how (and how not) to invest in commodities

hint -- don't own commodities directly. Photo by OmirOnia, via stock.xchng.So you’re bound and determined to add commodities to your portfolio, and for all the right reasons. Great! There are a few ways to do it…though I would only strongly recommend one.

Buy the commodities themselves. Stocks and bonds are quite liquid, since they’re essentially notes saying “you own X” or “we owe you X”. Commodities, much less so. Sure, you can buy gold coins, but to buy enough that they’re a substantial part of your portfolio — not to mention diversifying into other commodities such as timber — would get prohibitive very, very quickly.

Buy GLD. Purchasing a share of the SPDR Gold Trust ETF (“GLD”) entitles you to ownership of a piece of the gold held by the trust in reserve. You could even redeem a “basket” (100,000 shares) for the equivalent in gold, if you so desired. This is much more liquid than buying gold bars themselves, but in buying gold you’re holding a concentrated position in one particular commodity — one which has historically shown itself to be among the most volatile!

Buy precious metals equities. That is, buy stock in mining companies. This isn’t a terrible idea, as precious metals equities tend to be relatively uncorrelated to other equities and positively correlated with inflation, both of which are good for hedging, and you can buy a low-cost, diversified bucket of them via Vanguard’s VGPMX fund. However, like GLD, VGPMX is highly volatile, and its returns have not had nearly the sharp upward trend that GLD has had over the past decade.

Buy a collateralized commodity futures (CCF) fund. This sounds a little complicated, and it is — a little. A CCF doesn’t buy commodities, but rather it buys futures — contracts to buy commodities at a future date at a certain price. Moreover, the cost of buying the contract is a small fraction of the cost of the commodities themselves; the rest of the collateral can be invested in a high-quality investment like treasury bills or TIPS, which earns interest during the time of the contract. (Of course, the fund never actually buys the commodity, but rather keeps rolling the futures forward indefinitely.) What this means is that by investing in a fund like PIMCO CommodityRealReturn, you can double-hedge against inflation — once by the price of commodities, and again by the TIPS used as collateral. PCRIX is well-diversified and has a not-terrible expense ratio, to boot. You’re still not going to earn much more than inflation in the long run, but a dollop of this in your portfolio can reduce inflation-related volatility without sacrificing too much in the way of returns.

As you’ve guessed, I can really only recommend CCF’s, and even then only if you’re committed to investing in commodities. It may be comforting to invest in something that is “real”, but just because something is tangible doesn’t mean that its value doesn’t fluctuate as much — or even more — than something that is intangible! (And if you want to invest in something that’s exciting…well, I can only hope that you’re limiting your gambling addiction to a small fraction of your portfolio.)

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why (and why not) to invest in commodities

A delicious invesment!A couple years ago I wrote a cautionary post in the wake of the run-up on gold over the past decade. Since then, gold has…well, not gone really anywhere, and neither have commodities in general. So I figure now is a good time to talk about investing in commodities, when people aren’t jumping up and down about how they’re going through the roof (or the floor).

Don’t speculate on commodities. Well, I don’t recommend speculating on investments, ever, but it’s especially true for commodities. You think the stock market is a roller-coaster ride? Commodities will make you lose your lunch! Remember back in 2008-2009, when the S&P 500 got cut in half? GSG, an ETF that tracks the S&P Goldman Sachs Commodity Index, plummeted by two-thirds, and it’s hovering at around half of its 2008 high even today. Yes, the runup on gold since 2000 is drool-inducing, but so were internet stocks before 2000 and real estate before 2008. Don’t become yet another cautionary tale.

Don’t look to commodities to boost your returns. “OK, fine — I’m investing in commodities for the long term. They’ll make me rich!” No, they won’t. By definition, commodities are items that can be replaced. Any time any given commodity gets too expensive, corporations start figuring out how to do without it — witness the explosion in hybrid technology when oil prices were shooting up a few years ago, or the move to copper wiring by companies that traditionally use gold. No, over the long term commodities barely keep up with inflation — no surprise, since the price of commodities is pretty much the definition of inflation. (Gold has historically been no exception…which should make current holders of the shiny stuff very cautious when looking at charts like this.)

Don’t invest in commodities as your primary hedge against inflation. Afraid of inflation? Invest in Treasury Inflation-Protected Securities! While they have normal interest just like any other bond, their principal is adjusted for inflation, which makes TIPS a safe, low-volatility way to guard against inflation. (By design, their yield is exactly their inflation-adjusted return!) While commodities track inflation over the long term, they may go for years before reverting to the mean; in mathematical terms, they have a positive but lower correlation with inflation than TIPS.

