USING MUTUAL FUNDS

Throughout this book, most discussion and examples have assumed you are using some type of mutual fund for your investment program. The last sections of Chapters 1-3 pointed out some basic reasons why this is recommended. This section reviews your options, and it suggests that you consider using fully diversified low-expense no-load funds to carry out your formula strategy economically and effectively.

The Fund versus Stock Choice

If you are going to invest in the stock market, you could do so directly by buying shares of individual stocks, or you could indirectly buy the market by investing in mutual funds. There are two main reasons why you should use the indirect approach in implementing your formula plan: to minimize transaction costs (return enhancement) and to facilitate diversification (risk reduction).

Depending on which mutual fund you are considering and your volume of investing, your expenses for a formula plan can be much lower with a mutual fund. When you accumulate shares over time, low volume can cause sizable expenses with individual stocks but hardly any problem with most mutual funds. Small share purchases through a broker literally cost a fortune in terms of percentage of the amount invested. Some stocks provide dividend reinvestment plans and optional stock purchase plans directly through the company,¹ at no commision—perhaps one of the few routes for the individual investor to use low-cost DCA investing in individual stocks. There’s really no sensible way to use value averaging with an individual stock, though. No-load mutual funds that have low numbers for turnover, management fees, and other expenses will do a much better job of keeping your investment expenses down to a reasonable minimum.

Perhaps more important than the expenses incurred with buying individual stocks over time is the unnecessary risk you take in your formula strategy. Using a single stock for dollar cost averaging would leave you so undiversified that the risk factor in your investment returns could double, or worse. Individual stocks have more volatile returns, can take extended moves in the wrong direction, and can even go bankrupt. After decades of dollar cost averaging in stocks in the buggy-whip industry, some investors ended up with nothing to show for their trouble. Even though diversified mutual funds do have uncertain returns that can go down for a while, they are not likely to head south and never return. Individual stocks have gone bankrupt, but the stock market as a whole has never done so (although it came close in the 1930s). This point is exceptionally important for the value averaging strategy, which involves such heavy buying on downturns (you certainly wouldn’t want to “average” yourself all the way down to zero). It is critical that an investor using any variation of value averaging select an investment vehicle² that will not trend downward over extended time periods, such as a very diversified no-load mutual fund. You might even consider expanding your view of “the market,” investing in one of the many funds that balances investments across a more diversified set of assets than just common stock.

No matter what fund you choose, most likely you will desire it to be “linked” with a money market mutual fund for simplified transfer of funds (telephone switching) into and out of your investment plan. Most stock funds have an associated money market fund or are a member of a broader “family of funds,” giving you greater flexibility.

The mechanics are simple for using the fund in a value averaging plan. Once each month, quarter, or whatever period you choose, figure out how much you need to invest (or sell) to get the right value of your holdings. Ask yourself:

• What should the value of my holdings be this period? (Check your value path.)

• What is the actual current value of my holdings?

• What is the difference, which I must buy (or sell)?

Then call and make the transfer. Don’t fret that the price you used for your calculation was yesterday’s (today’s price is yet unknown)—this minor uncertainty makes the VA process less exact but reduces the rate-of-return advantage over dollar cost averaging only by a negligible amount.

Index Funds

Although hundreds of mutual funds exist that are extremely well diversified, some have sales loads or very high expenses. If you feel that the value provided is worth the money, then no one has the right to keep you from buying into “expensive” mutual funds. But for all of the work that goes into trying to make each mutual fund outperform the stock market, the overwhelming evidence is that the vast majority of actively managed funds actually underperform the market. If you happen to know up front which funds will perform the best, then you certainly have better things to do with your time (and your substantial millions) than reading this book. If, however, like most of us you have no idea which funds will do best in the future, then there are several roads you can take to seek a fair return for your risk. Beyond picking a comfortable risk level, getting convenient services, and meeting a few other criteria, perhaps the most tangible thing you can do to help increase your net returns using mutual funds is to keep expenses as low as possible. Stock index funds generally fit this bill, as they strive merely to match some market index—not a bad goal in that doing so would put them well into the upper half (of long-run returns) of all mutual funds’ performance. Due to the need for fewer active managers and less stock turnover, most index funds can provide diversified investment services with very low management fees and expense ratios. Thus, you can come very close to achieving the type of market returns seen in Chapter 1, without spending a lot on sales loads, management fees, and other expenses.

