Late last month I wrote about how my wife and I were going to consolidate our Vanguard accounts by transferring the assets in her individual mutual fund account into my individual mutual fund account. As it turns out, there is an even better way to do this and I was surprised the original Vanguard CSR didn’t mention it (I don’t blame him as I did ask him three different questions and this was the third and least significant one).

The easiest way to do this was for me to open a Joint mutual fund account with both of our names on it, something you can do entirely online, then call up Vanguard and request that they transfer the assets from my wife’s individual account and my individual account into that joint account. By doing it on the phone, with all the verbal verification of our individual security data, we could skip a trip to a bank to get a signature guarantee. (I manage to always miss the branch managers or go to banks that don’t have a manager able to do a signature guarantee - I still haven’t changed the accounts for my TreasuryDirect account!)

This was all kicked off when I called up Vanguard to confirm I filled out their Asset Transfer form correctly. The form, while not too complicated, was a little confusing because it had two places for signature guarantees, lots of optional information, and I’m easily confused and befuddled. When I called them up, the CSR just asked if I preferred it if she did the transaction for me. Ha, of course I preferred it.

The phone conversation took fifteen minutes, which included a lot of explanation, and the conversion/consolidation process took approximately five business days; our accounts are now finally consolidated!

Risk is a word that gets thrown around often, especially when referring to the stock market. Experts talk of the dangers of investing in the market and the dangers of not investing in the market. They talk about how you need to take on an acceptable level of risk for your tolerance and how you need to mitigate your desire for fantastic returns by taking on a reasonable level of risk. Risk sounds so risky! So, what are all of these risks and how can you mitigate them? That’s what I sought to finally understand and this is what I learned.

There are a lot of fancy names for risk but the bottom line is that understanding them gives you a better chance are being able to mitigate their effects. You can’t fully reduce risk but through proper diversification, you can reduce their effects on your total portfolio so there isn’t one silver bullet that can take you down.

First, let’s talk about the differences between systematic and unsystematic risk. Systematic risk also known as undiversifiable risk refers to risk that affects an entire market or market category, such as market risk. Short of investing abroad or hedging your bets, you can’t get away from market risk. Unsystematic risk is also known as specific risk and refers to events that affect a small number of stocks, such as the risk of a strike or poor management decisions. You can reduce unsystematic risk by properly diversifying your holdings.

Market Risk

Market risk refers to the risk you take on as a result of investing in a particular market, in my case it would be the United States. Market risk refers to the idea that if the overall market falls, perhaps in response to Fed actions on interest rates, rising costs of oil, etc., then your investment may slide along with every other stock.

To mitigate market risk, you have to diversify your holdings such that you’re not entirely committed to one particular market. An easy example is to diversify your holdings through the purchase of ADRs or emerging/developing/international stocks. In mitigating domestic market risk, you introduce several other risks such as the foreign country’s market risk (known as country risk) and currency risk (impact of the change in exchange rate between the dollar and the foreign currency). However, since you’re diversified, the effect of each of those risks is lowered.

Inflation Risk

Inflation risk refers to the risk you take by not investing your money, stock market brokers love this risk :). Inflation, which most rules of thumb peg at around 3-4% a year, erodes the purchasing power of your money every single year. If you don’t get 3-4% annual returns on your dollar, you’re effectively losing that money each and every year.

You mitigate inflation risk by investing your funds, but this naturally introduces a whole hosts of other risks. The only difference here is that inflation risk is a near certainty - inflation doesn’t roll the dice to see if she’ll erode your money this year, she always takes it.

Manager Risk

Manager risk, or management risk, refers specifically to the risk that your mutual fund, or the company you’ve invested in, will suffer as a result of ineffective, poor, or under-performing management. It essentially points to the fact that the company or fund may be sound but the management made bad decisions that cause the stock price or fund price to suffer.

This is difficult to mitigate outside of diversifying your assets because you often won’t see anything that could clue you in. Oftentimes, managers simply make bad decisions or bad bets and it’s nothing intentional. You don’t see many Enrons and, even if you did, there are no obvious signals warning you that something is foul. Simply do your research and be confident that the manager of the fund you’re interested in has a long, strong and solid history of performance.

