Since we bought this blog, we have written some interesting posts about asset allocation for beginner investors. However, knowing what the difference is between fixed income and the stock market is hardly enough to know how to invest your hard earned money!

This is why we are taking a closer look at how to invest in fixed income asset classes today.

First Fixed Income to consider: Government Bonds and CDs

Government Bonds and certificates of deposit (CDs) are the safest investment products you can use to build your portfolio. However, they are also the least flexible. Picture a bond or CD as you are the banker and not the borrower:

The principle behind this type of investment vehicle is that you are lending an amount of money to either a Government (Country, state or city) or a bank. Since you want your money back, you are lending your money to them for a specific period of time (called the term). Then, you don’t want to lend money for free (no one does this anyways?), so you will do it at a fixed rate of interest (called the APR).

Why bonds and CDs are less flexible investments?

Now go back to your usual borrower’s mind for a second: how would you feel if the money you have borrowed could be called back (i.e. the lender asks to be reimbursed right away) at any moment? You would probably not feel comfortable borrowing money from this person. This is the same way it works when you are lending money to the government or a bank; they want to make sure they have enough time to pay you back.

This is why it is usually harder (read very hard in the case of CDs) to break your contract and cash out your money before the end of term. You will usually have to suffer a penalty which would result in less interest paid to you than the original contract. In this time of very low interest rates, you certainly don’t want to see it reduced to even less than that!

Good news; there is a secondary market for bonds

While I mentioned it was harder to get your money back from CDs before the term expires, it is because you are dealing alone with the bank. However, there is a market (similar to the stock market) to trade existing bonds. This is where you can buy or sell existing bonds on the market. However, this doesn’t mean that your money will be guaranteed if you sell your bond before it matures (i.e. at the end of the term).

Why money invested in bonds is not guaranteed before the end of term? Isn’t it the safest investment?

Picture this: 5 years ago, you bought a 15 year government bond paying 5% interest rate. Today, after the rate goes down, you still earn 5% interest while new bonds issued in 2010 are giving 3.5% (I’m not using real numbers by the way…). Why would you sell your bond that is giving 1.5% more than anything else on the market? Answer: at the same price you paid for your bond, there is no way that you will sell it unless you really need money.

Then picture this second situation: You buy a bond today paying 3.5% for 15 years. In 5 years from now, interest rate rises and the same bonds (i.e. the same issuer) will pay 5% for new issues on the market. How can you sell a 3.5% bonds when anybody can buy a new bond with the same level of security but giving 5%?

There is an answer to both situation and this answer is found on the bond market: When you buy new issue, you buy it at a price of $1,000 per bond (i.e. if you have $10,000 to invest, you will buy 10 bonds). If the interest rate goes up in the future, your bond is less attractive since it is paying a lower coupon (3.5% vs. 5%). Since you have the option to sell it anyway, investors on the market will pay you less than $1,000 for the same bond. Since at the end of the term they will get back $1,000, the difference between what they pay (let say $975) and what they get at the end of the term ($1,000) will compensate for the lower rate (3.5%) that they will be earning in the meantime.

The same math applies if you have a high paying bond and the rate goes down; your bond will be worth more than $1,000.

This is why your fixed income portfolio can go negative from one quarter to another while your capital is secured . This often happens if you buy bond ETFs  or mutual funds invested in bonds. So there is no reason to panic, you just have to hold your bonds long enough to get your capital (and your interest) back!

Author: Mike.

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In order to invest intelligently, he suggested 4 investing principles that Warren Buffett has used during all these years to become the most prosperous investor of all time. You know what? Buffett doesn’t bring his laptop with his complicated investing formulas and doesn’t show 10 thousand graphs with moving averages and delta, sigma and the rest of the Greek alphabet. He simply looks at easy-to-understand investment basics:

#1 Quality

Regardless if a stock is the flavour or the month or not (you know, the stocks you keep hearing on the news every week as they used to do with RIM which has been replaced with Apple?), you need to aim for quality companies.

Quality means:

- good products

- good services

- good management team

- good financial structure

- good potential

- good, good, good.

You need to make sure that the company is not only good today but it has given itself the means to be good for a long time. This is what we call good quality stocks.

