Index Investing Small Amounts

I have a small taxable account that I’ve slowly built up with my “fun money” – $25/month. It’s only got$550 in it at the moment – not enough to buy an index mutual fund now nor or in the near future.  But, I like to invest in low cost index funds.  How can I do that when I don’t have the minimum to buy into one?

Enter ETFs.  ETFs are sort of mutual funds, sort of stocks.  They’re traded throughout the day, and so are priced “instantaneously” vs end of the day like mutual funds.  They have some of the benefits of mutual funds, but some of the risks of stock trading (most notably, buy-ask spread).   Some are low cost, others are very high cost – just like mutual funds.  Actively managed ETFs are more expensive than passive index based ones as you’d expect.

The best part – you can buy just one share.  As long as you have at least the value of the share plus any trading fees in your account, you can buy a share.  Fidelity (at least) offers a lot of no trading fee (NTF) ETFs – mostly in the iShares line of ETFs – so, for the cost of a “share”, I can invest in an index ETF.

The biggest disadvantage is that I can only buy whole shares (at least at Fidelity).  That means that I have some money sitting in the “Cash” bucket not really working for me like it could be in a fractional share of a mutual fund.

My Strategy

This is a taxable account, and is kind of my “playground”, even if it’s not a very big one.  Every 3 months, I transfer $75 into my Fidelity account – a decent amount to be able to afford most ETFs I want. Then I buy one of ITOT, IDV or HDV. This allows me to dabble in dividend investing for less than buying stocks outright (and less research required!), yet still be primarily index investing. How did I pick those? I looked at all the ETFs Fidelity offered that had no trading fee and an expense ratio of 0.5% or lower (use their ETF picker). These looked interesting. When I have the minimum$2500 to invest in the index mutual funds I prefer, I’ll likely sell the ETFs and buy the mutual funds, but at my current investment rate, that’s still a few years off.  Once all of our tax-advantaged accounts are maxed out, this account will begin to see more cash flowing into it, but it will likely be next year at the earliest that I can consider mutual funds.

Efficient Markets Hypothesis and Information

Over the last few weeks, I’ve learned a lot in my Computational Investing class, then I saw this article from Fidelity on ignoring the news and a lot of information on the role of information in stock markets.

Efficient Markets Hypothesis

In Computational Investing, we were looking at market statistics (“events”), and back-testing to see how a particular strategy would have worked.  One thing I really learned was that information is *extremely* important in markets.  There are three versions of the Efficient Markets Hypothesis: strong, semi-strong, and weak.  Under the strong version, the markets are 100% efficient and there is no opportunity to “seek alpha” – or make anything above and beyond what the market makes using information that’s not publicly available.  The semi-strong version says that the market is not perfectly efficient, and there is an opportunity to make more than the market through technical analysis or fundamental analysis.  The weak version, is that the market reflects all publicly available information, still prohibits technical analysis, but allows for fundamental analysis.  All of which are based on information.

I’m not going to get into the “politics” surrounding these theories, but I lean towards the semi-strong version, with some caveats.  After the computational investing class, I understand where there are opportunities for arbitrage; however, I don’t think that a “normal” investor can take advantage of them.  The arbitrage opportunities exist for such a short time (on the order of milliseconds), that unless you have a computer sitting on the stock exchange itself making the decisions, by the time you even noticed the “blip” in the order book, the opportunity would have already evaporated.  The information needed for these opportunities requires computers to notice and act on, I’m certainly not going to be able to do it. So, for all intents and purposes, to a “normal” investor, the Efficient Markets Hypothesis is “strong”.

Information

Information is needed to make investing decisions – but if you “ride” the market by buying index funds, you’re getting the collective knowledge of the people who are watching the markets with computer systems and making those small tweaks to bring the market into “accurate” pricing.  If you don’t need the information feed for making quick investing decisions, then you don’t really need much information at all other than the risk you are taking by investing in that particular index.  So you can proceed to ignore the markets 🙂

I think it’s interesting to see how the markets change according to current news events, but for me it’s purely an academic exercise.  I’m invested in index funds, and have no intentions of selling them until it’s time to re-balance to meet my asset allocation.

How does current news affect your investing?