Information on Specific Funds

Remember, this book is not about mutual fund selection. Pick the mutual fund (or other investment vehicle) you are most comfortable with for use in your accumulation plan. Consistent with the discussion in the previous section, though, a few index funds and other mutual funds with very low expense ratios are provided in Table 10-1. In no way are the funds recommended as the best available, nor is the list exhaustive. It is merely a starting point to give you some basic information you may find helpful in your wider search for the right fund for you.

TABLE 10-1 A Sampling of Equity Mutual Funds with Telephone Switching ⁵

This list is by no means complete; there are certainly other perfectly good funds that were not listed.³ Each fund here met several screening criteria⁴ that made them potentially appropriate for use in a formula strategy such as value averaging. All of them require a low minimum investment (at least for an IRA), and they all have “telephone switch” privileges and an associated money market fund. They are all no-load funds, with an expense ratio of 1.0% of asset value or lower; the expense ratio (including management fee, 12b-1 charges, and the like) of these funds averages only 0.76%, about half of the equity fund average of 1.43%. They are very diversified funds, closely matching either the performance of the S&P 500 stock index or the NASDAQ average, for funds of smaller stocks. Using a standard measure of diversification,⁶ these funds are 91% diversified, compared with the average equity fund diversification of only 76% (100% is perfectly matching the index). In terms of the standard deviation of their returns, the average fund listed in Table 10-1 is slightly riskier than the average equity fund. The average annualized returns over the past 10 years favor the group above: 14.2% annual return (281% total return) versus the equity fund average of 12.6% annually (239% total). Numbers for the five-year average are 11.0% compared to the average fund’s 8.5%; for the shorter three-year period this group returned an average 15.2% versus the overall average of 9.9%. These may not be all the best funds for you to consider, but they are certainly not a bad lot to choose from for an affordable, well-diversified equity investment. Don’t just pick the fund with the highest historical return—it varies by the period chosen, and past performance is no real indicator of future success. Look at all the variables that concern you.

For investors who hold other assets besides just the one mutual fund, another relevant measure of risk is beta, a number that simply measures the amount of “co-movement” with the market. The average stock would have a beta of 1. If a stock has a beta of 0.6 and the market moved up 10% over a very short period, you would expect (on average) a 6% gain on the stock.⁷ The basic intuition is that high-beta stocks are riskier, even after you diversify them by putting them in a portfolio with other stocks. As a result, we expect that stocks (funds) with a higher beta will achieve a higher investment return, on average (deeper intuition about beta is beyond the scope of this book). The average equity mutual fund has a beta of 0.6-0.7 (depending on how/when you measure it), in that many hold a lot of cash, bonds, and other low-risk items as well as stock. In Table 10-1, the very low-risk funds have a beta of 0.5-0.6; the low-risk funds, 0.7-0.8; the average funds, 0.8-0.9; high-risk at 1.0-1.1; and the very high-risk funds have a beta of 1.1-1.3. The beta risk measure will help you (later in this chapter) with determining a reasonable estimate for the expected return factor r. Most of the major sources of mutual fund information available in libraries include an estimate of each fund’s beta.⁸

There are a few other promising funds for your potential use, but they do not allow telephone switching, which may not be a concern to many investors. Here are four that may meet your needs:

• Dodge & Cox Stock Fund has only a 0.65% expense ratio and a 97% diversification, almost as good as an index fund. Their 5- and 10-year average returns are 11.9% and 16.1%. Its beta, like the beta of the Vanguard index funds below, is just under 1.00. Phone (415) 434-0311.

• Dodge & Cox Balanced Fund is a very low-risk option with a low 0.63 beta. It has a 0.70% expense ratio, 96% diversification, and 5- and 10-year average returns of 11.0% and 14.6%.

• Vanguard Index Trust 500 is an index fund, with an incredible 0.22% expense ratio and a 100% diversification (it matches the index). The 5- and 10-year average returns are 11.6% and 15.1%. Phone (800) 662-7447.

• Vanguard Quantitative Portfolio is a similar but newer fund, but uses a little fancy footwork with more active management to try to eke out more return than the index fund. The expense ratio is 0.64%, the diversification is 99%, and it has an above-average 3-year return of 14.3%.

