out or would you feel compelled to sell?
* Standard deviation: this tells how much the fund has varied from the 3 year average. 68% of the time, your return will be within 1 standard deviation. Lower is better (means the fund is more consistent). Compare a fund's standard deviation to the standard deviation of the index.
* Morningstar's risk rating:
* low: least risky 10% of funds
* below-average: next 22.5%
* average: the middle 35% in terms of risk
* above-average: next 22.5%
* high: most risky 10% of funds

Evaluating the Fund Manager
* Look for 10 years experience as an analyst or portfolio manager, with at least 5 of these years as a portfolio manager
* Seek ones who spent their early years at a high-quality firm like Fidelity or American Funds
* Management changes -- consider selling if the management changes and the fund is from a small family has just a handful of fund, or if the fund is the only good one in that family, or if the catagory is small or emerging markets

Analyze Costs
* Growth, small-cap, and international funds will have higher expense ratios because they require the fund to do more research.
* Look for funds charging < 1.25%
* Compare the fund's expense ratio to the following averages:
* large-value: 1.41
* large-blend: 1.24
* large-growth: 1.5
* mid-value: 1.43
* mid-blend: 1.40
* mid-growth: 1.60
* small-value: 1.51
* small-blend: 1.53
* small-growth: 1.64
* Foreign (Europe, Japan, and World): 1.75
* Foreign (emerging markets): 2.19
* Sector funds: 1.72

Portfolio Mix
* Main asset classes are stock, bond, and cash. Some consider foreign, emerging markets, and REITs as separate classes.
* Diversity among the main classes is the most important.
* Diversity among the sub classes (style box, foreign) is useful but not as crucial.

Where to invest money for your short-term goals (plan to use the money in 1-5 years)
* Money-market
* Ultra-short bond funds (bond maturities < 6 months)

Where to invest money for your medium-term goals (plan to use the money in 5-10 years)
* 25% in short-term bond or cash
* 75% in stock funds -- either large-blend or balanced funds
* Shift the money into bonds as you get closer to the goal

Where to invest for long term goals
* I seem to be missing notes for this

Structuring your Portfolio
* Your foundation should be made of a core of funds, comprising 50-80% of your assets. Recommend large-cap domestic fund for the foundation
* Small cap should be < 20% of your portfolio
* Consider having some foreign funds in developed markets (ie Europe and Japan)
* Risk diminishes significantly by owning at least 3 funds
* Above 7-10 funds, risk doesn't diminish
* Watch out for overlap if you own multiple large-cap funds
* Four-corners strategy: invest in large-value, large-growth, small-value, and small-growth
* Check total exposure to each catagory sector -- no more than 30% in any one sector

Write down why you bought each investment.

Understanding the investment strategy of your fund:
Value Styles:
* relative-value: choose stocks that are cheap compared to benchmark such as historical price ratios, industry, or overall market. American Funds Washington Mutual is recommended for this strategy
* absolute-value: figure out what a company is worth, and buy when the stock price is less than that amount. Manager studies the company's assets, balance sheet, and growth patterns. Be prepared to wait out long dry spells.

Growth Styles:
[indent]* earnings driven or "momentum": focus on identifying accelerating earnings. This style has a price risk -- the price of a stock may plunge on bad news. These funds tend to have significant short-term drops.
* revenue-driven: buy stocks that have strong revenues
* GARP (growth at a reasonable price): strike a balance between strong earnings and good value. Fidelity Magellan is a recommended example

I think there may be one or two chapters at the end that I didn't cover...

7 Books that Helped Me Learn About Investing

July 28th, 2008 at 09:42 pm

Books I've found useful, and the main topic covered. I've placed them in the order I would recommend reading them. You can click on my Booknotes catagory to read my summaries of numbers 1, 2, and 7.