A close relative of manager risk is active risk, which refers to the risk associated with a manager of a mutual fund trying to beat his or her benchmark. Active refers to actively trading, or active mutual fund (vs. passive index mutual fund), and it’s been shown that the more active the fund, the more divergent it will be with respect to returns vs. its benchmark. Sometimes you beat the benchmark, sometimes you don’t, that’s active risk.

All Other Risks

There are plenty of other risks out there with fancy names like Political Risk (effect of political instability or changes in a foreign country), Liquidity Risk (lack of demand for your investment might make it difficult to sell), Reinvestment Risk (you can’t reinvest your funds at the same rate, or at all), etc. but I felt that those big ones were the only ones worth focusing on at this point. There are a lot of risk terms out there that can get as specific or as general as you could ever possibly want, but understanding market, inflation, and manager risk is usually sufficient for most purposes.

When I was first approached to review the book titled Beating the Market, 3 Months at a Time, I thought I was looking at one of those “invest in this hot new sector, you’ll be rich in three months.” Then I saw that the publisher was Financial Times Press and that allayed my concerns some more, FT Press isn’t going to put out some day-trading, hawkerish type book and, this is something I learned later, neither of the authors are your BS snake-oil salesmen types.

The book isn’t about day-trading, though Gerald Appel is well known for his technical analysis and marketing timing (Gerald Appel created the Moving Average Convergence / Divergence technical indicator), but about active investing and how it can yield higher returns than “buy and hold” strategies. By active investing, they mean that you can use their strategy to review your portfolio once ever three months (rather than the often advised once a year rebalancing act). So, through active investing and a one hour review every three months, you can beat the market with their proven investing plan. That’s the promise they’re making.

Basic Investing Education

Beating the Market begins by educating the reader on how to put together an investment portfolio, what your goals should be, how you should approach it, and is generally a good primer on investing in general. For example, it’s important to note that you want to get a rate of return greater than the risk-free investments you have available to you. I could put my funds in an E*Trade Online Savings account and get 3.15% risk-free, so my investments have to beat that. (usually the benchmark is money market funds and 90-day T-bills) Another goal is to manage the risk of your investments, something individual investors are notoriously bad at. Emerging markets are always hot and can return big double digit returns, but they can also lose big doubt digits… are you getting enough return for the risk you’re taking?

It Gets Complicated, Quickly

After the eight page primer on putting together a winning investment portfolio, the books slices right into diversification and risk management. I don’t want to recap the entire book but the topics it covers run the gamut from discussing ETFs and emerging markets, to the purpose of bonds in your portfolio, to special bond market investments, and end with discussions of retirement, planning for the political impacts, and an appendix chock full of resources. There is even a chapter called the Definitive Portfolio in which they build out a well diversified example portfolio with a mix of two types of bonds, two types of ETFs, and one overseas component.

The Investing Plan

So what’s this plan I spoke of earlier? The plan is the whole book. By understanding all the pieces of your portfolio (including risks, investment profiles, and all the nitty gritty described in each chapter) and how diversification works to reduce your risk, you can actively participate in the management of your portfolio without having to pay a manager 1-2% of your investments. That’s what active means in their plan, not day trading.

There’s a lot of information in this book and it’s definitely one I will be reading more closely over the next few weeks. There are discussions about high yield “junk” bonds and about the international markets that I glossed over, two things I know very little about, so if you have it at the library or bookstore (I tend to borrow all my books from the library) I wholeheartedly recommend that you pick it up.

Bear Stearns had 85 straight years of profits followed by one bad quarter and then a fire sale at $2.30 to JP Morgan Chase, which was increased to $10. (though the mid-2007 catastrophic failures of two big hedge funds, the High Grade Structured Credit Enhanced Leverage Fund and the High-Grade Structured Credit Fund, might have indicated things were a little shaky at Bear Stearns)

Bill Miller, chairman and CEO of Legg Mason Capital, beat the market for 15 years straight before “hitting a wall in 2006.” Since then he’s bad some spectacularly unlucky moves by investing heavily in Countrywide, KB Homes, and Bear Stearns.

Roulette wheels show the history of the spins not because it’ll give players an edge in picking the next number, they do it to entice you to bet. Intellectually, people understand this. Emotionally, they throw caution to the wind if they see five red numbers hit in a row. They’re putting their smart money on black. (then it comes up red again!)

