Part 2:  Pursuing Diversification, the Power of Staying Invested, Savings vs Investing, the importance of Matching, Duration

By Bob Peters || November 20, 2022

What I hope you take away from this blog post

-Some people will be compensated with the stock of their employer…sharing my story.

-How low cost funds like VTI and VTSAX can be used to diversify your long term investments.

-The importance of separating Savings and Investments:  Short, Intermediate and Long term buckets.

-Staying Invested is REALLY important to your goal of achieving Financial Security.

-You will be well served to not let your “loss aversion” bias cause you to sell your long-term investment bucket when you see the price of your long-term investments decline.

-Savings and Investing are two different things.

-It is important to match your investing with your short, intermediate and long-term goals.

-Longer duration investments are subject to more price volatility and should be matched with your long-term goals:  Jill the Investor, Home Town Fund and Cross Town Fund.

-The risk-free rate and why we all pay more than the US Government.

-As the Risk-Free rate increases there is pressure on the price of all other investments to decline.  The opposite is also true.

Where am I and where am I going 

Since I retired I have been selling the stock of my two prior employers.  Given that a significant portion of my compensation was in stock I had built up an outsized exposure (remember my mistakes?) While employed at these businesses I was restricted from selling stock. A high stock concentration contributes to alignment with shareholders but, it materially increases your personal risk.  I currently have about 20% of my investable assets in individual securities.  My goal is to get this down to less than 5%.

I may rely on professional advisors to help me plan for my ultimate demise (ouch) but I don’t need an advisor to tell me what stock to buy and which one to sell or when to buy or when to sell.  If I do my asset allocation review once per year I will be fine (there is more to say about asset allocation but we will leave that for another post).

Selling individual stock positions and buying VTI and VTSAX

I’ve been selling these concentrated stock positions while increasing my ownership of Vanguard Total Stock Market Index Fund (ticker:  VTI) and Vanguard Total Stock Market Index Fund (ticker: VTSAX).  There is compelling academic research that supports that the average investor is likely better off purchasing a low cost total stock market index rather than trying to pick and choose subset of the market.  When it comes to investing for your financial security, buying the total market (aka acknowledging you are not in possession of information that is not widely known) is likely to reward you well over the long term.

Quickly,…what is a “Ticker?”

Every publicly available security has a name and a “ticker”.  The ticker is a series of letters like an abbreviation that is used to identify that particular security to buy or sell on an exchange through a broker.  The ticker for Vanguard Total Stock Market Index is “VTI”, the ticker for Bank of America is “BAC”, the ticker for Apple is “Appl”, the ticker for Berkshire Hathaway is “BRK-A or BRK-B” and so it goes for thousands of stocks, mutual funds and exchange traded funds.  If you want to buy 100 shares of Citibank, you could sign into to your brokerage account at Vanguard, Fidelity, Schwab, etc. and enter “C” as the ticker.

Back to VTI and VTSAX

Back to VTI and VTSAX…Both of these funds own the market weighting of all US publicly traded equities.  VTI is an Exchange Traded Fund and VTSAX is a Mutual Fund.  The annual cost is very low for both; 3 basis points for VTI and 4 basis points for VTSAX.  As with all exchange traded funds, the price of VTI changes throughout the day, just like a stock would change prices throughout the day.  VTSAX is a mutual fund and, like all mutual funds, the price of the shares are determined once per day at the close of business.  If you open up an account at Vanguard, the minimum investment amount for VTSAX is presently $3,000 and all subsequent investments of at least $1 are allowed.  The minimum investment of VTI is the price of one share which, as of Oct 12, 2022, was $179.03.  Unlike mutual funds which allow you to buy less than one share (also referred to as fractional shares), ETF’s require you to buy whole shares which makes reinvestment of dividends and frequent automated purchases a bit more challenging.

What should you do…I don’t know you so I am not in a position to say

Providing investment advice is regulated by the US Government for good reason.  There have been many charlatans who have made great personal wealth giving poor advice, or worse, defrauding individuals (i.e. Bernie Madoff).  The Government (Securities and Exchange Commission “SEC”) requires investment advisors to be current on certain certifications for investment management activities.  I don’t know your circumstances so can’t opine further but here is what I do know…

Staying invested in a highly diversified low-cost fund over a long time period is what leads to Financial Security

There has been a lot of academic work that strongly suggests that future expected returns in the stock market are highly correlated to recent past returns.  I refer you to the chart in a prior blog post composed by Nobel Prize winning economist, Robert Shiller.

