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financial planning

Remortgaging Your Home at a Lower Interest Rate

Jan 31st, 2011
by jsanders.
1 comment

Remortgaging your home at a lower interest rate comes with several advantageous aspects. Many people purchase a home with what they think are reasonable interest rates; however, many times as time goes by they see that interest rates have dropped. Remortgaging is a wonderful way to access and take advantage of a lower home interest rate. Many times the result of remortgaging leads to a lower monthly mortgage payment, as well as being able to consolidate other debts. Both lenders and brokers can help a person decide if it is best they proceed through a remortgage process.

Important Things to Consider

It is always important to keep in mind that a remortgage should be heavily evaluated and contemplated before completed; this is the key behind making a remortgage cost efficient. Thinking ahead often allows a debtor to secure a remortgage rate several months in advance. Being able to secure a rate in advance enables a debtor to stay ahead of potentially rising interest rates. Almost all lenders will advise debtors to think ahead at least 6 weeks when they want to secure a loan before one expires.

Plan Ahead

Being prepared and staying ahead of the market involves a great deal of research. This allows a person to find the absolute best interest rates to help them save money on a remortgage. Most times it is wise to consult with a broker and/or lender and follow their advice; after all, remortgaging is a daily part of their lives. There are many online websites that offer remortgage price comparisons, and these are very helpful tools to view when it comes to receiving an accurate idea as to whether a debtor should refinance.

Lowering the amount of a loan significantly helps the chance of securing a remortgage loan with a low interest rate. Many lenders will allow a debtor to pay off part of their existing mortgage with any savings or extra money they have on hand. Lower interest rates are almost always accompanied with loans that have a lower value.

Be Prepared and You’ll Be Fine

The remortgaging process is often confusing; however, being prepared is the key aspect at obtaining all the benefits it has to offer. Always think ahead, shop around for different available interest rates, and always try to lower your mortgage loan amount. Not only will remortgaging save you time and money, many times it can help bring you peace of mind.

There is no need to stress about remortgaging. The easiest way to see if you qualify for a remortgage is to talk to your lender. They can guide you through the complete process of a remortgage, and most times offer you helpful tips that will save you time and money when it comes to completing the process.

Photo by james.thompson

Lifetime Income Disclosure

Jan 28th, 2011
by jblankenship.
2 comments

lifetime supply by Christina Welsh (Rin)There is a piece of legislation hanging around in the Senate that makes a good deal of sense, and really shouldn’t cause too much grief to implement in the long run.

This particular bill, introduced by Senators Bingaman (D-New Mexico), Isakson (R-Georgia), and Kohl (D-Wisconsin), is called the Lifetime Income Disclosure Act, and it proposes that the administrators of ERISA-approved retirement plans provide for their participants a disclosure of the “annuity equivalent” of the total benefits that each participant or beneficiary has accrued within the retirement plan.

What this means is that, for likely the first time for most folks, an estimate would be provided to them with their statement that outlines what that lump sum means in terms of real, annualized income replacement in retirement.

Specifically, the government would establish certain assumptions about the annuity value of a lump sum, given the participant’s age, and from those assumptions a lifetime income stream valuation would be derived.

This could be an important provision giving folks an eye-opener into what they could expect from their 401(k) plan when they retire.  Most folks won’t actually purchase the annuity described for many reasons, one being that in order to purchase an annuity you must deal with an annuity salesman.  But this illustration of the potential income value is a good step in the right direction for folks to gain a better understanding of their present position.

Of course, just knowing this fact won’t necessarily resolve our retirement savings shortfalls, but maybe it would help to inspire folks to save more and spend a little less.  Every little bit can help.

If you agree with me that this provision makes sense and if you’re inclined to do so, write or call your representatives in Congress and tell them so.  Unless you speak up, they won’t hear you.

Photo by Christina Welsh (Rin)

Your 2% Opportunity in 2011

Dec 31st, 2010
by jblankenship.
1 comment

opportunity center by {Guerrilla Futures Jason Tester}By now you’ve heard the news from the 2010 Tax Act – one of the provisions is that during calendar year 2011, the Social Security withholding tax is reduced from 6.2% to 4.2%.  This means that you have an additional 2% of your income, up to the $106,800 limit, available to you to do with as you wish.  This is your opportunity to make a splash!