#2 Growth vs Profitability

Growth is nice but can the sector still be profitable once many competitors enter? Sometimes, we might be tempted to invest in a company that is the first in its niche. That we think the growth is there for the next 10 years. But what happen when everybody knows that the growth is going to be in a specific sector? A ton of competitors, copies arise like weeds in spring and the price drops. Therefore, will there be enough room for everyone to make good money after a few years?

#3 Risk of loss first

Buffett says that he looks at the worst case scenario at any time before investing. Therefore, he makes sure to know what his potential losses are. This is also why they keep 20G$ in liquidity in Berkshire.

They don’t make much on this cash sitting in the money market but they are sure to avoid depending on anybody else. They know they can go through a rough economic stretch. This is the kind of guy that will never be caught out by a sudden drop in the economy.

The funny thing is that when I invest in a stock, I usually think about the potential gains I can make and completely put the potential losses aside. I tell myself I am young and that I have enough time to make it right… Maybe I should realign my investment strategies with Buffett’s practices.

I actually did it once when I sold my Smith Manoeuvre portfolio back in May 2009 knowing that I was probably leaving a lot of money on the table but I also knew that I couldn’t stand more risk since my wife was quitting her job and we needed liquidity as a backup more than potential gains on paper!

#4 Disciplined Attitudes

Definitely, the most common and ignored investment advice: follow your investment strategy, not your emotions when investing! Stay disciplined and never sell when there is a wind of panic hitting Wall Street.

I have often run into clients who want to buy when it’s high and sell when it’s low… Unfortunately, we all want to make money when we see others doing well and we don’t want to be the only loser in the market

Overall, I think I am way more aggressive than Warren Buffett but I also think that his basic investment advice are gold. Everyone should keep these 4 investment tips in mind before each trade they make!

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I’m a bit late, but I usually like to check my IRA asset allocation and see if I need to make any adjustments to contributions. I made a few tweaks, but I’m pretty much keeping to my plan.

Asset allocation has a big impact on your account’s performance. You basically determine your assets allocation on factors, such as:

• Time -How long will it be before you retire and start withdrawing? The longer you have, the more risk you can take.
• Risk Tolerance – Some people are naturally more conservative than others. If the recent ups and downs have you wondered, then you may not want to put all you money in emerging markets for example.

Not Too Late to Contribute

Don’t get discouraged if you haven’t opened an account up. It’s still not too late to contribute. You have until you file taxes to make your contributions. If you file your taxes mid February 2011, you can make contributions that count for 2010 until mid February.

How much can you contribute to your IRA?

Right now you can contribute $5,000/year to a Roth IRA if your modified AGI is :

• $167,000 for married filing jointly or qualifying widow(er),
• $116,000 for single, head of household, or married filing separately and you did not live with your spouse at any time during the year, and
• $10,000 for married filing separately and you lived with your spouse at any time during the year.

Source: IRS Publication 590

Curious to Learn More?

Mike has some great posts here on getting the right asset allocation for you.

• Know Your Asset Classes
• A Closer Look at Fixed Income Assets
• Invest in the Market When People Have Chickened-out
• What Are My Other Investing Options?

Don’t be afraid to ask others about what they’re asset allocation is and how they chose it. While there are some principals people should follow with how they design their portfolio, there is a lot of leeway based on individuals risk tolerance.

If you don’t have the time or interest in adjusting and balancing your portfolio, you may want to check out a target retirement fund. It is supposed to adjust as the years pass and it will become more conservative the closer you get towards retirement.

How are your retirement accounts doing? What’s your current allocation for your investment account? Are you going to change them?

Today, I am leaving the world of asset allocation to talk a little bit more about Exchange Traded Funds (ETF). This is probably one of the most popular investment products. Its popularity is soaring amongst smaller investors especially over the past 5 years.

The purpose behind ETFs

Wouldn’t you think that we had enough financial products? That the world of investing is complicated enough that we don’t need another way to invest our money? Well, the purpose behind ETFs is to make investing easy and simple .

In fact, most ETFs track the value of a type of investment. The most common will track a stock market index like the S&P 500 or the Dow Jones. Therefore, if the Dow Jones made 4% in the past 4 months, your investment will show a growth of near 4% too (the index yield less minimal management fees). So it is a very easy way to diversify a small portfolio without having to pay huge fees.

However, there are a few things you must know about ETFs before trading them:

Trading Fees

ETFs are traded on the stock market as regular shares. Therefore, instead of buying 100 shares of Apple on the market, you can buy 100 unit of the ETFs replicating the NASDAQ for example. Since they are traded as a stock, each time you buy or sell an ETF, trading fees will apply.