In choosing a fund, remember that low cost, diversification, reasonable performance, and convenience are all factors that should weigh heavily if you plan on using the fund profitably in a long-term formula investment plan (or even if you’re just going to “buy and hold”).

WORKING OUT THE DETAILS

As you’ve no doubt noticed by now, a multitude of sensible options are available for implementing a DCA or VA formula plan. This section tries to address some of the more common questions and concerns about putting a plan into action, while giving pointers on how to tailor one that fits your needs. Even though working out all the details ahead of time is an admirable goal, you should avoid becoming so paralyzed by details that you forget to start investing. As you gain experience with trying out different variations to the basic strategies, much of what you do will be “made up as you go along.” That’s OK, as long as you remember not to chicken out at market bottoms or get too excited at market peaks. A major goal of these formula strategies is to provide a discipline to guide you through these extremely emotional times in the market, sometimes against your “better judgment” (which judgment after the fact seldom turns out to have been better).

Examples of planning and executing these strategies, with all of their “real-life” complications, are provided in Chapter 11.

Using a Side Fund

With value averaging, or any other formula plan that involves purchases and sales, you should have a side fund in addition to your main investment fund. The obvious choice for this is a money market fund in the same family of funds as the primary fund in which you are investing.

The sometimes radical cash flows resulting from value averaging strategy scare some people at first glance. For example, after the October 1987 crash, you would have needed to invest a huge sum to meet your value goal the next month. Where would it have come from? From the other half of the value averaging—from previous sales. As the market went a little crazy going up in early 1987, you would have been selling a lot of “excess” shares to meet your value goal. You aren’t supposed to take this money out and have a huge party with it. You should put it in the side fund until it is needed back in the market after a later market dip—post-October 1987, for example. You won’t always have money in the side fund, though, particularly when the market is down. After all, this is not a self-financing strategy that creates value out of thin air.

One problem with value averaging is that you can’t automatically have the “right amount” transferred from your checking account into your investment fund every month (or other period). But if you establish a side fund that has telephone exchange privileges into your investment fund, you can set up an automatic investment using the following procedure. Start out with a little “buffer” money in the side fund—you may need it if the market goes down, and you have to have an initial investment anyway to start up in a money market fund. Next, set up an automatic transfer on a periodic (usually monthly) basis from your checking account into your money market (side) fund. The fixed amount you set up should be roughly equal to the value of $C (as described in Chapter 5), the effective net monthly investment in value averaging that was similar to the monthly amount in dollar cost averaging. Over time (every year or two), you should adjust this fixed amount up (increase $C at rate g, as discussed in Chapters 4 and 5) to keep up with increased prices. Then, each month or quarter (or period of your choice for “doing” value averaging), calculate your required investment, and make a telephone transfer of that amount from the side fund into your main investment fund. When a sale of shares is called for and you go through with it, just transfer the proceeds into your side fund, where you’ll keep them for a rainy day. Always maintain a side fund with value averaging if you plan to sell shares. You may need the money later when the plan calls for a sizable investment (after prices drop); if not, then you get an unexpected “bonus” return.

Operating Within a Retirement Account

Due to the tax advantages, a retirement account (IRA, Keogh, or SEP, for example) is the obvious place to implement a strategy such as value averaging. Because taxes are deferred in such plans, the fact that value averaging involves selling has no downside, as your gains taxes would be deferred. But because you can’t, as a rule, take money out of your retirement account at will, you need to establish a side fund along with your investment fund to hold your “winnings.”

Suppose you decide to use value averaging within an IRA, and you want to invest the full $2,000 each year. You can send $166.66 ($2,000 divided by 12 months) into the money market fund portion of the IRA using an automatic transfer. Then every period on your value path, call up and transfer the required money into or out of your stock mutual fund, also in the same IRA. Just make sure you set a value path that is reasonably small, considering your $166.66 monthly IRA investment limitation. You wouldn’t want to start with a value of $C that was already high, like $150. If you start out a value path that is too high, you may end with a recommended amount to buy that exceeds the amount you have in your IRA side fund, if the market goes down. Obviously you shouldn’t exceed the investment limits of your IRA, so you would just temporarily fall short of your value goal if the market did that poorly.