So, if we need to pick a mutual fund and we shouldn’t rely on the past, what should we rely on?

Fees

The one thing you can predict and control about a particular mutual fund is the amount in fees you’ll pay. When selecting a fund, be sure to remember to take a look at the fees involved because they directly impact your rate of return. A 1% annual fee is a 1% decrease off your returns, which can be significant over the court of 40 years. A $1,000 investment that gains 10% each year will be worth $6,727.50 after 20 years, the same fund with a return of 9% a year is worth only $5,604.41 - a 20% difference in value! (and that’s based on a tiny starting investment)

Diversification

How does the fund stack up with your other investments? You need proper diversification to reduce risk and improve returns, so make sure the fund fits properly into your portfolio. While you can’t control the performance of the funds that make up your portfolio, you can at least ensure that you aren’t over-extended in one particular area. While this means that you won’t be hitting any home runs, you’ll be getting more base hits than strike-outs (think Ichiro Suzuki and not Alfonso Soriano).

Returns & Standard Deviation

While past returns are not indicative of future results, that doesn’t mean you shouldn’t pay attention to it! The key, however, isn’t to focus entirely on the returns but to check out the standard deviation of those returns. That will give you an indication of how wide future swings may be and you might not want a fund that can just as easily return 30% as lose 30% (or you do!).

So, when reviewing funds, don’t look just at the returns because they don’t mean much. Look instead at the things you can control (fees and your own diversification).

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The 151st Carnival of Personal Finance (amazing, one hundred and fifty one carnivals…) is available at Alpha Consumer, my post about laddering CD’s at ING Direct was included this week.

As a personal finance blogger, I often write about the importance of an emergency fund but today I want to introduce an idea I call an opportunity fund. The point of an opportunity fund is to have a cash reserve on standby in case you see in opportunity that you don’t want to miss. You fund it with savings, after you’re funded your emergency fund and paid off your debts,

Why A Separate Fund?
One good question to ask is why should you have a separate opportunity fund? Why not just dip into your savings? It’s all about discipline and planning. Much like an emergency, you have no idea when an opportunity is going to present itself. When it does, you’ll want to have the funds around so you can take advantage. If you don’t have a fund, you’ll be scrambling to scrape up the funds and you’re much more liable to make a costly mistake.

For example, let’s say you hear that I am teaming up with Warren Buffett and Bill Gates to start an investment club and we’re looking for $5,000 investments from a hundred people to get started. If you have $5,000 in your opportunity fund, you’re set and you can wire it over to me. If you don’t but really want to get in, you might do something as foolish as put $5,000 on your credit card or liquidate some of your existing assets just so you can get in. Since there’s no guarantee that a Blueprint-WarrenBuffett-BillGates fund is going to turn a profit (it is the stock market after all), you might find yourself in some serious credit card debt! As Confucius once said: “Success depends upon previous preparation, and without such preparation there is sure to be failure.”

Determine How Much
Much like an emergency fund, you’ll have to determine how much you’ll want to save into your opportunity fund. Since these amounts will be put towards an investment of some kind, you’ll only want to put as much as you’re willing to lose in case the investment goes sour. In the investment club example above, if you are willing to go after an opportunity for at most $5,000, then the answer is simple: put $5,000 into your opportunity fund. If you can’t stand the thought of losing $5,000 and can only handle losing $2,000 or $500 then put that amount into your opportunity fund.

You’ll want to make this decision now, now when the opportunity presents itself. Right now you’re balanced, you’re calm, and you’re rational. When you hear that opportunity of a lifetime, you’re likely not going to be any of those three so having a set dollar amount you can lose, decided when you were calm, is going to be valuable as well. Let’s say you decided that $2,000 is how much you were putting into your fund and the investment club demands $5,000 - don’t join. As appealing as the club may sound, it’s out of your price range so just let it go and seek out the next one.

Waiting Game
What should you do with the funds while you wait? Should you put it in a high yield savings account or invest it in the stock market? I recommend that you put the funds in a high yield savings account and let it sit there until an opportunity presents itself. Investing it in the stock market, while appealing from a historical average yield perspective, is an opportunity in and of itself and one that carries risk. Like an emergency fund, you don’t want the risk, so you want to be in a holding pattern until you find the right opportunity (or it finds you). So be patient and put the funds in a place for safekeeping. (If you want to invest in the stock market, by all means do so but recognize that the stock market becomes the opportunity.)

