Saturday, December 31, 2016

Your household needs a year-end report

Along with rebalancing my portfolio, the other thing that I do with my finances before the year ends is updating my household's end-of-year spreadsheet. It doesn't have to be overly complex. Mine is very simple and can be done by anyone who is Excel savvy.

I've been updating the Excel document since 2013 to help us keep track of our expenses relative to our income on a yearly-basis.



What does mine contain?

Itemized expenses

The first column is reserved for the name of the institution receiving the payment. For example, I'd write "American Express" for my credit card payments (which, BTW, I always pay in full). For expenses that are difficult to track, I end up using the generic description of the expense (e.g. ATM withdrawals).

The second column contains the total payment that I've sent to that institution for the year. In the case of a generic expense, I just use the column to total the expense for that category.

I use the third column for the monthly average, i.e. I divide the corresponding value under the 2nd column by 12 to obtain the average.

Lastly, the bottom row contains both the yearly and monthly average totals (sums of second and third
columns, respectively).

Net income per earner

This is similar to the above except that the 'expenses' are recorded from the perspective of our employers. I write my wife's name and mine under the first column, since we are the only ones working in the household.

The second column contains the total amount of the paychecks received by the individual for the year. Like what has been done above, the third column is used for the monthly average and the totals are calculated on the bottom row.

Total savings

I reserve a section to record the total savings that we made that year. The total is calculated by subtracting the total expenses from the combined total net income that my wife and I earned that year.

In addition, I also record our total 401K contributions (including employer contributions) for the year as separate line items. It doesn't make sense to add them to the total savings because they were made before taxes.

Net-worth statement

This spreadsheet also contains our net-worth statement (i.e. assets minus liabilities). This is sort of like the year-end balance sheet of a Fortune 500 company except that the items are expressed in hundreds instead of millions (not to mention that the C.E.O. of the household is also the Chief Financial Officer).

Institutions

This tab contains a list of institutions that I conduct business with. It includes the account numbers, website info, and other essential information. I try to refrain adding password information in this tab for security reasons.


My year-end-report spreadsheet



Why is this important

Maintaining this spreadsheet has the following benefits, among others:

Decision making tool

You can use it to make informed budget decisions for the year ahead. For example, you can adjust your emergency fund goal for next year based on the average monthly expenses that you have incurred in the year.

Historical projection tool

It helps you perform intelligent 'guesstimates' like when you need to project your future net worth. The numbers can help you set long-term goals such as setting a retirement savings amount goal. You see, retirement is not a matter of reaching a certain age-- who wants to retire broke?

Record keeping tool

I've uploaded this spreadsheet on the 'cloud' (One Drive, to be specific) so I can easily share the document with my wife (who happens to be my household's chairman of the board). In this way, it is easily accessible from any device and not forever lost in the unlikely event that I get ran over by a truck.


That, my friend, is why you need to create a household year-end report...

I wish you all a happy, healthy and prosperous New Year!!!



via GIPHY

Tuesday, December 27, 2016

Rebalancing your portfolio is like going to the dentist

There's probably nothing more uncomfortable than your visits to the dentist. I don't know about yours, but my dentist certainly doesn't have the gentlest hands that I can brag about. Once you're seated on that dreaded chair, you'll be as helpless as a toddler as she works on scraping the tartar buildup from every corner of your teeth with her very rough hands. It's never a pleasant experience.

The same can be said when rebalancing your portfolio. Except that now, you're in charge. You are the dentist and your patient's set of teeth is your investment portfolio.

Your portfolio needs regular checkup

Every six months you need to get your teeth checked or else you might get cavities no matter how skillful your brushing skills are. Same is true with your portfolio- it needs regular checkup no matter how good your mutual fund or stock picks are.



Just like your visit to the dentist, it's never a pleasant experience. But you know it needs to be done regularly to maintain your financial health. Unlike your experience at the dental chair, the pain is purely psychological.

Rebalancing your portfolio involves selling your winners-- the ones that went up substantially in value, and buying some 'losers' with the aim of adjusting the allocation to match your original goals.

The problem is that this process goes counter to natural human emotions. Because of greed, we tend to buy more of those that went up. Out of fear, we sell those that went down without regard to the long-term outlook. As a result, we end up buying high and selling low.

Perform an X-ray of your investments

The dental X-ray machine provides pictures of the teeth, bones, and soft tissues around them. Not only do these images help find issues with the teeth, but they can also provide some insights on possible problems with the mouth and jaw. A similar tool should be used for your portfolio, and it's probably already being offered by your online brokerage.

I've been a Charles Schwab customer since 2002. I have benefited immensely by the investor tools available on the website. One of them is the "Schwab Portfolio Checkup" tool, which I've been using to 'x-ray' my portfolio on a regular basis.

The following aspects of your portfolio should be thoroughly examined.