If your future goals are sizable, they may dictate a value path that demands sizable purchases, perhaps much more than the $2,000 per year allowed into your IRA account. You could meet your goals, though, by investing in a non-IRA account once you hit your $2,000 annual limit. More on this at the end of this chapter.

Establishing a Value Path

Chapters 4 and 5 went into great length about how to calculate the required investments and value path for the strategies over time. There are lots of options in this process, so it pays to be reasonable and make decisions now that you know you can live with later. A few guidelines in this section help you establish the value path (for value averaging) or the required investments (for dollar cost averaging) for your plan.

Recall that there are four pieces of information you need to help complete your investment puzzle. First is your final target or goal—$V accumulated in t years. The other three inputs are $C (your initial investment quantity for the first period); r, the expected rate of return on your investment; and g, the amount by which you are willing to increase your periodic investment ($C) each period. You must determine your own investment goal (remember to allow for the effects of inflation!), and you likely have some good concept of how much ($C ) you can contribute right now toward that goal each period. We’ll spend a bit of time now on the other two inputs: the growth factors r and g.

Remember, the process is not exact—you really don’t know what the market will do in the future. To that end, be a little conservative in your assumptions about market growth—conservative, but not timid. With government bond rates in the 7-8% range, a monthly r of about 1.0% for the expected rate of return on the stock market is reasonably conservative. Table 10-2 provides representative figures to use for r, the expected rate of return on your fund investment. If you invest quarterly and use quarterly figures in the formulas (from Chapter 4 or 5), then use the top of Table 10-2. If you invest monthly, you want to use the monthly rates of return in the bottom half of the table. Using a method⁹ similar to the calculation of the expected return on the stock market in Chapter 1, the expected return on a fund investment is calculated based on the interest rate and the fund’s beta measure of risk. For example, if the 10-year Treasury bond rate is 8.0% and you have a fund with slightly below-average market risk (β = 0.9), use a monthly r of 1.01 % or a quarterly r of 3.0% in any formulas that project compound growth or value paths over time. If you want to be conservative, then round the interest rate and the beta measure down to the lower cell.

TABLE 10-2 Expected Compound¹⁰ Return—Quarterly

(Use the number in the table as figure for quarterly r)

2006 NOTE

These numbers are a bit too high for today’s market expectations. Adjust the quarterly expected returns on top by subtracting - 0.3% and the monthly expected returns on bottom by subtracting - 0.1 % from the table returns.

The r growth factor just discussed refers to the expected growth of money you have already invested. The other growth factor, g, refers not to investment results, but to increases in your own contributions to the investment fund. In dollar cost averaging, g is simply the amount by which your investment changes from month to month (or whatever period is used). In value averaging, g is the amount of increase in your expected contribution each period, on average (that is, if your fund grows in value at the expected return, r). If you want to keep your net investment amount a little ahead of inflation, a reasonable value for g is roughly the T-bond ¹¹ rate (on an annual basis—divide it by 4 or 12 to get an approximate value to use for quarterly or monthly investing). You could also use the same value for g as you did for r; however, your required investment contribution would grow at a very steep rate over time. The lower you peg r and g, the less chance there is that you’ll be unpleasantly surprised by failing to meet your investment goal, or by having to shell out higher-than-planned amounts to invest.

Setting Up a VA Value Path: An Example

Here’s an example of how to set up a value path for a value averaging strategy.

Fred and Kathy Smith are considering a monthly value averaging plan. Recall that formula (19) from Chapter 5 for the value averaging value path was:

V_t = C × t × (1 + R)^t where 093

The Smiths plan to send their eight-year-old daughter to a public college in 10 years. Based on a recent Education Department study and their own calculations, the Smiths expect the average annual cost of a public college to be $12,500 by the 2001-02 school year. If a fund of $50,000 is accumulated in 10 years, it should be sufficient; interest after that point should keep up with the increases in later tuition years. They will use 20th Century Select Fund, which has a beta of about 1.07; the current T-bond rates are around 7.2%. Using Table 10-2, the pretax value to use for r is seen to be 0.98% monthly—that’s the expected rate of return over the average month for their fund investments. This fund is actively managed, so almost all of the capital gains are paid out and taxed each year, along with the fairly sizable dividends. Still, some of the gains accrue tax-deferred, and the Smiths estimate that their effective tax rate (they are in the 28% tax bracket) on fund investment returns is about 24%. Still, to be conservative, they use the full 28% tax rate here; that means that the after-tax rate of return is not 0.98% but only 72% (100% − 28%) of that, or 0.7%. The Smiths also expect to increase their average expected monthly contribution to the fund at roughly the T-bond rate of 7.2% annually, or 7.2% ÷ 12 or 0.6% monthly. Thus, the growth factors they will use are:

r_{after tax} = 0.7% g = 0.6% R = 0.65% = 0.0065

Recall that R is just the average of the two growth factors. Now they can solve for $C, in the formula:

$50, 000 = $C × 120 × (1. 0065)¹²⁰

$C = $191.49

So the value path for month t with value averaging would then be:

V_t = $191.49 × t × (1.0065)^t

The Smiths could establish t = 0 as right now, and no investment would be due yet (V₀= 0). Next month, the value path is $192.73, so in a month they would have to invest that amount. They would invest enough two months from now to increase their fund holdings to meet the value path of $387.97; in a year, $2,484; and after 10 years, the goal of $50,000. You could always establish t = 0 as the previous month, so that it is t = 1 right now, and you can start investing right away (and achieve your goal a month quicker).

Alternative #1. If the Smiths wanted to use a higher investment amount, $200 for example, and set t = 0 at the previous month, so that t = 1 now and t = 121 in 10 years, they could instead calculate a value path by solving for R instead of $C:

$50,000 = 200 × 121 × (1 + R)¹²¹

which yields a value of R = 0.0060, or R = 0.60%. Because R is the average of the 0.70% after-tax expected rate of return r and the contribution growth factor g, then g must be 0.50% for the average to work out to 0.60%. This g is a (roughly) 6% annual increase in their expected investment contribution. Using R = 0.0060, the value path they should follow is:

V_t = $200 × t × (1.0060)^t

and if t = 1 right now, their first investment should be for $201.20.

Alternative #2. The Smiths think they can increase their contributions over time at a faster rate than the g = 0.50% that was (implicitly) used in the last value path. Suppose they wanted to stay with the g = 0.60% (derived from the T-bond rate) used in the first example, giving the original average growth factor of R = 0.65%. Putting this, with $C = 200, back into the value path formula, they could just use the formula:

V_t = $200 × t × (1.0065)^t

With the t = 1 timing just discussed, in 10 years (t = 121), the resulting value is calculated to be $53,000, or $3,000 over their goal. This alternative is actually quite conservative, in that the plan to overshoot the goal yields a $3,000 future “buffer” in case anything goes wrong.

The Smith example has provided various methods of initial planning for the use of value averaging to achieve your investment goal. A much more complete example is presented in the next chapter.

Other Important Considerations

It is important to readjust your plan from time to time. One of the few universal truths in financial markets is that things change. No matter which strategy you use, you must reevaluate it every year or so to see if you are still on track with your ultimate investment goal, given your portfolio’s performance and any changes in the investment environment.

One simple but often overlooked step in setting ultimate investment goals is to consider inflation. If typical college costs are $60,000 today, it would be unrealistic to use $60,000 as your investment goal for your newborn’s college fund. Take a reasonable guess as to what that goal needs to be in the future, inflation and all. It’s OK if you gradually find you were wrong, because you should continually readjust your investment plan to account for miscalculations and new information.

Don’t feel you must follow the plan to the penny. If you are dollar cost averaging and your plan is to increase your monthly investment amount at a 0.5% monthly rate (a bit over 6% annually), you probably wouldn’t want to go to the trouble of actually increasing your investment every month—you more likely would automatically transfer the same amount each month. Simply adjust it each year. Start with an investment 3% higher; if you planned an initial amount of $100, invest $103 instead. As the required investment grows monthly on paper at a 6% annual rate (to $106), you will be 3% behind by the end of the year. So on average, it balances out to about the right amount over the entire year. Then at the end of the year, get back to 3% over your required amount (to about $109) by increasing your first-year amount by the necessary 6% or so. This approach is a lot easier, and it should preserve your sanity.

Finally, don’t forget that the relatively risky investments in your formula plans should be only a portion of your overall portfolio. Very few investors would be well served by having their entire portfolio of wealth all rolled up in a single asset.