Staying invested in a highly diversified low-cost fund over a long period of time is what leads to Financial Security.  Staying invested during all market conditions is much better than trying to time when to buy or sell.  One of the biases that cause us to make poor financial decisions is called “loss aversion” where losses are more emotionally painful than gains are joyful.  Loss aversion can lead to selling when the market is down because its emotionally painful to see your wealth decline.  The problem is that by selling when the market is down you can miss out on the recovery when market prices rebound.  I suspect that you will be shocked to see the cost if you had missed just a few of the best days over a long period of time.

To illustrate:  JP Morgan Asset Management analyzed the S&P 500 Total Return Index between January 1, 2002 and December 31, 2021.

Below are the highlights if you compared staying fully invested:

Comparison of Annualized Returns Jan 1, 2002 to Dec 31, 2021 (7,300 days):

Fully Invested:  9.52%

Missed 10 best days:  5.33%

Missed 20 best days:  2.63%

Missed 30 best days:  .43%

Missed 40 best days:  -1.51%

Note:  Seven of the best ten days occurred within two weeks of the ten worst days so just as your fear of loss aversion is likely to be the highest (urging you to sell) you would have missed out on seven of the ten best days if you had waited more than two weeks to reenter the market.

So it’s pretty clear that your long term Financial Security is materially better off if you don’t succumb to the bias of loss aversion.  Understanding that the emotions associated with a decline in wealth are real does not insulate you from the risk of selling your investments when they decline in price.  Being able to survive the storm:  Liquidity matters.

Separating Savings from Investments…Mingling of two concepts

Sometimes, people sell their long-term investments because they find themselves in a liquidity crisis which may be caused by the mingling of two concepts:  Savings and Investing.  When people sell long term investments out of fear or loss aversion they hurt their long term Financial Security.  The term saving and investing are often confused as one in the same.  Let’s separate Savings and Investments.

It’s true that when you save money you can choose to invest these funds but you will need to save for many other reasons.  If you are seeking financial independence you will want to save an emergency fund to cover unanticipated expenses such as a job loss, high medical bill or other unanticipated expenses.  In addition to an emergency fund (I suggest roughly 6 months of Basic Needs) you may also want to save for a purchase of assets such as a car, a new cell phone, a vacation, furniture, a down payment for a home.  How long it takes you to save each month to purchase these items is based on how much income you have after covering your Basic Needs.

If you know you will need to save $20,000 for a car you hope to buy in 3 years you have a fairly short time horizon where your top priority is to have $20,000 available in 36 months.  If you end up with only $16,000 because you invested in more volatile investments you would not accomplish your goal.  The takeaway is that the types of investments you make needs to align with the time horizon of your goals.

Matching Savings and Investments to support different goals

We illustrated how impactful it can be to miss the best 10, 20, 30, 40 days of the market out of a consecutive 7,300 days.  The bias of loss aversion is a risk that every one of us faces which will drive our urge to sell after a substantial loss of wealth when there is a significant downturn in the market.  To help avoid the risk of selling investments when there is a market decline it’s important to match savings and investments to support different goals. 

Think “Buckets”

Savings and Investing buckets; short, intermediate and long-term goals.

Short Term Bucket

Short term goals range from buying gasoline, food, paying rent, normal medical/dental bills, education, car maintenance, etc., etc.  We’ll just say that short term are expenditures you will need to make in the next three months.  Because the time horizon is so short, you really do not want to take any “risk” with these savings and you will want to have immediate access.  The safest place to hold these funds is in a federally insured deposit account at your local bank or credit union.  Checking and Savings accounts at local financial institutions will benefit from a full US Government guaranty of your balances up to $250,000.  In exchange for this level of safety you will earn very little or no interest.