1. All Your Worth (getting your basic financial picture in order so you have money available to invest)
2. The Complete Idiot's Guide to Getting Rich (helps with goal setting)
3. Bogleheads Guide to Investing (explains mutual funds and the indexing strategy)

Text is and Link is An online book abpuy impkementing the Bogleheads strategy,
5. The Intelligent Asset Allocator (how to structure your portfolio)
6. Morningstar Guide to Mutual Funds (how to analyze and pick funds)
7. Common Sense on Mutual Funds by John C. Bogle (highly technical analysis of index investing)

Booknotes: Money-Driven Medicine

February 13th, 2007 at 12:26 am

Every time I hear a news story about the rising cost of health care I ask myself, “Just where does all the money go?” Somebody must be getting rich from all this, but it’s not clear who it is. So I was pleased to see Money-Driven Medicine on the new books shelf of my library. It’s written by Maggie Mahar, a financial journalist. While I have no means to judge her credentials, the book is well written and has some interesting points. (If anyone else can recommend similar books on the topic I’d love to read them!)

First, a breakdown of where the money is coming from:
(* denotes money from taxpayers, for a total of 51% funded by the government)
30% Private insurance
17% *Medicare
16% *Medicaid & SHCIP (I think this is a program for uninsured children?)
14% Patients out-of-pocket (ie copays and uninsured self-pay)
12% *Other public spending (including veterans, public hospitals, school programs)
6% *Private insurance for government employees
5% Charity and philanthropy (includes private money for hospital construction)

Next a breakdown of where the money is going:
31% Hospital care
22% Physicians and other clinical services
22% Other spending (dentists, home health services, over-the-counter medicines, etc.)
11% Prescription drugs
7% Nursing home care
4.5% Private insurance profits and administrative costs
2.2% Government programs administrative costs

According to the author, in theory free market competition should reduce the cost of a product, but in practice, “the current system pits each of the health care industry’s players against one another: hospital vs hospital, doctor vs hospital, doctor vs doctor, hospital vs insurer, insurer vs insurer, insurer vs drugmaker, drugmaker vs drugmaker.” She quotes Michael Porter, a Harvard Business School professor, “competitors do not create value, they divide it. And sometimes, they destroy it... all are trying to assemble bargaining power so that they can strike a better deal for themselves while shifting cost.” Gains from one player come at the expense of another, creating no net value and adding administrative cost.

Another thing that hinders market forces is the nature of health care. The customer is faced with a great deal of ambiguity. According to Kenneth Arrow, a Nobel laureate economist, “Recover from disease is as unpredictable as its incidence…The information possessed by the physician as to the consequences and possibilities of treatment is necessarily very much greater than that of the patient.” The author states, “Health care is not a commodity. While two consumers may derive pretty much the same value from a new refrigerator, a particular course of treatment can have a drastically different effect on two different bodies…Three out of four health care dollars are spent on products and services that the patient has not purchased before…there are no warrants and no guarantees. The patient cannot return an unsuccessful operation.”

Historically, the fee-for-service model of medicine had the supplier (the doctor) both telling the customer (the patient) what he needs to buy and setting the price for it. “Allowing physicians so much autonomy all but guaranteed that the cost of health care would soar…The patient wanted as much care as possible; the physician had been trained to provide the best care possible. The price was not his concern. To the contrary, from a purely economic point of view, it was in his interest to see health care spending climb.” Until the 1930’s the patient’s ability to pay was the only check on rising health care costs.

When private insurance became the norm, this restraint was removed. “Blue Cross helped pave the way for health care inflation by reimbursing hospitals on the basis of their costs – an early example of the perverse incentives that would fuel health are spending for the rest of the century…Any hospital that tried to be more efficient and managed to reduce the cost of doing business would find its income reduced by an equal amount….hospitals were encouraged to solve financing problems, not by minimizing costs but by maximizing reimbursements.”

The book’s first chapter goes on to cover the rise of insurance, Medicare, and HMO’s, and concludes, “As medicine becomes more corporate, it is driven by the quest for profits…more sales lead to higher earnings. But more health care – more devices, more drugs, more procedures – does not necessarily lead to greater health.”

The second chapter covers how all the players are competing against each other. For instance, all the hospitals in an area may have a “medical arms race” to all open competing facilities in the most profitable areas such as cardiac care. The result is redundant service centers and a push to do procedures to profit from the investment, thus encouraging patients to have things done sometimes with doubtful benefit. On the other hand, “If too many facilities are trying to specialize in heart surgery, the surgical teams at these hospitals do fewer procedures. They may draw enough business to turn a nice profit – but not enough to remain at the top of their game.”

