Wall Street's Flavor of the Week

It seems like it was just yesterday that John Paulson was the darling of the investment community, earning billions of dollars in personal profit and causing fellow institutional investors to hang on his every word and action. How times have changed! A headline on WSJ.com today states, "Rivals Scout Paulson Assets" - if that doesn't sound dire, I don't know what does! I've brought this subject up before but it bears repeating because it shows how fickle investors are - you can be the "can't miss" investment manager one day and a goat the next. 


On Wall Street, you're only as good as your last trade. This goes for all types of investors and helps make the case for passive management much easier. After all, a handful of institutional investors - from hedge fund managers to mutual fund managers - are wildly outperforming their benchmarks at any given moment. The question then becomes how much staying power do those managers have; in Paulson's case, it appears, only a couple of years worth. In the case of the actively managed mutual fund manager, the same is true. It was only a few years ago that Bill Miller, the manager of Legg Mason's Value Trust had his 15-year streak broken of beating the returns of the S&P 500. From 1991-2005, Miller's fund posted returns that were greater than those of the index and was lauded in the press as an investment titan. There is no doubt that Miller is a great finance mind but even he admits that much of his streak was due to luck: "As for the so-called streak, that's an accident of the calendar. If the year ended on different months it wouldn't be there and at some point the mathematics will hit us. We've been lucky. Well, maybe it's not 100% luck—maybe 95% luck."       


The problem for investors like you and I comes when we're tasked with picking the managers who can consistently outperform year in and year out. Here's some food for thought: What's amazing about Miller's success is that consistent outperformance is so rare (1 in 2.3 million, according to Michael Mauboussin), yet the ultimate goal of most individual investors is to invest in mutual funds that can post that type of outperformance...which never comes. If that's the case, why are we throwing good money after bad?

It's Much Easier to Spend What's Not Yet There

Much of what there is to be learned about managing your finances properly comes when we tame our emotions and focus on the psychological aspects of financial decisions. A mistake that many people make when they get paid is that they have much of their cash on the way out as soon as it comes in. This typically happens when an individual has credit card bills and other debts to pay. The easiest way to avoid this type of occurrence is to make sure you only charge to your credit card(s) that which you know you can easily pay back when you have income come in. Secondly, even if you find yourself stuck with some bills, be sure to keep contributing to your 401(k) for the tax and compounding benefits and save a set percentage of every paycheck for an emergency fund. Ultimately, the 401(k) and emergency fund contributions are two cash "outflows" that shouldn't make you feel bad because by making them, you're only helping yourself. 


By not "segmenting" (outside of the 401(k) and emergency fund contributions) your money before your actual paycheck is deposited, you will immediately begin to see substantial savings. After all, it's much harder to spend money when you can actually see your account balances declining with each purchase, rather than simply thinking about it and accounting for it later at which point you'll likely realize that most of your paycheck is gone before it's even arrived!

The Benefits of the High-Yield Index Fund

Many people are often faced with the seemingly difficult situation of trying to maximize their income due to lack of sufficient cash flow. This becomes even more of a problem as economic growth slows and employers lay off workers and cut salaries in order to help manage their cost structures during a downturn. Luckily, there are some investments that offer regular distributions that can help add a few extra dollars to your household balance sheet every month.


One such investment is a high yield bond index fund. High yield bonds - also known as "junk bonds" - are the debt of corporations and other entities that may be experiencing financial distress. As a result, investors receive a higher interest rate as compensation for the greater risk to their invested cash. As Rob Williams, director of Income Planning at Schwab notes, "Defaults on investment-grade bonds have historically been low, though the frequency increases as credit quality declines."   


Better still, the diversification of a high yield bond index fund ensures that if one issuer were to default, the likelihood of a significant impact on the rest of the portfolio is minimum. How do such funds help maximize current income? The funds pay out their distributions monthly and in the case of the Vanguard High-Yield Corporate Investor Shares (VWEHX), currently yields 6.91%. Thus, even though the numbers might appear small in the beginning - only $30 or so extra a month on a $5,000 investment - you have the choice of taking that cash every month to maximize current income or reinvesting it to help your stake compound which will lead to even higher passive income amounts in the future. 

Overall, high-yield bond funds are a much better avenue for investing in high yield securities due to their overall lower risk profile, low fees and impressive long-run returns. 

Helping Kids Understand Credit

A recent WSJ article regarding kids and credit cards piqued my interest and led me to think more about the role that parents play in shaping their child's view of money and finances. The old saying goes "the apple doesn't fall far from the tree" and in the world of financial learning, that is indeed correct. Much of what children learn about spending in their formative years comes via observation. If they observe their parents engaging in profligate spending, they are more apt to believe that is OK behavior because they have little understanding of cause and effect. After all, if they are still living in a comfortable home with nice clothes, food on the table and toys to enjoy, they will likely take that as a confirmation that their parents' spendthrift ways are rational behavior. Similarly, if a family carefully watches its budget while still providing the same nice clothes, food and toys in a household, a child will take this as confirmation that their parents' budget consciousness is important. 

Children are very impressionable. If they see you reaching for a credit card every time you go out to shop, they will begin to think that credit cards are an instant source of money (they are) but it's up to you to set the example and teach them that when the time comes for them to get a credit card, its balance should be paid off in full every month. 

This is a problem that confronts Gen Y parents in particular because we are gradually moving away from a monetary system based on physical dollar bills. Instead, the majority of consumers are more likely to use electronic payment methods such as a debit or credit card to pay for a store purchase. This has its pros and cons but there is one key thing I would recommend all parents do: before exploring credit cards with children, teach them about saving and spending the old fashioned way - with cash. There is much greater regret among children when the $10 bill they were given is spent than if it were simply accounted for via swiping a card. It may be old fashioned, but it certainly worked for me when I was a child!