Using Guidelines and Limits

You should establish sensible guidelines and limits for your investment plan so you can feel truly comfortable with it. We have already covered several such guidelines in previous chapters. For example, if you find yourself only a few dollars away from your value path, there’s really no need to buy 0.013 shares to equate to exactly the right value. Small variances like this will be picked up during the next period. Another example of such a guideline is the no-sell variation of value averaging, which may be better for some people in some situations (see Chapter 6). Another variation of this that has some nice properties discussed earlier (see Chapters 6 and 9) is to delay sales for a month or two.

One important guideline to determine up front is how often you will value average. Whereas most examples in this book have used a monthly period, a quarterly period may be better from a return standpoint, and in terms of lowering transaction costs and saving time. Using automatic monthly investments into a side fund and then doing value averaging on a less-frequent basis was mentioned earlier in this chapter.

One of the key concerns of some investors with the value averaging strategy is the perceived danger (as opposed to opportunity ) of the larger share purchases after market dips—imagine the size of the “required investment” after the 1987 crash. If that concerns you, you can limit the volatility of the cash flow in several ways. Let’s say you have a value averaging plan that currently involves roughly a $100 monthly increase. You could limit your monthly purchase to no greater than some amount, such as $300, $500, or $1,000—whatever maximum you’re comfortable with. Remember that much of this money probably came from prior sales of shares in the strategy, so the large sums being “invested” really aren’t always new contributions you had to scrape up. Taking this idea a step further, you could limit new contributions only. That is, you could invest any amount—as long as your side fund covers it—but never more than, say, $200 of “new money.” There are many ways to craft your own limits now to avoid excessive responses and guide your actions in later turbulent times. Wellthought-out guidelines may protect you against straying from your plan in a desire to follow the crowd.

It’s your investment program, and it’s your money. Make sure that the plan you follow is one you can be comfortable with, especially when times are particularly good or bad.

NOTES FOR FINANCIAL PLANNERS

Because some investors shy away from calculators and figures in general, financial planners often may find themselves dealing with some sort of formula plan as part of their advisory duties.¹² This section briefly highlights a few points concerning these plans that may be of interest to planners.

The guidelines and limits outlined above should be thought about by the financial planner, and discussed and perhaps “paper-traded” with the investor prior to any agreement to implement a plan. In familiarizing the investor with the process, the planner should lay out the value path and expected increase in the amount invested, as well as the projected portfolio value over time. Along the same lines, the planner should ensure that the investor understands the crucial role of the side fund as part of the investment plan in value averaging. The investor must not think of the side fund as a pot of bonus money to be spent immediately.

Dealing with inflation and taxes provides an opportunity for the financial planner to truly add value to this process. Reasoned input is important here, not only to make decent estimates of the ultimate investment value goal, but to evaluate how investor contributions might increase over time. The planner should integrate the long-term budget with information about expected changes in the availability of investment money. Perhaps investment accumulation can be programmed to accelerate now while income is increasing and demands are low so that later, when the family’s needs are greater, growth can be slowed. The plan should also be sensibly integrated into the overall investment portfolio; that is, limits should be established so that investment mixes don’t get too far out of whack, and so that the entire bond portion of the portfolio won’t need to be sold to buy into the value averaging fund after the stock market turns down.

Because reassessing performance and readjusting the plan is a possible area of planner involvement, financial planners should master the material in Chapters 4 and 5. Investment amounts, portfolio values, and value paths should be analyzed every year or so to ensure that the trajectory of the investment plan is still going to carry the investor to a pot of the required size at the end of the rainbow. Any change in an investor’s situation may require readjustment of the parameters of an established plan. Good examples of handling these and other complications are provided in Chapter 11.

Advanced Methods

Planners and investors may want to consider a few “advanced” possibilities.

It may be wise, and fairly simple, to take advantage of the term structure of interest rates instead of putting the VA side fund only into a money market fund. As of this writing, money-market interest rates are a few percentage points below the rates of CDs and intermediate-term bonds. For instance, if a bull market has your side fund flush with cash and your guidelines limit how quickly it can end up reinvested back into the main fund, then you can squeeze a little more yield out of the side fund by taking advantage of an upward-sloping term structure with bank CDs or a short-term bond fund. This may be more trouble than it is worth but would be beneficial in certain situations.