I think it would be a very good idea to bump up your 401(k) deferral by 2% if you aren’t already maxed out.  If you have maxed out your 401(k), you could use the extra money to contribute to your Roth IRA, or put some money into your taxable investment account.  No matter what, since this money was originally intended to be for retirement (if it had been withheld for Social Security, it would have gone to *someone’s* retirement), you should put it toward some variety of savings or debt paydown.

It’s not often that you get the opportunity to take control of your Social Security withholding, and many folks are chomping at the bit to do just that.

Don’t waste your opportunity – this is the chance you’ve been waiting for!

Photo by {Guerrilla Futures | Jason Tester}

Timeless Thoughts on Investing

Dec 13th, 2010
by jblankenship.
1 comment

800px-Timeless_BooksI was recently reading an older book, The Money Game, by “Adam Smith”, and I came across a very poignant passage that I thought I should share.  This book was written in 1967, and it is a very interesting view of money and how we view it.

The passage relates to how we view investments in general, as well as the importance of having a goal for your investments and saving activities.  Keep in mind that passage was written more than 40 years ago, so some references will be woefully out of date, but the message is still clear and valid.  Let me know if it gives you inspiration – I thought it was particularly good:

A stock is, for all practical purposes, a piece of paper that sits in a bank vault.  Most likely you will never see it.  It may or may not have an Intrinsic Value; what it is worth on any given day depends on the confluence of buyers and sellers that day.  The most important thing to realize is simplistic: The stock doesn’t know you own it. All those marvelous things, or those terrible things, that you feel about a stock, or a list of stocks, or an amount of money represented by a list of stocks, all of those things are unreciprocated by the stock or the group of stocks.  You can be in love if you want to, but that piece of paper doesn’t love you, and unreciprocated love can turn into masochism, narcissism, or, even worse, market losses and unreciprocated hate.

It may sound a little silly to have a reminder saying The Stock Doesn’t Know You Own It were it not for all the identity fuel provided by the market these days.  You could almost sell these identities as buttons:  I Am the Owner of IBM, My Stocks Are Up 80 Percent; Flying Tiger Has Been So Good to Me I love It; You All Laughed When I Bought Solitron and Look at Me Now.

Then there is a great big master button called I Am a Millionaire, or I Am So Shrewd My Portfolio Has Gone into Seven Figures.  The magic of this million-dollar number, and of its accessibility to Everyman, is so great that books sell with titles like How I Made A Million or You Can Make Millions, with very little content at all.  They are the most dangerous of all the things written on the market because (and I collect them as a hobby) inevitably there is some mechanical formula somewhere within.  Never mind who you are or what your capacities and abilities are, just charge in with the book open to chapter three.

If you know that the stock doesn’t know you own it, you are ahead of the game.  You are ahead because you can change your mind and your actions without regard to what you did or thought yesterday; you can, as Mister Johnson said, start out with no preconceived notions.  Every day is a new day, providing, in the Game, a new set of continuously measurable options.  You can live up to all those old market saws, you can cut your losses and let your profits run, and it doesn’t even make your scar tissue itch because, being selfless, you are unscarred.

It has been my fate to know people who have made considerable amounts of money, sometimes millions, in the market.  One is Harry, who made it and blew it and made it again.  Harry really wanted to make a million dollars, and he did.  I think Mr. Linheart Stearns had a very good point when he said the end object of investment ought to be serenity.  Now if you think making a million dollars will give you serenity, there are two things you can do.  One is to find a good head doctor and see if you can discover why you think a million dollars will give you this serenity.  This will involve lying on a couch, remembering dreams, talking about your mother, and paying forty dollars an hour.  If your course is successful, you will realize that you do not want a million dollars but something else which the million dollars represents to you, such as love, potency, mother, or what have you.  Released, you can go off about your business and not worry any more, and you will be poorer only by the number of hours you spent in accomplishing this times forty dollars.

The other thing you can do is to go ahead and make the million dollars and be serene.  Then you will have both a million dollars and serenity, and you do not have to deduct the number of hours times forty dollars unless you feel guilty about making it.