Sometimes, the temptation of timing the market is very high. Therefore, you could be tempted to buy and sell the index at different times of the day or week. If you get sucked into this market timing game, you will end-up with huge trading fees at the end of the month and this will affect your overall yield drastically.

ETFs are for investors with a certain asset size

If you only have $5,000 to invest, you might want to consider mutual funds to build a well diversified as an ETF portfolio could be costly in term of transaction fees. Imagine that you buy 5 ETFs to build your portfolio (replicating the US market, international market, bond market, resources and emerging markets). This will cost you a good $50 of transaction fees (assuming a $10 transaction fee). This is already 1% of your portfolio. But if you have to rebalance your portfolio (or make any other modification) during the year, you will increase your trading fees to 2%-3% easily. If you add up the low but still existing MER fees of ETF, you will end-up paying a 3%-4% overall fees on your small portfolio where you could pay lower than 2% to have a well diversified mutual fund portfolio.

Independent investors DYI

Most investors who choose the ETF route already know a lot about investing and how the stock market works. An ETF portfolio requires knowledge to be built properly. You want to buy the right ETF in order to have the right diversification.

In addition to that, you will have to rebalance your portfolio to match your asset allocation at least twice a year. Therefore, if you don’t want to take care of your investment too much, building an ETF portfolio may not be the right solution for you.

Diversification and not Diworsification

Be careful of the temptation of the Toys “R” us syndrome; when a kid goes into this store, he wants to buy it all. Sometimes, having too much choice is worst than not having any. ETFs are now able to track just about anything you could possibly imagine. So you could enter into a diworsification of your portfolio instead of managing a great asset allocation!

You are better off with passive investing

I am not a believer of market timing. In fact, I am sure that you will always end-up losing if you try to time the market. So if you invest in indexes through ETFs, you are better off doing it for the long run. Try ETFs in your retirement portfolio. This way, you will be less tempted to sell them when the market goes down .

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Being a financial planner is not always fun. I often find myself between a rock and a hard place: the best interests of my client and the target of the hand that feeds. Unfortunately, our profession leads us to a continuous conflict of interest. Even though I always disclose if I get a better commission from one investing solution than another, I am still in the middle of a conflict of interest between the client and my pocket.

During the 63^rd CFA institute congress in Boston, MA, Ariely mentioned that a financial advisor is always in a losing position if he is in a conflict of interest while doing his job. I was surprised to read this since I had thought that by disclosing the way I am compensated decreases the potential conflict greatly since the client had all the information to make the best decision possible. However, he made a very interesting point.

When you disclose that you make more on one product than another (which I do), there are 2 possible conflicts of interest that may arise:

#1 The client may ignore or give less attention to the solution with the higher commission attached since he may think it’s only good for the advisor.

#2  The advisor may reinforce his arguments in the favour of the higher paid solution thinking he’s right since he disclosed his conflict of interest upfront.

No matter what you do, no matter how ethical you are; there is always a conflict of interest when money is related to your actions.

However, I still think that it is important to discuss with your advisor on the manner by which he gets paid. Depending on which company he works for, his income can be determined by a lot of things:

#1 100% commission

#2 100% salary

#3 Salary + commission (based on revenues, growth, objectives, etc.).

Therefore, if you spend enough time knowing how your financial advisor is paid, you will be in a better position to understand if he is trying to work for your best interests or if he is only working for himself.

The main problem with this issue is that financial advisors must be paid (like any other worker). However, a 100% salaried approach will encourage people to slack off and not try to give the best service possible (they will end-up with the same pay check anyway, so why bother?). On the other hand, having a 100% commission pay check will push the advisors to sell as many products as possible in order to have a big fat pay check at the end of the month. This doesn’t sound ethical either!

In my opinion, I prefer the mix between base salary plus a variable commission. Where I work for example, I have a bonus based on the net growth of my book. Therefore, if I sell a lot of things but I don’t do my job right, my clients will withdraw their money sooner or later and this will affect the net growth of my book. This is how this system pushes a financial advisor to keep a higher level of service. While not being perfect, I think we have an interesting way of compensating financial advisors.

How do you feel about commissions? Do you think financial advisors should be only be paid a base salary?