Intermediate Term Bucket

For intermediate goals (3-36 months) an investor can find investment options that will likely pay a rate of approximately 70-90% of the current US 3-month Treasury Bill rate.  These Investment options can be found in Money Market Funds or Government Cash Reserve Funds.   A person can open an account at Vanguard or Fidelity (other broker dealers too) and tie it to their checking account.  A sale of these funds can be done Monday thru Friday, excluding holidays, these firms will send the funds to your bank account typically within 1 or 2 days.  While these funds do not have a government guaranty they generally invest in very short term (less than one year) of very high-quality government and corporate obligations.  These funds are managed in a way to preserve 100% of the capital. While there have been very few instances where the value of some have dropped below 100%, they generally recover to 100% within days.  There is typically negligible credit risk or interest rate risk because the high quality and term of the underlying investments is very short term.

For a bit of a longer intermediate goal (36-60 months) you can go a bit further on the risk horizon and buy an US intermediate term bond fund.  These funds generally hold debt securities of US Government and US Corporations with maturities of 3-6 years.

Let’s go back to why they are “further out on the risk spectrum”.  We acknowledged that Money Market Funds and Government Cash Reserve Funds hold short term maturities less than one year as compared to the US Intermediate term bond fund with maturities typically between 3-6 years.  A term we use to describe the term of a bond is duration.  The longer the duration the longer the weighted average time of the present value of all cash flows and the more volatile the price of a bond is as interest rates change.

Duration…A case study of Jane the Investor

To illustrate duration let’s look at Jane the Investor.  Jane has saved for her emergency reserve and is setting aside money each month she needs for larger purchases for the next three years.  She has a goal to go on a big vacation in 4 years and would like to earn a bit more interest than the Money Market Fund so she invests in a fund called Home Town Fund.

In Home Town Fund there are only three investments:  A $1,000, 6 month loan to Joe “the Barber” with an interest rate of 4%, a $1,000, 12 month loan to Sally “the Accountant” with an interest rate of 5% and a $1,000, 18 month loan to Susan “the Lawyer” with an interest rate of 6%.  All of these loans were made on the same day, January 1, 2022 and because the rate of interest is fixed at a predetermined rate (4%, 5% and 6%) we call this a fixed income fund.

Duration can be calculated by determining the weighted average time of the present value of all cash flows.  The mathematical equation is more complex but suffice it to say that the longer the duration the greater losses would be in a rising interest rate environment.  For simplicity sake, we will say that the duration of Home Town Fund is 12 months.

Now let’s show how changes of interest rates and duration can change the price of Jane’s $3,000 investment in Home Town Fund

Ok, so a month goes by and Jane is happy with her investment of $3,000 and now the duration is 11 months.  But now let’s throw in a new factor; the market has now determined that there is likely to be high inflation and as such the rate of interest being charged on new loans has gone up.  In fact, the Cross Town Fund just made three $1,000 loans today with maturity dates of 5 months, 11 months and 17 months and the loans pay a rate of interest of 5%, 6% and 7%, respectively.  We will assume that duration is exactly the same as the Home Town Fund of 11 months but the yield is 6%, 1% higher than the loans in Home Town Fund.

Now, Jane’s brother Tom comes by and says that he would like to make a $3,000 investment in a Fixed Income Fund with an 11-month duration.  Putting aside for the moment the credit worthiness of the borrowers inside of both funds, which fund do you believe Tom would be willing to pay $3,000 to buy?  If you said Cross Town Fund you would be correct.  For $3,000 Tom would earn $27.50 more if he invested $3,000 in Cross Town Fund because he could earn 1% more in interest over the 11 month duration of the fund ($3,000*1%)/(11/12)=$27.50.

In reality because these funds are highly liquid, which means many investors buy and sell them every day, what would happen is that the price of Cross Town Fund would be $3,000 and the price of Home Town Fund would have decreased by approximately $27.50 to $2,972.50 which would make the effective yield on both funds 6%.  This illustrates how, as an investor in fixed income investments, a bond investor can lose value when interest rates rise.

Interest Rates…the Risk-Free Rate

When you borrow money for a credit card, student loan, mortgage, car, business, etc. (all borrowed money) the rate of interest you will pay will be some amount over what is called the risk-free rate.  The risk-free rate is what the US Government pays to borrow money.  There is one big advantage to be the US Government…it has taxing authority, which means that if Congress passes laws that increase the amount of income tax you will pay more and the government will receive more revenue.  Because of this authority, investors have deemed that the safest obligation is the US Government.  This is an important concept to understand. The rate of return on every other investment must be greater than the risk-free rate.  The amount of the premium is based on the perceived riskiness of a specific investment.