It seems simple, and there is indeed a catch.  What do you do if the million dollars arrives and serenity does not?  Aha, you say, you will worry about that when you get to it, you are shure you can handle it.  Perhaps you can.  Money, contrary to popular myth, does help people more than it spoils them, simply because it opens up more options.  The danger is that when you have your million, you then want two, because you have a button saying I Am A Millionaire and that is who you are, and there are, all of a sudden – as you will notice – so many people with buttons saying I Am a Double Millionaire.

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The trouble with Harry is not just the trouble with one man who made and lost a lot of money, nor even that there are hatching, at this very instant, other Harrys who will play out this role next month and next year.  The trouble goes beyond Harry, beyond Wall Street; it’s a kind of virus in the whole country, when the cards of identity say not how well the shoe is cobbled or the song is sung, but are a set of numbers from an adding machine.  Usually we hear only the triumphs by adding machine, but those who live by numbers can also perish by them, and it is a terrible thing to have an adding machine write an epitaph, either way.  Perhaps measuring men by the marketplace is one of the penalties of our age, but if some scholar would tell us why this must be, we would all know more about ourselves.

Boilt down, the gist of this passage is two lessons:

1) Don’t get emotionally involved in your stock, fund, or whatever investment you make.  All decisions should be made without regard to your past ownership or any other factors besides the fundamental and technical analysis you do on your investment choices.

2) Have a goal in mind for your investment activity.  What “Smith” recommends is simply serenity – and if you can define “serenity” for yourself, you’ve set the goal.  And if serenity isn’t what you’re looking for, choose and define “chaos” or whatever is important to you.

Photo by Wikimedia

Excerpt from The Money Game, by ‘Adam Smith’, pages 81-84

New Book: “Can I Retire?”

Dec 6th, 2010
by jblankenship.
4 comments

Can I Retire CoverMy friend Mike Piper at Oblivious Investor recently published a new book Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less. The book is available for sale on Amazon.

As the latest addition to Mike’s “…in 100 Pages or Less” series, this book answers two questions:

  1. How much money will you need to retire?
  2. How should you manage your retirement portfolio to minimize the risk of outliving your money?
What Makes This Book Unique?

How does this book hope to be better than, for example, The Bogleheads’ Guide to Retirement Planning or Jim Otar’s Unveiling the Retirement Myth?

It doesn’t. It’s not better. It’s shorter.

Can I Retire? is written for the person who might not be able to find the time to read Otar’s entire 525-page book or the 370-page Bogleheads’ Guide.

If you’re considering reading a more in-depth guide to retirement planning, I wholeheartedly encourage you to do so. (Both of the above-mentioned books are excellent!) But if there’s a good chance that, if you were to buy one of those other books, it would sit unread on your coffee table or bookshelf, then this book is written for you.

What Topics Does the Book Address?

Some of the topics addressed in the book include:

  • How to calculate how much you’ll need saved before you can retire,
  • How to use annuities to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • When it makes sense to use a Roth IRA conversion to save on taxes,
  • How to choose an appropriate asset allocation for your retirement portfolio, and
  • How to minimize taxes by proper use of an asset location strategy.
Retiring Soon? Pick Up a Copy of Mike’s New Book:

Can I Retire CoverCan I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

Click here to see it on Amazon.

Organization, Efficiency & Discipline

Nov 29th, 2010
by jblankenship.
2 comments

organization by BLW PhotographySimplification is usually beneficial to any pursuit.  If you can break down the basic principles of whatever “big thing” it is that you’re hoping to accomplish into simple concepts, you’ll do well in your pursuit.

This is true for whatever you’re hoping to accomplish – climbing Mount Everest (train, prepare, keep going up); write a book (gather information, organize, keep writing); or get a college degree (show up, pay attention, study).  In preparing for retirement, I’ve always broken the concepts down to organization, efficiency, and discipline.

Organization

In order to get things started, it’s important to know where you are in your financial life.  When you’re getting driving directions from Google Maps, the first thing they ask you is where you’re starting from.  The same goes for “mapping” your financial path.  Gather together your information and organize it so that you know what assets and what liabilities you have.  This can be as simple as listing everything out on a piece of paper, or a computer spreadsheet, or using some of the tools available on the internet, such as Mint.com.