Another option with any of these strategies is to use closed-end mutual funds as the investment vehicle. Because closed-end funds are traded in the marketplace and involve commissions, this would probably make sense only for substantial investment plans. Still, many investors like closed-end funds for their discount feature. For the motivated and experienced investor, there are several well-diversified, closed-end funds available at a “discount” that might be viable for a formula plan. The investment amount could even be adjusted for the size of the discount, relative to some historical norm such as a 200-week moving average. However, I wouldn’t recommend this option if the commissions involved would be at all significant relative to the size of the investment.¹³

A final point of interest to planners has to do with using a split investment fund, best explained with an example. If you’re using value averaging as part of your IRA and one month you need to invest more than the tax laws allow, there’s nothing stopping you from investing the required amount outside your IRA, into a taxable account. Your value averaging investment would now be split between two funds. Later, if a sale was dictated, you would sell some of the IRA shares (moving the proceeds to the IRA side fund)—not the taxable shares—thus avoiding any tax liability. The split-fund approach has other applications to reduce transaction costs. For example, if you were to invest in closed-end funds, you would hate to sell and incur another brokerage commission. But if you split your investment between a normal fund and a closed-end fund, you could make all required sales out of the normal fund, thus avoiding excessive brokerage charges. Many investment programs could benefit from splitting funds between a base fund and a transaction fund, using the latter to effect transactions more cost effectively.

SUMMARY

There are limitless variations you could employ in executing a formula strategy. While previous chapters discussed the pros and cons of many of these variations, this chapter focused on employing them in a manner that you are comfortable with. Your decisions and actions alone will determine whether your investment plan gets results you can live with in good times and bad. So, tailor a plan you can be happy with!

ENDNOTES

1 Nearly all of the companies require that you be a shareholder before enrolling you in these purchase plans. To get your first share, there are three organizations that I know of that provide an alternative to using a broker. For a nominal service charge, they can arrange for the purchase of one share in many of the companies that offer dividend reinvestment and stock purchase plans. They are:

First Share, Marti Mernitz and Associates, 28 East 55th St., Indianapolis, IN 46220. (800) 683-0743.

Moneypaper, (a newsletter—Vita Nelson, editor), 1010 Mamaroneck Ave., Mamaroneck, NY 10543. (914) 381-5400.

National Association of Investors Corporation, 1515 East Eleven Mile Road, Royal Oak, MI 48067. (313) 543-0612.

2 In view of this discussion, I suppose it’s possible to value average a portfolio of individual stocks through a dividend reinvestment/ optional stock purchase plan, but, you would have to be careful. Suppose you had two stocks (you ought to have more!), and you used DCA to invest $200 in stock ABC and $100 in stock XYZ, monthly. If you wanted to value average your purchases, you should not set up separate value paths and use VA with each stock separately. You could, though, apply VA techniques to the total (portfolio) value, and then divide the portfolio investment between the stocks. For example, you could set value targets of $300 (Month 1) and $600 (Month 2) for your two-stock portfolio. If, at Month 2, your ABC had gone down to $170, and XYZ to $70 (for a $240 total), VA would call for a $360 investment. You would divide this: $240 to ABC and $120 to XYZ. Also, as selling is cumbersome in these programs, you would likely use the “no-sell” variation described in Chapter 6.

3 The previous edition listed several funds not shown here. These are good funds that didn’t quite meet all the screening criteria; the selection process is fairly sensitive to the time period chosen. The other funds are: Fidelity Trend, Founders Blue Chip, Janus, SAFECO Equity, SAFECO Growth, Steinroe Special, Vanguard Star, and Wellington.

4 The data analysis comes from the Rugg & Steele database, which is also used by Kiplinger’s Personal Finance and other magazines in constructing their annual mutual fund articles. All data were current as of June 1991.

5 Risk is measured relative to the market index, or the S&P 500 stock index in this case. Average risk is about 2.0% (weekly return standard deviation). The “Very High” and “Very Low” risk funds varied from the average by more than 25%.

6 The correlation coefficient (with the S&P 500 index) is given, put into percent form for exposition. Perfect diversification relative to the S&P index would give a coefficient of 1.00—in fact, a few index funds report a 0.99 or higher. The average correlation coefficient relative to the NASDAQ index for this group of funds was 0.87, compared with the average equity fund coefficient of 0.75. In this group, the highest “large stock” correlations (with the S&P 500) were 0.96, for 20th Century Select, Windsor II, and Vanguard Morgan. The highest “small stock” correlations (with NASDAQ) were .91-.92, for Nicholas, Columbia Growth, and Value Line Leveraged Growth.