“Private insurers regularly skim off the top 10-25 percent of premiums for administrative costs, marketing, and profits. The remainder is passed along a gauntlet of satellite businesses – insurance brokers…lawyers, consultants, billing agencies…and so on. Their function is to limit services in one way or another. They, too, take a cut….as much as half of the health-care dollar never reaches doctors and hospitals.”

The third and fourth chapter cover (in far too great length!) various instances of hospital takeovers by for-profit companies and some of the sleazy doings of the guys at the top.

The fifth chapter covers the issue of end-of-life spending. Some of the rise in health care cost is attributable to doing lots of procedures on elderly and frail patients who die anyway a short time later of other causes. There is a map of the US showing a map of Medicare spending. It’s titled, “During the final six months of life, Medicare patients in high-spending regions receive 60% more care.” “Doctors like to fix whatever is fixable, and as a result, many patients die in intensive care units with their blood chemistries in perfect order.”

The sixth chapter covers the impact of the uninsured. “While well-insured Americans face the hazards of overdiagnosis and overtreatment, millions of uninsured patients routinely receive care [that can be described as] ‘too little, too late.’ And in the long run, ‘too little, too late’ proves expensive.” “Contrary to urban myth, it is not the uninsured who are crowding emergency rooms.” Hospitals find subtle ways of discouraging uninsured patients – such as charging the uninsured higher rates than those with insurance.

The seventh chapter calls for the industry as a whole to improve their use of computer technology, to move to “pay for performance” models (paying hospitals and doctors based on measured quality rather than simply on number of procedures performed), and to adopt evidence-based medicine.

The eighth chapter covers device makers, drugmakers, and their relationship with the FDA. Large device makers have very high profit margins – something like 19 percent in some cases. Some things other countries do to regulate or negotiate prices for devices and drugs: set reimbursement rates for new drugs based on how they compare to existing drugs (Japan), capping profits (Britain), putting a ceiling on total spending (France), restricting the rate of medical device and drug inflation to no more than general inflation (Canada). In the US, drugmakers and device makers can charge whatever the market will bear.

All in all, a very interesting read, although it’s hard to take away from this book a bullet list of why everything is so expensive.

Booknotes: The Millionaire Maker

February 9th, 2007 at 03:03 am

I stumbled across The Millionaire Maker on the "new books" shelf of my library. While it is actually a "get rich quick" instead of a "get rich slow" book (the things the author recommends doing with your home equity and your IRA are truly frightening, and her example investments and returns are ridiculous), it did have a couple of ideas that I found useful.

I really liked her version of a net worth statement:

One-Year Freedom Day Goals:
• List goals for where you want to be in 1 year, for example:
• Establish a business
• Shift from draining assets to performing assets
• $ of invested assets
• $ /month in passive income
• Create $ / month of cash flow from new business
• Eliminate $ of debt
• One less employee in family (replace salary with passive income)

Asset plan

Shift $ of Assets as follows:
• For instance:
• buy $ of rental property
• invest $ in a business
• loan $ in a promissory note


Cash Machine
• List type of business, cash flow goal, and ramp-up time

Passive Income: $ /mo
• For instance:
• $ /mo in rent
• $ /mo from note
• $ /mo from dividends

• Projected appreciation on rental property

Financial Baseline:

Income: $ /mo (pre-tax)
Expenses: $ /mo (average)
Assets: $
• List assets
Liabilities: $
• List liabilities

Skill Set:
• List skills

The author doesn't believe in saving your way to wealth -- in her view it takes too long. Instead, she advocates finding ways to generate extra income, through starting small side-businesses and passive income from owning rental property. She wants you to think up a business you can start within the next 24 hours based on skills and resources you already have (simple things like dog walking, computer tutoring, etc.) You use this first business to learn about how to run a business, and to provide a source of income for real estate investing. Eventually your goal is to reach the point where you have enough income from your side businesses and rentals that you can quit your job if you choose.

Our goal is to take those skills and gifts you have and put you in immediate action so that you can learn a whole new skill set, that of running your own business….Here’s the sequence:
1. Use a known skill set.
2. Create a viable Cash Machine.
3. Learn business skills.
4. Take those business skills into any arena you desire.