Also gather your information about your monthly and annual expense requirements – preferably with an eye toward understanding what is a “must” expense and what is a “nice” expense.  If you’re having trouble balancing your budget (your income is less than your expenses) you’ll need to look at the “nice” expenses and determine what you can do without.

The last piece of Organizing is to set forth a goal – or several goals, depending on your situation.  Maybe it’s a goal to retire in five years… or to send your kids to college in 8 years.  Whatever is the goal, you need to quantify it (put it in terms of dollars and time), and so that you can map out the way to get there from where you are now.

Having everything organized will tell where you are financially, and knowing what your expenses are, compared to your income, will help you to understand what you can do to make changes in your financial life in order to reach those goals.

Efficiency

Now that you know where you are and where you’re going, it’s time to figure out how to get there.  As you know, there are many types of investment accounts, investment products, and the like, that you could use to increase your bottom line.  My preference is to use the most Efficient methods, in terms of placement of funds, taxes, expenses, and risks, in order to take you toward those goals.

We discussed the most Efficient placement of funds in an article some time back, entitled Retirement Savings – Where to Start.  This article will help you to understand which types of accounts are the best for saving your money.  The article also helps you with maintaining efficiency in terms of the tax treatment of your various savings vehicles as well.

Efficiency in expenses can be addressed by utilizing no-load index mutual funds and/or Exchange-Traded Fund (ETF) indexes.  These two types of investment products generally provide the most cost-efficient methods of investing.  In addition to the cost-efficiency, ETFs are also very tax-efficient, due to the structure of the funds.

Not only are indexes very cost-efficient and tax-efficient, but indexes are also risk-efficient as well.  If you invest in indexes you are getting (generally) the market’s movement in returns – something that less than 40% of managed funds can do regularly.

Discipline

Now that you’ve figured out the methods to use in getting to your goals, you have generated a plan to accomplish those goals.  This is where discipline comes into the picture.  In order to achieve these goals, you have to create your plan and stick to it, through thick and thin.

When the market is having difficulties and your accounts are experiencing a downturn, you need to maintain the intestinal fortitude to continue with your investing activities.  This is where a good financial advisor or just an accountability partner can help you out a great deal.

It’s maintaining the long-term view in the face of short-term “noise” like a market downturn that helps you to meet those goals.  Chickening out and selling at the wrong time can derail things.

Discipline also extends to creating your budget and sticking to it as well.  By reviewing your expenses and determining where you can reduce, you’ll be able to free up more money each month to eliminated debt and increase your savings balances.

Bottom line

By putting these basic tenets of Organization, Efficiency & Discipline to work for you, you will soon begin to see progress toward your goals.  Keeping things as simple as possible helps to ensure that you’ll stay with your plan.  As with everything else, let me know if you have questions!

Photo by BLW Photography

Not Sure About a Roth Conversion in 2010? Don’t Fret

Nov 17th, 2010
by jblankenship.
2 comments

fender fret by markhillaryAs you’ve undoubtedly seen EVERYWHERE, 2010 is a special year with regard to Roth Conversions.  This is due to two changes to the law that took effect this year: 1) the income limit on Roth Conversions was lifted – previously if your MAGI was greater than $100,000 you couldn’t do a conversion; and 2) there is a special provision for 2010 conversions that allows you to spread the tax over 2011 and 2012.

But maybe things aren’t so clear cut for your situation so that it makes very good sense for you to do a conversion in 2010.  All is not lost!  The only part of this special 2010 set of provisions that you’re missing out on is the tax spread provision.  Although this is a good provision to take advantage of for some folks, it’s not a defining reason to do a conversion without other compelling factors.

Perhaps your tax rate this year and for the foreseeable future is going to be relatively high, making a conversion not such a good idea this time around.  The good thing is that the first part of the law change is permanent:  you won’t have the income limit problem in the future for other potential Roth Conversions.

Of course, if your MAGI is greater than $100,000 it could be argued that a Roth Conversion might not make sense for you anyhow… but the point is, Roth Conversions can be done in 2011, 2012, and for as long as the law allows.  It doesn’t have to be done in 2010.  So, if you’re not sure about doing a Roth Conversion this year, relax – look at it again next year, and the next, and just see then if it makes sense.  And if you need help looking over the numbers for a conversion, just let me know.