Asset allocation

You need to stick to your long-term plan. The majority of your assets should be invested in equities when you're in for the long haul (10 years or longer). Historically, stock investments offer the best upward potential compared to other investments. In my opinion, someone with a high tolerance for risk and longer investing time horizon should allocate 90% of  his portfolio to stock funds.

Equities are often categorized based on market capitalization: large, mid, and small caps. Large-caps are companies that have market capitalizations of $10 billion or more.  As a consequence, they provide stability and liquidity to a portfolio. Small and mid-capitalization companies have more up-side potential for growth given their smaller size.

As you approach retirement, it's wise to gradually increase your allocation to fixed-income instruments such as bonds, which are less riskier. This is especially true when you find yourself unable to sleep at night, constantly worrying about an incoming market crash.

Not only will fixed-income instruments 'soften' the effect of a market crash having no direct correlation with stock market price movements, but they also generate regular income flow that you can potentially reinvest.

My asset allocation as of August of 2016

Sector diversification

The equities portion of your portfolio may be diversified in other aspects, say, market capitalization. But if those companies all belong to single sector then you may be in trouble.</

For example, everyone knows what happened to the airline sector in 2011 as profits were trimmed substantially when the travel industry was hit hard by rising fuel prices.
The chart below displays the percentage of my equity holdings by sector compared to the overall market (S&P Global BMI). Any deviation of at least 20% will be a red flag.



Equity concentration

Billionaire investor Warren Buffett famously stated that "diversification is protection against ignorance" and many investors took this to heart and lost a lot of money.

The problem is not because they got cocky or too confident about their picks that they end up investing in just a couple of individual stocks. Rather, it's because their portfolio is highly concentrated in a few stocks (not to mention that they're not Warren Buffett).

In my case, the two largest individual stocks in my portfolio are Microsoft (MSFT) and Bank of America (BAC), both of which I've owned for a very long time. But they represent less than 5% of my portfolio.


The thing is even if you run the company yourself or are involved in its day-to-day operations, there will always be some risks that need to be managed. The saying that you should never put your eggs in one basket still holds true.

Fixed-income

Like equities, your typical fixed-income mutual fund may be comprised of different types. For example, US treasuries provide stability while municipal bonds provide tax-exempt income. Treasury Inflation-Protected Securities (TIPS) provide protection when inflation is high.

You should examine the allocation of your fixed income holdings to make sure they still reflect your original goals.


Bonds can be also classified based on the credit ratings of the companies or institutions that issued them. For example, US issued treasuries are rated AA+ by Moody's. On the other end of the spectrum are junk bonds, which generally offer higher yields and therefore riskier.

Lastly, it is important to understand how your fixed-income investments react to higher rates. For the past decade, the Federal Reserve kept interest rates very low to promote economic recovery. This is where the time-to-maturity matters. The longer the bond matures, the more sensitive its price reaction will be against interest rate hikes.

Quality

There are many techniques that you can do to check the quality of an investment. In my opinion, it doesn't make much sense to perform fundamental analysis on a baskets of stocks like mutual funds or ETFs (or you'd be more inclined to pick individual stocks instead), so we normally rely on some reliable benchmark to compare to.

One red flag is the consistent underperformance relative to its benchmark. Given a choice, I'd personally invest only in mutual funds that have a long positive track-record. Sadly, they seem to be hard, if not impossible to find, in employer-sponsored retirement plans.

I'd pick a fund with higher Morningstar ratings (3 stars or more). The company provides data on thousands of investment offerings, including mutual funds. It has emerged as the trusted source of investment research.


Expense ratios

You need to pay attention to your fund's expense ratio as it can easily eat up your return. Actively managed funds have substantially higher expense ratios than index funds for obvious reasons-- they need to pay a fund manager and other expenses related to actively managing the fund. Sadly, most actively managed funds don't beat their respective benchmark indices.


I'd personally avoid any actively managed fund that charge more than 1.2% unless the fund has an exceptional track record. Note that international funds generally do have higher expense ratios so it doesn't make sense to compare their expense ratios to domestic funds.


What's next

Your portfolio's 'X-ray' report is an important tool. Using the numbers and information that you gathered, you can adjust your portfolio to better reflect your risk tolerance and time horizons for various goals.
As for me, here's how I've rebalanced my portfolio for 2017. With rising interest rates and record-high equity prices, I decided to increase my cash position while making sure that it is still completely aligned with my current goals.


Just as X-rays can be harmful to you when done too frequently, rebalancing your portfolio too frequently can do more harm than good.

You don't need to follow the day-to-day changes in your portfolio either--- for most of us, that would be stressful and could potentially just lead to reactive, bad investment decisions driven solely by emotions.

In my case, I rebalance my portfolio once in every six months. About the same frequency, as my visits to the dentist.