Whatever you decide to do, your first business:
1. Should have a low barrier to entry. That is, you should be able to have it up and running and possibly generating real money within 24 hours.
2. Shouldn’t take more time than you can allot, though perhaps you can get up an hour earlier every day.
3. Shouldn’t take more of your capacity than you can allot, tough it will be a stretch.
4. Should diversify your income.
5. Should give you a nice return on your investment.

Again, I want to emphasize that I think the book promises the moon, and I’m definitely not following her investment advice. However, a few worthwhile ideas gave me that lightbulb feeling: 1) the idea of starting a side business to learn business skills, 2) focusing on passive income in addition to salary vs. expenses, 3) setting long term and one-year goals.

Booknotes: All Your Worth

January 27th, 2007 at 01:12 am

Until I read this book, I never had a good sense of when my saving was "enough" and it was ok to spend on things that would be enjoyable today. I almost missed out on buying my first house because I wasn't sure it was ok to reduce my 401k contribution from 15% to 10% for a few years. On the other hand, after marrying my DH, we bought a larger house together and remodelled the kitchen, and I didn't have a good sense of whether the amount we were spending on it was ok or should've gone into long-term savings instead (we paid cash, so it wasn't "beyond our means", just a though call on enjoying life vs saving).

All Your Worth was the first book I've read that gave the guideline I was missing. Her recommendation is that you divide your money 50% for needs, 30% for wants, and 20% for saving/debt reduction. It strikes me as a reasonable balance that should allow you to have some enjoyment of your wants today while still saving for tomorrow.

Here are her definitions of needs, wants, and savings:

Needs: Mortgage or rent, utilities, a basic grocery allowance, car fuel, all forms of insurance (health, dental, car, home, etc.), minimum credit card payments, car loan, phone and internet access (necessary for job hunting), and any contracts you've entered into (such as a cell phone contract).

Savings: Emergency fund, 401k and IRA contribution, extra payments that reduce loan principal, long-term investments (for instance stocks and mutual funds), and other long-term savings vehicles

Wants: Everything else -- clothes, entertainment, cash, dining out, vacations, groceries above your allowance, etc.

The thrust of the book is that you analyze your needs, wants, and savings to see where you're out of balance. The point is to focus on finding ways you can save big bucks (insurance) instead of pennies (Starbucks coffee). (My favorite quote is, "What do all these financial advisors have against coffee, anyway?"). If your needs are too high, she advises you to look for ways to reduce them by taking out less expensive insurance and not entering into contracts. She has a section on how to tell if you ought to go to extreme measures such as selling your house or car and buying a cheaper one.

She goes a little too far for me in saying you should pay for all your wants in actual cash. The book is geared toward people who have credit card debt, so I felt some of the advice didn't apply to folks who have some assets built up. She is a big advocate of paying off your mortgage early, where I think it's smarter to invest that money in mutual funds and get a larger return.

She also gives some examples of when it's ok to temporarily violate the 50/30/20 rule. One example was taking a couple of years off after the birth of a child then returning to the workforce.

As for myself, our budget is currently 58/33/9, so we are out of balance a great deal on the needs side, and a little bit on the wants side. I'm working on getting the wants down to 30% so we can increase the savings/investing to 12%. (Interesting -- I set this goal initially because I thought increasing our savings in small steps would be easier to stomach than making a big change. I just checked with my Target Savings Goal calculation from The Complete Idiot's Guide to Getting Rich, and to meet our TSG we need to save exactly 12%!)

Here's the breakdown of our budgeted needs:
mortgage/tax 36.0%
insurance 3.3%
utilities 3.3%
car loan 2.8%
contracts 2.9%
groceries 4.4%
gas 5.4%
total 58.2%

We might be a candidate for downsizing the house if I didn't plan to return to work in a few years. (If I were to go back to work our needs would drop to around 40% for part-time or 30% for full-time.) Although I plan to shop around, our insurance already has high deductibles so I don't think there's much savings to be had there. The biggest places to consider saving are the car loan and contracts -- that's 5.7% that isn't going into savings. The grocery allowance is reasonable (in fact we enjoy cooking and entertaining so there's a separate line item in our budget on the wants side for food above the allowance.) Gas isn't going down unless DH changes jobs or the Middle Easts settles down.