Photo by markhillary

Social Security vs. Saving

Nov 12th, 2010
by jblankenship.
3 comments

bank safe combination by Todd Ehlers I received a question from a reader that sort of dovetails with the post from last week about payback from Social Security, so I thought I’d run through the numbers on his question here.  As you may have noticed, I never met a spreadsheet I didn’t like!

Here’s the question from the reader, verbatim:

started work at age 20 retire at age 70.

Over 50 years of work I average $50,000 a year.

If I put 10% of my income away every month from age 20 to age 70 how would I come out versus depending on the government social security checks I would receive after retirement.

Initial Reaction

My initial reaction to this question was that you’d be much better off with the savings option, since you’re saving at a much greater rate (10%) than the withholding, and for fifteen more years than the Social Security system takes into account.  However, that’s not altogether correct, since the Social Security system includes both your withholding and your employer’s withholding, for a rate in 2010 of 12.4%.  But this rate is much lower in the earlier years of the calculations. So let’s go ahead and run the numbers.

Assumptions

There are a few assumptions that we have to make in order to complete this problem:

  • In order to come up with an average of $50,000 per year, I first looked at the maximum Social Security withholding.  By calculating the average from 1961 to 2010, we come up with an average of $43,804.  This is a little less than the average that the reader suggested, but it will work for our purposes and keep the calculations a bit simpler.
  • Putting aside 10% each year requires that we come up with a rate of return for this investment account.  I used a simple 5% return, which is reasonable over that period of time.
  • I assumed that the side account is an IRA or a 401(k), so taxes have not been factored into the equations.

Calculations

As we saw in the previous post, earning the Social Security maximum over the final 35 years of your working career will give you a monthly benefit of $3,204 in 2011.

Saving 10% of your earnings (using the maximum Social Security wage base) over 50 years at 5% will bring you to a total in your IRA or 401(k) of $443,969.  Unfortunately, just running a few simple quotes from single premium annuity websites indicates that a joint and survivor annuity paying a $3,200 monthly payment will cost a total of $584,830 or $610,909 depending on the website you choose.  And that’s a fixed payment, not a COLA-adjusted payment like your Social Security benefit is.

However, upon the death of both you and your spouse, there is nothing left over – so the question becomes one of longevity.  If you both live long, full lives, the Social Security option works out much better.  If you and your spouse die earlier, any time before about age 85, there will be something left over for your heirs in the savings option.

Of course, the Social Security benefit could be taxed, up to 85% depending upon your other income.  Since the savings option is in a qualified account or an IRA, 100% of the disbursements will be taxed.  If it was a non-qualified account, just a regular savings or investment account, the taxation would be considerably less.

Conclusion

In the end result, it seems that the Social Security benefit option is a pretty good deal, especially since we all hope to live a long, full life.  The savings option works better if you die earlier than (roughly) age 85, providing a residual amount to your heirs.  This is a little different from what I’d originally thought, but when you consider that the average life expectancy of a male age 70 is roughly 84 (86 for females), there’s a high probability that you won’t outlive your savings, although there’s a similarly high probability that you will outlive your savings.

And finally, since you don’t really have a choice in the matter, the entire question is really moot – but an interesting exercise, nonetheless.

Photo by Todd Ehlers

Your Payback from Social Security

Nov 5th, 2010
by jblankenship.
3 comments

800px-Hold_on_to_the_sheepOne of the big questions that many folks face with regard to Social Security benefits is – I’ve paid in so much, will I ever see it come back?

I thought I’d show what a payback break-even might look like, in terms of the money you put into the system and what you’ll get back out of it.  I made an assumption in the calculations:

  • Future COLAs were not calculated into the example, keeping things in terms of today’s dollars.  COLAs would only confuse the calculations.

Full Retirement Age

In this first series I assumed the normal, Full Retirement Age scenario, with two options:  1) you earned exactly half of the wage base that SSA requires withholding for each year of your 35-year working life, and you’re now age 66, Full Retirement Age; and 2) you earned exactly (or more than) the maximum amount of money that the SSA requires withholding during that period.  Here’s the outcome:

Earnings Withholding Benefit Payback Period
Half $1,037,350 $64,315.70 $1,728/month 3 years, 1 month
Full $2,074,700 $128,631.40 $2,427/month 4 years, 5 months

Did you find that surprising?  I bet you might have.  So, in terms of dollars in, dollars out, you get your money back out of the system in less than four and a half years, even less if you earned less.