7 Actually, these are “excess returns” as compared to sure-thing returns—gain over and above riskless government interest rates. So, if interest rates are 8% and the market gains 18% (a 10% “excess”), a stock with a 0.6 beta would expect (on average) a 6% “excess” over the interest rate, or a 14% gain.

8 One such source is The Individual Investor’s Guide to No-Load Mutual Funds, 12 ed. (Chicago: International Publishing Corporation, 1993).

9 There are a few differences in this more complex calculation. The simple return over and above the interest rate, called the risk premium, depends on the value of beta (it is beta × market risk premium). Then there is an adjustment to convert the average of the variable returns into what the compound return would be if it were smooth (nonvariable). This is an arithmetic-to-geometric mean conversion, necessary because the formula assumes the same rate compounded (geometrically) over many periods. The formulas involved are beyond the scope of this book.

10 The “Expected Compound Return” is the geometric average expected, which is smaller than the common (arithmetic) average expected return. This applies to calculations where the varying returns will be compounded over time, as in the formulas for DCA targets and VA value paths.

11 Use any long-term T-bond rate, such as the 10-year rate used in Table 10-2. The short-term T-bill rate is too unstable for use in the long-term formulas.

12 Since its introduction, many financial planners have been using value averaging successfully with clients in their practice.

13 For more information on closed-end funds, see Frank Cappiello, The Complete Guide to Closed-End Funds: Finding Value in Today’s Stock Market, 5th Ed. Chicago: International Publishing Corporation, 1993.

2006 NOTE

Wow. This chapter provides ample opportunity to witness how much the world has changed in only 14 years. Throughout most of the book, the prescriptions I provide for how and why to invest with value averaging, and its advantages, are much as they were back in the early 1990s. Chapter 10, though, gives an amusing glimpse into how different, and difficult, investing was back then.

Along with my waistline, my views on investing have broadened over the years—and so have the opportunities available to the investor. And it’s not all just the changes brought on by the Internet. In no particular order, here are some of the new developments and tools in today’s investors’ arsenal:

• Mutual fund account management on the Web; Internet screening and fund analysis (e.g., Morningstar)

• 529 plans for college and Roth IRAs

• Inflation-linked Treasury bonds

• “Pooling brokers” (a recent development and few in number, but becoming popular with small investors), which aggregate customer orders to provide small investors market access (usually at regular intervals) at nominal fees—you’ve seen their ubiquitous banner ads

• Online low-cost execution brokers

• Asset based-fee, full-service brokerage account structures

• ETFs (e.g., tickers SPY and QQQQ)

• Lower market spreads, transaction costs, and taxes

• Even a Web site devoted to implementing the value averaging strategy

We’ve come a long way, baby. All of these developments make it much easier for you to profitably employ value averaging at much lower hassle and cost today. You can put much more money to work today in tax-advantaged accounts, and you have many more ways to do it. If you are starting out from scratch, it probably still makes sense to use mutual funds to get your strategy off the ground. As you build assets, though, you may find that alternatives, such as using ETFs and other diversified investment products within a brokerage investment account, make more sense for you. This could be with a pooling broker or other online broker, or with a financial planner or broker who is compensated, not on trades/commissions, but with a small percentage of your asset value each year. Whichever approach you choose, I’ve come to appreciate the importance of a good financial planner to act as a guide on your investment journey. Any good planner should be able to help you navigate successfully through a long-term value averaging investment plan (or whichever formula or strategy you choose).

Another market “development” I’ve mentioned in my Chapter 1 Note is the likelihood (no one knows for sure) that the expected future return on stock market investments is lower than it was at the beginning of the 1990s. As a result, I added a note to the important Table 10-2, suggesting that you use lower expected returns (i.e., r estimates) in establishing your VA value path or even in working with the simpler DCA strategy. At today’s low bond yields (about 5%) and probably-low equity risk premium (4 to 5% range), I’d suggest that you start with something like r = 2.2% for quarterly investments and r = 0.73% for monthly investments (for average stock risk, such as an S&P mutual fund or SPY ETF).