Once you’ve established your opportunity fund, it’s time to go seek out opportunities.

I had a lackluster experience with an alleged financial planner and I’ve read many articles detailing how you should find a financial planner, what you should ask him or her, and everything else you need to do to make sure you don’t a raw deal in the process. I’m sure many of you have read those same articles warning you about how you need to find fee-only financial planners or sleep on their advice. Well, I wanted to highlight a columnist at CNNMoney called “the Mole.” The Mole is an actual practicing financial planner who gives you the full skinny on what you should do to get the right financial planner.

Here are the one’s I felt were valuable reads:

• When you should dump your adviser - some red flags that your financial adviser isn’t up to snuff.
• Are investment newsletters worth it? - “You’d be much better off just throwing the money in the nearest dumpster than buying these newsletters and risking a big chunk of your nest egg in following the newsletters’ advice.” (he’s very honest)
• What a good financial adviser should be doing for you - Discussion on the various aspects financial advisers should help you with.
• Four good questions to ask your adviser
• What your adviser doesn’t know might hurt you

You can find all of The Mole’s articles here.

Last year, the Treasury Department limited the amount of Series I and Series EE Savings Bonds that a US Citizen could purchase in a single year to, effectively $20,000 (TreasuryDirect release). The limit had been $30,000 in paper certificates and $30,000 in electronic certificates for each the Series I and Series EE bonds, meaning you could feasibly purchase $120,000 in savings bonds ($30k electronic Series I, $30k paper Series I, $30k electronic Series EE & $30k paper Series EE) a year ago. The current limit not drops the total amount of savings bonds you can purchase to $20,000 a year (which is still a lot for most Americans).

Why? The stated reason was to “refocus the savings bond program on its original purpose of making these non-marketable Treasury securities available to individuals with relatively small sums to invest.” That is not achieved by lowering the maximum limit, that was achieved when TreasuryDirect allowed you to purchase electronic bonds as low as $25 each.

Another reason was that “Approximately 98 percent of all annual purchases of savings bonds by individuals are for $5,000 or less.” Again, that’s not a legitimate reason to lower the maximum limit. The “it won’t affect that many people” defense won’t work for a lot of things, I don’t see why it’s viable here.

I suppose you could make the argument that lowering the maximum will help those with smaller sums if there was a limited supply of US Savings Bonds. However, if you take a look at our growing debt and growing deficit, you’d be hard-pressed to make the argument that US debt is in short supply.

So why? I’m at a loss and I don’t understand it well enough to make much of an informed guess. I would’ve expected the US government to want to be indebted to its own citizens, rather than foreign interests, so perhaps there is something else going on? I tried searching online but didn’t find any editorials or other insights into why the rate was (really) lowered. Anyone have any thoughts?

Incidentally, the Treasury announced the new rates and the fixed portion of the Series I Savings bond dropped from 1.2% to 0.00%!

I don’t know if TreasuryDirect changed their policy or if EmigrantDirect changed theirs, but my attempt to purchase Series I Bonds and take advantage of the potentially awesome new rates was foiled! I received the following message from TreasuryDirect:

Dear JIM,

We’re sorry, but your purchase request IAAAB was canceled. While trying to collect payment from your bank, they returned our debit. Please check the Investor InBox section of your TreasuryDirect account for more detailed information.

Thank you for using TreasuryDirect.

It was entirely my fault. It wasn’t Emigrant Direct’s fault, or the Treasury Direct’s fault, it was Jim Direct’s fault. The only linked account I had was from an Emigrant Direct savings account and I assumed it would still be valid to make another purchase. I had purchased $100 in Series I bonds a while back just to play with the system and assumed everything was still good. Unfortunately, TreasuryDirect now debits the linked account rather than a regular ACH transfer (I think) and so a savings account doesn’t debit! (The other explanation was that there were insufficient funds, but I confirmed I had enough)

So the only solution is to head over to the bank and buy a paper Series I Bond so I can still take advantage of the upcoming favorable rates. I suspect it should be pretty easy, the government always makes it easy for you to give them your money :).