I’ve included the half wage base example to point out the fact that people who earn more take a longer time to receive all of their money back out of the system.  This is because of the way your benefit is calculated – notice that the benefit for the half wage base earner is actually 71.2% of the benefit of the full wage base earner, even though the half wage base earner only earned (and paid in) half of what the full wage base earner did.

But wait a second… if I didn’t have that money withheld by SSA, I’d be doing something with it, right?  Okay, let’s look at the situation if you had put that money into a savings account for later use (but we all know you’d likely have just bought something with it, right?).

Saving The Withholding Yourself

So we’ll assume that you put this money aside in a savings account which earns 3% per year.  Here’s the outcome:

Earnings Withholding
(plus interest)		 Benefit Payback Period
Half $1,037,350 $99,386.93 $1,728/month 4 years, 9 months
Full $2,074,700 $198,773.90 $2,427/month 6 years, 9 months

Still, in my opinion, a pretty surprisingly low number.  This means that, in the maximum withholding example, you’ll get back everything that you put into the system in less than 7 years, by your age 73.  And if you calculated in the value of the employer’s portion of the withholding, the figure would double, to your age 79½, approximately.  In the half wage base earner example, your money is returned to you in less than five years, by age 71.

What happens though, if you take your benefit early, at age 62?

Starting at age 62

Since at age 62 you’d be taking the benefit at a 75% rate, this will take a bit longer to pay back, but you’re starting earlier so you’ll perhaps have more life ahead of you to achieve the payback.  Here’s the result from these calculations (with the interest factor built in):

Earnings Withholding
(plus interest)		 Benefit Payback Period
Half $1,037,350 $99,386.93 $1,296/month 6 years, 4 months
Full $2,074,700 $198,773.90 $1,820/month 9 years, 1 months

In the half wage base example, your payback period is increased to more than 6 years, but you’re only age 68 at this stage.  Also with the full wage base, more than two years is added to the payback period, but instead of age 73, you hit the break-even point at age 71.  And once again, if you factor in the employer’s portion of the withholdings, the payback period is doubled, to your age 80 – just slightly more than the payback period for beginning at FRA.

Just for grins, let’s figure this out for age 70.

Starting at age 70

By delaying to age 70, you achieve an 8% increase in your benefit each year.  Here’s the tale of the tape (again, with interest added in):

Earnings Withholding
(plus interest)		 Benefit Payback Period
Half $1,037,350 $99,386.93 $2,281/month 3 years, 7 months
Full $2,074,700 $198,773.90 $3,204/month 5 years, 2 months

In the full wage base example, your personal money paid into the system, with interest added, is paid back in just over five years (less than four years in the half wage base example), when you’re age 75, or just over age 80 if you include the employer’s portion of the withholding.  In the half wage base option you’ve been paid back in full just after your age 73½.

Conclusion

If you happen to have the mindset that you should try to get your money back out of the system as soon as possible (which I believe is a short-sighted approach), then you should start taking your benefit as early as possible at age 62.  You’ll get your payback by age 71 if you’ve maxed out your withholding, or by age 68½ in the half wage base example.

Unfortunately, you’ll be short-changing yourself (and your spouse, if you’re the primary breadwinner) of future increased benefits at the cost of saving only four years in the payback cycle (or five years in the half wage base example).  See the article Ah, Sweet Procrastination! for more details on the benefit of delaying taking your Social Security benefit.

Photo by Wikimedia

Are You Really Diversified?

Oct 25th, 2010
by jblankenship.
1 comment

alter eggo by turtlemom4baconSometimes we fool ourselves.  Sometimes we think we’re doing the right thing, when in fact the result is that we’re not doing what we think we are.

I’m talking about your investment diversification.  Within your 401(k) you have certain options available for you to choose from:  a large cap stock fund, a mid cap stock fund, an international stock fund, and a bond fund.  Recalling an article you read somewhere… you know you need to split up your investments among many allocation options.  So, wanting to do this diversification thing right, you split up your 401(k) contributions with 25% in each of the funds available.  You’re well-diversified, right?