Do invest in commodities to reduce your overall portfolio volatility. Commodities are very interesting in that they don’t often move in tandem with either stocks or bonds. This means that, with regular rebalancing, a canny investor can take advantage of commodities to smooth out their portfolio, selling commodities when they are high to buy stocks and/or bonds, and vice-versa, with the overall effect of reducing volatility. Now, note that I said “don’t often move in tandem”; in 2008, they crashed along with nearly everything else, so don’t look to commodities to work miracles. That’s the job of short-term treasuries!

So yes, commodities can be a useful part of your portfolio, if bought for the right reasons. Next stop — how (and how not) to invest in them!

self-compassion over self-esteem (in finances and beyond)

Many of us born after a certain year have had “self-esteem” drilled into us since we were children. “Good job!” is still ringing in our ears after the innumerable times it was said to us — to the point where the words have almost  become meaningless. And why not? Confidence seems to be the underpinning of almost every form of success, even more so than intellectual ability, and the best way to build confidence in someone is to continually tell them how awesome they are, right?

Wrong.

Per the book by Dr. Kristin Neff of our very own University of Texas, this is more like “stuffing ourselves with candy.” We get a brief “high” of increased self-worth…which then crashes in despair when reality tells us something different. We try to pump ourselves back up by more “positive self-talk”, ignoring our faults and placing the blame for failures on something (anything!) outside of our responsibility…which sets up a continual high/crash cycle that ultimately goes nowhere. After all, how can we improve — really improve — if we refuse to learn from our mistakes?

This affects every aspect of life — including finances. Full of confidence in our ability to stick to a budget, we get aggressive in cutting back on perceived luxuries like new clothes or electronics; the next month, we stare in horror at our five-hundred-dollar Nordstrom or Fry’s bill, and give up budgeting entirely in despair. Full of confidence in our ability to time the market, we load up on “sure-fire winners”; then the bubble pops, and in the ensuing financial and emotional crash we pull our money out of the market entirely. It happens everywhere, all the time; self-esteem not only blinds us, it hobbles us and keeps us from growing.

The alternative? Self-compassion.

Self-compassion goes by several names, like humility or perhaps intellectual honesty, but it is, in its basic essence, deciding not to judge yourself. This does not mean refusing to evaluate your performance in any given area; rather, this means separating that performance from your worth as a human being. It means allowing yourself to make mistakes, with the knowledge that we grow by making those mistakes and allowing ourselves to embrace and learn from them. By acknowledging that we can and will make those mistakes, we can better deal with the consequences.

Of course, this applies to finances as well. When making a budget, we might set more realistic spending limits, or create an “oops” category for mistakes, or set aside a regular time to adjust next month’s budget based on last month’s spending. When designing a financial plan, we might be more willing to seek outside help and opinions, more able to take the right amount of risk, and less likely to panic and “sell everything” in the face of the unexpected.

So, great; how do we do that? The first step, of course, is in acknowledging that self-compassion is a valid choice — perhaps the hardest step for many of us, with our artificially-inflated egos that are more afraid of giving up that false self-esteem than we are of the inevitable real damage that it causes. But by taking this step, we are allowing ourselves to take the next: to surround ourselves with compassionate people. By choosing friends and advisors that judge our actions without judging our character, that compassionately tell us what we need to hear rather than what our egos want to hear, we are setting ourselves up for real growth.

And the more often we hear truth delivered with compassion, the more our self-compassion will grow, our egos shrink, and our lives improve.

ETF’s vs. index funds: fight!

Though the financial media buzz has faded somewhat in recent years, ETF’s (exchange-traded funds) exploded in popularity in the mid-2000’s as an alternative to index funds. What are they, and should you invest in them?

An exchange-traded fund is exactly what it says: a fund (mix of securities) that sells on a stock exchange. A regular mutual fund has its price re-computed at the end of the day by looking at the value of all of the securities that are in it; shares of an ETF, on the other hand, are actually bought and sold themselves. This seemingly small change can make all the difference in the world:

  • ETF’s often (but not always) have lower expense ratios than their corresponding indexes. Why? Because a mutual fund firm has to deal with a lot of paperwork when mutual funds are bought and sold, because they are the ones that have to process it. Not so with an ETF; since they’re sold on a stock exchange, the brokers do all the work there. (The ETF has some work to do — I’ve sidestepped the whole issue of how the price is maintained — but it’s comparatively small peanuts.) This alone can be a good reason to invest in ETF’s, as expense ratios are just about the only way to differentiate between funds that follow the same index, but that advantage comes with several less-obvious disadvantages:
  • ETF’s often (but not always) have commissions. Since you have to buy and sell ETF’s through a brokerage like Schwab or Fidelity, they’ll often charge you a commission to make the trade. If you’re putting a part of your paycheck into an IRA every month, this can quickly eat up any gains you may have gotten over an index fund (and then some!). However, many of the ETF’s most investors are interested in are offered commission-free by the broker; you just have to be careful what you buy. (Of course, mutual funds often have commissions, too.)
  • ETF’s are very difficult to auto-invest. As of this writing, the only popular brokerage I know of that allows you to automatically invest in an ETF is ING’s Sharebuilder, which, while cheap at $4 per automatic investment, is not commission-free. The others only allow automatic investment for mutual funds. Of course, if your ETF has a commission, you probably won’t be automatically investing monthly anyway; likely, you’ll save up in a money market account every month, then invest in ETF’s once every three or four months, so you’re only charged the commission three or four times a year. Either way, it’s not as easy as mutual funds.
  • ETF shares are generally more cumbersome to trade. With mutual funds, you just tell your mutual fund company how many dollars of your funds you want to buy, sell, or exchange (in the case of rebalancing), and the firm takes care of it all at the end of the day, no muss, no fuss. With ETF’s, if you’re rebalancing, you have to sell the shares from the too-high ETF, wait for everthing to clear, then buy the shares from the too-low ETF. And in the meantime, because you can only buy whole shares, you’ve got money piling up in your money market account, leftover from each trade. On the whole, annoying.
  • ETF’s have a bid/ask spread. Because they’re traded on an exchange, there’s a small amount of “friction” involved in buying or selling an ETF, in the form of a bid/ask spread. The more you trade, the more the spread will eat into your returns. Mutual funds do not have this problem.

So, are all the disadvantages worth the lower expense? They can be; however, it’s worth it to sit down and plot out how much you would save in dollars per year if you moved from an index fund to an ETF, and make your decision based on that.

(One note: if you use Vanguard (and I highly recommend you do), there’s virtually no reason to use an ETF. Why? Because they recently lowered the minimum for purchasing Admiral Shares of many of their funds to $10,000, making them very accessible, and in just about every instance, the expense ratio for Admiral Shares is exactly that of the corresponding ETF!)

Got a preference? Tell us about it in the comments!

your own worst enemy

There are two stories that I am tired of hearing.

One is a story of greed. I heard it a lot around the turn of the century, and again just before the 2008 crash. It took many forms: day-trading with a 401(k); dumping Oracle stock for that of a smaller company because the database giant was “only” scheduled to double; after some clever analysis, placing a disproportional bet on muni bonds. In every case, the portfolio in question became dangerously out of balance, and when the inevitable crash came, it lost far more than its share. In the cases where its owner was approaching retirement, the impact was disastrous.

The other is a story of fear, and I’m hearing it a lot now.  Retirees whose entire portfolio is in cash, and pre-retirees who are considering not bothering with their 401(k) anymore — because it seems that no matter how much they put in, the balance stays the same or goes down.

Of course, neither of these stories has a happy ending — they’re the source of the Behavior Gap that Carl Richards is so fond of talking about. It’s easy to blame them on fear or greed, but that’s really only part of the story. A more sinister villain is also at play here: recency bias, the well-known tendency of humans to believe — irrationally! — that things are going to stay the way they are, whether good or bad. In 1999, everyone knew that tech stocks were going to continue to go through the roof; in 2006, everyone knew that real estate was a sure bet; in 2008, everyone knew that the stock market was going to plummet forever. (You might ask yourself: what does everyone know now?)

Recency bias is a powerful enemy, though. It masks itself as rational behavior — why keep my money in bonds when stocks are going to continue to outperform? Why keep my money in stocks when they’re going to continue to remain volatile? And in our effort to stay informed, we expose ourselves to an amplification effect from the financial media (whose job, recall, is not to give us unbiased information, but to sell copy) that barrages us with provocative headlines like “Are Stocks Dead?” and “Is This The New Normal?” It’s enough to make even the most rational investor bail out (or jump in, as the case may be).

So what’s a poor human to do? Well, you know my answer: systems. In the case of investing and saving for retirement, there are some handy weapons in your arsenal for dealing with your own worst enemy (yourself); stay tuned for next week’s post, when I’ll introduce you to some of them!

the ins and outs of espp’s, part 3: so now what?

So I gave you a summary of what ESPP’s were all about, then went into detail on the intricacies of ESPP’s and taxes. Now: what exactly are we to do with all this information? Should you participate in your company’s program, or not? And if so, how long should you hold on? Well, everyone’s situation is different, but for most people, I would say this: participate in your company’s plan as much as you are able, and sell as soon as you can. I’ll break down the reasons why, so you can see whether this applies to you in particular.