Measuring Investment Risk – Calculating Returns

In addition to Computational Investing, I’ve also signed up for the Introduction to Computational Finance class through Coursera – it’s a similar topic, but a different point of view.  Instead of assuming you want to be a hedge fund manager, it goes into calculating returns, risk of an investment, and building a portfolio.  This is more “normal” stuff that any investor should know – but it has a very mathematical bent (several proofs, etc).  The class is self-paced through November, so it’s not too late to join if you’re interested.

The first two weeks are on calculating simple, annual effective rate, and continuously compounded returns and the probability background needed to complete the class.  One of the closing topics of week two was measuring investment risk.  It’s generally accepted that standard deviation (σ) is an easy to calculate measure of risk.  This tells you how far values deviate from the expected result – the mean (μ) – or the simple/continuous rate of return, so you know how “wild” the investment can be.  A larger standard deviation implies a larger risk to the investment.  In investing, a larger mean (or expected return value) also tends to imply a larger standard deviation because people expect to take more risk for a larger return. We haven’t gotten to actually calculating the standard deviation yet – although I think I know how.

Calculating Returns

The first value to calculate is a return over a time period.
$R$: Return
$P_{t}$: Price at time $t$
$P_{t-1}$: Price at time $t-1$
$R = \frac{P_{t}-P_{t-1}}{P_{t-1}}$
$R$ can be any time period, but we’ve been using monthly for the most part in class.

Calculating Portfolio Returns

Not only do we need to worry about the returns for a single investment, but we also need to calculate the return for our entire portfolio for it to be useful. The return for a portfolio is pretty easy, it’s a weighted average based on the initial total investment. If asset A has a return of 5%, and asset B has a return of 3%, and we spend $3000 on asset A, and$7000 on asset B, the portfolio rate of return is:
$R_{p,t} = .30*R_{A} + .70*R_{B} = .30*0.05 + .70*0.03 = 0.036$
or 3.6%

Disclaimer: I’m writing these posts as a way to solidify my understanding of class materials, they may not be completely correct – and I welcome any corrections.

Asset Allocation

Image courtesy of iosphere/ FreeDigitalPhotos.net

As I turn 35, I just spent a good chunk of time updating all of our investment accounts.  I recently read All About Asset Allocation by Richard Ferri and decided that my haphazard investment selections needed to change, and I needed to really focus on what we wanted.  We want to retire when I turn 50 (exactly 15 years from now), with approximately $2.4 million in assets. Now, that’s a lot of money, and I’m basing it off the 85% rule – we’ll want 85% of our current salary in retirement, then multiply by 25 for a safe withdrawal rate of 4%. I’m hoping that we can work to reduce that number closer to$1.5 to $1.6 million (and also the retirement age!) as we work through our debts and lowering our expenses. We’ve been very aggressive investors up until now – only about 5% in bonds, the rest in equities of varying types – but with a 15 year horizon, we want to start being a little more conservative. I learned a lot about assets and their correlations and statistics in the book, and I took a look at what we were doing – we had a halfway decent allocation for our very aggressive model, but it could be improved. Changing our 529 investing plan I’ve been researching fees and tax strategies, and I’ve decided to move our 529 plan from Fidelity to our state’s direct plan (Virginia inVEST). The fee is .02% higher for the aggressive portfolio I selected, but the up to$4,000/year with unlimited carryover deductions on state taxes more than makes up for the fee.  There are also a *lot* more investment options in the Virginia plan than there are in the Fidelity NH plan.  I’ve opened up the account and made the initial deposit, but I need to file the paperwork (on paper!) to transfer the old 529 account into the new.  I didn’t realize that you could transfer 529 plans until I started researching it – I figured we were “stuck” with the initial choice (which I admit to having selected Fidelity because all of our other accounts are there).

I like Fidelity, their 529 plan is very easy to manage and I’m keeping my other accounts there, but the tax savings of moving were too enticing.  We currently contribute $600/year of our own money plus whatever Daughter Person gets for her birthday/Christmas (is usually another$600 or so from various grandparents).  We intend to increase that significantly (into the $400-$500/mth range) once our debt is paid off so that we can completely fund her college for at least an in-state school.

I know that there are differing opinions on whether we should pay for her college or not, but we feel very strongly that we should pay for her undergraduate education at an in-state school.  If it comes down to it, we’re going to prioritize retirement over college, but hopefully, we plan better than that.