Wrong city, bucko.

Correlation

Welcome to correlation.  Investopedia defines correlation as: a statistical measure of how two securities move in relation to each other.  It’s pretty complicated, but the gist is this – if two securities are perfectly correlated, when one moves up or down, the other moves up or down in perfect relation to the other.  Such securities are said to have a correlation coefficient of +1.

On the other hand, if one security moves up and the other moves down (and vice versa, by the same proportions), they are said to be negatively correlated, with a correlation coefficient of -1.

Lastly, if one security’s movement has no relationship whatsoever to the other security – that is, any particular movement by one of the securities may or may not result in a movement in the same direction, the opposite direction or no movement at all.  These two securities have a correlation coefficient of 0 (zero).

Most pairs of common securities fit somewhere along the spectrum between +1 and 0, since very few are perfectly correlated.  Negative correlation is typically found in hedge funds – which are a costly, complex sort of asset to hold, being designed to work opposite of the general market movements.

With the above explanation, hopefully it becomes clearer to you why we want securities in our portfolio that are not correlated closely to one another… having such pairs of securities spreads out our risk of any single market event having adverse impact on everything in our portfolio.

Examples of Correlation

Back to our example portfolio, here are the correlation coefficients for your four choices, shown in a matrix:

1 2 3 4
1. Large-Cap Stock 1.00 0.96 0.93 0.28
2. Mid-Cap Stock 0.96 1.00 0.91 0.27
3. International Stock 0.93 0.91 1.00 0.44
4. Bond Fund 0.28 0.27 0.44 1.00

As you can see, the large cap, mid cap, and international stock choices are very closely related to one another.  That’s why, even though you thought you were well-diversified during the market slump a couple of years ago, everything you had took a dive.

This is why the first, most important allocation choice you can make is between stocks and bonds (we’ll get to some other allocation options later).  These two, of the choices you have, are the least correlated, so it’s very important to include these non-correlated assets together in your allocation scheme.  And then within your chosen split into stocks, you can choose some of the other asset options – large cap, mid cap, small cap, international – since those assets aren’t perfectly correlated, it can be beneficial to include diversification among these options as well.

The same goes for bonds – other types of bonds, such as Treasury Inflation-Protected bonds, are not perfectly correlated with the total bond market, so it might make sense to include some of these as allocation options as well.

What about other types of assets?

We’ve talked about some very basic allocations – but what about other types of assets?  There’s real estate (both domestic and international), emerging markets stocks, commodities, and others.  How does the correlation of these assets look?

The table below details the correlation matrix for these additional assets in relation to domestic stocks, international stocks, and bonds.

1 2 3 4 5 6 7
1. Domestic Stock 1.00 0.93 0.27 0.84 0.93 0.89 0.60
2. Int’l Stock 0.93 1.00 0.44 0.79 0.96 0.93 0.65
3. Domestic Bond 0.27 0.44 1.00 0.33 0.39 0.32 0.25
4. Domestic RE 0.84 0.79 0.33 1.00 0.83 0.68 0.44
5. Int’l RE 0.93 0.96 0.39 0.83 1.00 0.88 0.65
6. Emerging Stock 0.89 0.93 0.32 0.68 0.88 1.00 0.71
7. Commodities 0.60 0.65 0.25 0.44 0.65 0.71 1.00

As you can see in the matrix, adding these additional asset classes gives you even more diversification (per the correlation).  Commodities show up as the next most non-correlated, after bonds, which explains why this is an important asset class to include.  Not only are commodities not well correlated with stocks, they are even more non-correlated to bonds.

Real estate, both domestic and international, gives you some diversification, but not nearly as much as bonds and commodities – turns out that real estate, while not a perfect match for stocks, does follow the movement of stocks somewhat closely.

How?

You might be saying “but I don’t have those kinds of options available in my 401(k)” – what can you do?  This is part of why it can be useful to have other savings plans in your scheme, such as a Roth IRA or a taxable account.  With these other accounts, you can have the flexibility to invest in whatever asset classes you like.

Photo by turtlemom4bacon
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