Participate, because it’s free money. The discounted price at which you get to buy the stock is, if you sell immediately, almost always guaranteed free money. (Among the exceptions are companies with extremely volatile or rarely-traded stock.) If you don’t participate, you are, as they say, leaving money on the table. Obviously you don’t want to go into debt over it, but if you can swing it, do it!

Sell immediately, because to do otherwise is to greatly increase your risk. Holding onto these shares is, in most cases, a highly risky proposition. Yes, holding onto them for long enough to make a qualified disposition may give you some tax advantage, but is it really worth dealing with the ups and downs of your company’s stock?

Moreover, if you think of an “investment” as a “source of future income”, you’re already highly invested in the company you work for. For diversification’s sake, do you really want to put even more eggs in that basket?

“OK,” you may say, “but what do I do, then, with this sudden influx of cash?” Well, your first instinct may be to splurge — and if so, that’s OK. Set aside some amount you feel comfortable with — say, 5 or 10% — and go for it. Consider giving some of it away, as well; chances are, if you have access to an ESPP, you’re in a position to help other folks out. Set the rest aside — either for basic financial goals or long-term ones, like retirement or your children’s education.

Of course, I know several engineers who quite simply and literally have more money than they know what to do with. You know who you are — and that’s perfectly OK. I may go into more detail on recommendations in a future post, but for now (assuming you’re already maxing out what options you have in the way of tax-advantaged accounts), I’ll just recommend parking the money in a well-diversified balanced stock-bond fund, such as the T. Rowe Price Balanced Fund, the Vanguard LifeStrategy Moderate Growth Fund, or the Fidelity Balanced Fund. Any of those will give you a nice, simple, inexpensive compromise between returns and stability until you decide you want to pull that “mad money” out.

Now that I’ve said that: what do you currently do with your ESPP, if you have one? Has this post given you any new ideas?

the ins and outs of espp’s, part 1

Employee Stock Purchase Plans are, like much in the stock-related world, a double-edged sword. Depending on how you swing them, they can either be a handy supplement to your paycheck or just another source of complexity and, in the worst case, a way to flush income down the drain. As many of my fellow geeks have access to them — though not as many as a decade ago — I’d like to take some time to talk about them. Even if you’re already familiar with ESPP’s, it’s a good idea to know what’s out there — not every company’s plan works the same as yours, and it’s handy to know what the possibilities are when you’re job-hunting!

The idea behind the ESPP is relatively simple: as part of the benefits your employer is showering upon you — like manna from the heavens — you are given the opportunity to buy their stock at a discount. Nothing in the world of employer benefits is ever that simple, of course, so I’ll walk through the caveats.

The money for purchasing this stock is withheld from your paycheck. In this way, ESPP’s are much like 401(k)’s: you allocate a certain amount of your paycheck to be withheld, and that amount never graces your bank accounts. Also, there are heavy restrictions on when you can change that allocation; generally you can jump out if you like, but you can’t jump back in until the beginning of the next ESPP period.

The stock is often (not always) purchased in one chunk, at the end of the ESPP period. In this case, rather than buying stock each time you get a paycheck, it’s all purchased at the end of an ESPP period (generally 3 or 6 months). You can expect to see fun little jumps in your employer’s stock price on that day, as some/many/most employees (depending on the company) turn around and sell their newfound shares (and speculators buy or sell in response to this).

There is a cap on how much you can purchase. The cap can be either a maximum percentage of your paycheck, or a maximum number of shares bought, or both.

The discount varies greatly with the employer. Most common is a range from 5%-15%; alternately, the company may “match” your contributions to the ESPP up to a certain percentage of your income. Also, the discounted price is not always the fair market value on the day the stock is bought; it could be the lower of that price and the price at the beginning of the period, or even the price at the beginning of a window of periods! For example: say your employer’s stock price was $10 when you joined a year ago, $20 at the beginning of the last period, and $30 today, the end of the latest ESPP period. Depending on your employer, the buy price could be 5%/10%/15% of $30, $20, or even $10!

Depending on the company, it may not be a guaranteed win. In most cases, if you sell immediately you’ll lock in your profit and get a nice bonus. However, if you work for a company with a highly-volatile stock price (e.g. a “microcap”), you can lose your discount (and more!) by the time you sell your stock.

The taxes on ESPP’s are…interesting. So interesting, in fact, that I’ll be devoting my entire next post to them!

See you then! In the meantime, tell us about your ESPP — has it done well by you? And does it fall into one of the above descriptions, or is it a variant that wasn’t covered?