I actually set up the catagories in my budget according to needs, wants, and savings rather than the traditional auto, home, etc. This makes it really easy to quickly determine how my balance is looking.

Booknotes: Common Sense on Mutual Funds

January 18th, 2007 at 01:22 am

Common Sense on Mutual Funds by John C. Bogle

This was a very good book on mutual funds, very thoroughly researched, lots of historical information. Gotta warn you, though, it's long and the analysis gets very dense, not for the math-phobic by any stretch.

Here are the points I remember from the book (I don't have it in front of me).

* Although some mutual funds beat the index in any given year, there's no way you can know in advance which ones they will be.

* Over a longer period of time, all funds tend to return to the average performance of their class -- funds that perform higher than average early on tend to do less well, funds that are lower than average tend to improve -- so that over a 10 or 25 year horizon they pretty much mirror the performance of the index. This is known as "reverting to the mean".

* Once you take all fees into account, you're better off just buying a low-cost index fund in the first place.

On this last point, although supported by huge amounts of convincing analysis in the text, it should be noted that the author is very famous for having invented the very first index mutual fund! This may explain why a lot of the getting-started type books like The Complete Idiot's Guide to Getting Rich recommend that you purchase a single no-load index fund -- I think the authors have all read Bogle!

When I asked my dad about index funds a few years ago, he said that because everyone was jumping on the index fund bandwagon, they were becoming overvalued. How ironic if all the advice out there to buy index funds was actually creating a bubble in the stocks that are members of the indexes!

I think I do believe there is value in having fund managers who do research on the companies they are investing in. Warren Buffet made his wealth that way.

Booknotes: The Complete Idiot's Guide to Getting Rich

January 16th, 2007 at 12:24 am

As I started hitting the library for books on personal finance and investing, I had a really hard time finding books that fit my situation. I don't need advice on getting out of debt. I'm not interested in get-rich-quick schemes. I have a solid foundation and want advice on moving up to the next level.

I found The Complete Idiot's Guide to Getting Rich to be very inspiring and motivating. A good background and starting point book, although it's too general to be of any help in my quest to pick a good mutual fund.

The biggest idea I got from this book was how to numerically set my goals. One time I asked my dad how much I should save and he said, "everything you can." Well, when have I saved enough that I can slow down and enjoy a little of it today? I've plugged numbers into online retirement calculators, but by the time you futz around with the inflation and return assumptions it's hard to know if you're out in left field or not.

Once you've figured out your current monthly expenses, the author lays out a calculation of two key values: Target Portfolio Goal (TPG) and Target Savings Goal (TSG). The Target Portfolio Goal is the amount of money you would need to have to be able to retire and live off the income without touching the principal. Target Savings Goal is the amount you need to invest each year to reach the TPG by your desired retirement date.

Next the author defines 5 levels of wealth:

Level 1: You are living within your means and save enough to meet your Target Savings Goal. Your financial focus should be on maximizing your actual savings amount by either increasing your income or reducing your expenses -- portfolio return is secondary.

Level 2: The returns each year from your investment portfolio are equal to your Target Savings Goal. This means that you are accumulating double your goal each year -- on part from your savings, one part from your investment returns. Your financial focus should be equally split between maximizing savings and maximizing investment return.

When your portfolio returns are twice your Target Savings Goal, your focus to maximizing investment return alone. The final goal at this level is to have returns three times your Target Savings Goal.

Level 3: Your portfolio returns enough to cover your annual spending, inflation, and your Target Savings Goal. Employment is now optional.

Level 4: Your portfolio has grown large enough to generate a return that allows you to substantially increase your standard of living while still keeping up with inflation. Financial focus is on total return and reducing volatility.

Level 5: You have more money than you can easily spend in your lifetime. You have the option not to work, raise your standard of living, and give large charitable gifts. Once you reach this level, you need serious estate planning help.

It is possible for most people who are employed by someone else to eventually reach Level 3 by the time they retire, but to reach level 3 earlier or to reach levels 4 and 5 you pretty much have to start your own business and be successful at it.

Doing the numbers and seeing our Target Savings Goal was a real wake-up call that we needed to get back on track with budgeting and saving.