bonds vs. bond funds

You may hear sometimes that purchasing a ladder of bonds is better than purchasing a bond fund. A ladder of bonds just means you buy say 5-10 different bonds with various maturity dates. When each bond matures (assuming the issuer doesn't default), you get paid the principal amount of that particular bond. If you plan on spending the payments received upon each bond's maturity then you have a 'non-rolling ladder' bond portfolio. If you plan to reinvest the maturity payment into another bond, then you have a 'rolling ladder' bond portfolio. Since bond funds reinvest the maturity payments received from their maturing bonds, a passively managed bond fund is largely equivalent to a rolling ladder. Except a bond fund provides better diversification and lower transaction costs than you can achieve by constructing your own rolling ladder. But to realize the lower costs of a fund, you have to pick one that is passively managed with a low expense ratio.

Although comparing an individual bond or a non-rolling ladder to a bond fund is like comparing apples to oranges, folks sometimes think a non-rolling ladder provides more certainty and/or less risk because one can ostensibly predict the future payments to be received. However, this perceived attribute isn't real when you account for opportunity costs.

Additional resources:
https://advisors.vanguard.com/iwe/pdf/ICRTBF.pdf

bonds

I'm not a bond guy, but if I were allocating part of my portfolio to bonds, this is how I'd do it. Whatever you do, DO NOT allocate more than 2-3% of your portfolio to a single bond. Doesn't matter if it's rated investment grade. You can buy it investment grade and the next week it can be non-investment grade. Trust me, I know from personal experience.

recent reading

In the past month, I've read a few well written books about investing, all of which advocate value investing:

Bull's Eye Investing - Not only an interesting read, but the author was writing in 2004 and got a lot of things right about the subsequent six years.

The Little Book that Still Beats the Market - Starts off really hokey, but the second half makes a compelling case for buying quality stocks with cheap prices based on an objective formula that adjusts for varying tax rates and debt loads of companies, so you won't miss some good buys just because they have depressed earnings.

The Little Book of Sideways Markets - Explains why the overall stock market will continue to tread water with high volatility over the next decade and recommends a means of outperforming in such an environment. I thought this book might have been banal, but it actually makes a lot of smart, nuanced observations and is well written.

buying foreign small caps; decreasing exposure to Yen and China

I'm generally of the opinion that it makes sense to avoid mutual funds and exchange traded funds with their embedded management fees that act as a drag on a portfolio's returns. I feel this way due to the advent of platforms such as folioinvesting.com where individual investors can construct a portfolio containing a large number of stocks without incurring commissions for each trade. However, with foreign stocks, pretty much the only ones that trade on U.S. exchanges are large-cap companies, many of which happen to be energy companies and banks. Since I wish to obtain exposure to other sectors, I've purchased the following exchange traded funds geared to foreign small caps (within the model portfolio - 1% allocation to each): BRF, SCIF, and DGS.

To make room, I've sold the three Japanese stocks - WACLY, NTT, and DCM - which is in keeping with concerns about the future direction of the Yen. Basically, I'm trading out of a country with poor demographics and high debt and into countries with with favorable demographics and low debt, which I believe will provide for some long-term currency appreciation to go along with the investment returns from economic growth.

Separately, I sold the two Chinese stocks - HNP and SNDA. I don't have a rigorous reason; I'm just worried about the Chinese economy being unbalanced and the potential turbulence in Chinese stocks that would likely result from a recession over there. As replacements, I bought VE and TM (1% allocation to each).

Wait, didn't I just say I was worried about the Yen? Yes, but actually TM should benefit from a declining Yen as 70% of its revenues are derived from outside Japan and 58% of its expenses are incurred inside Japan. Furthermore, the stock is cheap based on price/book, price/cash flow, and price/sales, all of which is in keeping with my re-born value investing fetish.

happy holidays

coleman 100 portfolio

The charts above are created by morningstar.com as a feature of their premium membership offering. As you can see, the 100 stocks provide for a well diversified portfolio by economic sector, market cap, and geography. In fact, I would go so far as to say this equal-weighted porfolio is more diversified than the S&P500, which is market-cap weighted.

The average beta of this portfolio is 0.69x, which means in any short run time period, it should zig and zag with a magnitude about equal to 69% of the S&P500. In the long run, as the small short-run deviations accumulate, I'm expecting the portfolio to out-perform the S&P500 and also out-perform my true benchmark, which is the Vanguard Global Stock ETF (ticker: VT).

The portfolio is tilted towards stocks with valuation ratios (price/earnings, etc) lower than the S&P500 and growth prospects (earnings growth projections) greater than the S&P500. The benefit of investing in companies with decent growth prospects, rather than solely low valuation ratios is that it helps one avoid companies that are cheap for a reason that have increased risk of bankruptcy. It's a nod to the value investors' philosophy of buying companies with decent business prospects at a cheap price.

Lastly, the first chart above is a back-test showing how this portfolio would have performed against the S&P500 over the past five years. This is only an indication and isn't definitive because some of the 100 stocks haven't been around five years, which is indicated by the dotted line for the first portion of the time period.

Note: In order to view the chart above showing the 100 stock holdings, or any of the other charts, click the image twice for a larger version.

portfolio overhaul

It has now been exactly 15 months since I established the model portfolio 9/4/09. There have been changes along the way, as I tried my hand at a little market timing from June-November with a market-neutral portfolio. Although the hedge used was the ETF that moves inversely to the S&P500, which left the portfolio somewhat exposed to foreign currency movements vis-a-vis the dollar and small cap stocks vis-a-vis large cap stocks. The portfolio has also evolved as I've continually pruned it from roughly 700 stocks down to 169 stocks. This was mainly done by eliminating all but the lowest beta stocks. This week I've culled the portfolio down to 100 stocks by eliminating some of the pricier names, thereby increasing the tilt towards value stocks.

My intention is to hold these 100 stocks throughout 2011. Furthermore, I'm going to fund my account at folioinvesting.com and henceforth report the results from my real portfolio, rather than a model (paper) portfolio.

The next post will provide a summary of the 100 stocks, but before getting to that, I've posted for the record the results of the model portfolio over the past 15 months (see charts above). Nothing stellar, but not bad. Essentially, total return was in line with the overall market, but the pathway of getting there was less stomach-churning than the overall market, so if you had been invested like the model, there was less chance you would panic and sell out at the bottom. I mention this because most investors fall short of matching the overall market for this very reason, which is why in some ways, I think the volatility of one's portfolio is an important determinant of realized returns.