Lately municipal bonds have also been under scrutiny, with some analysts predicting widespread municipal bankruptcies with resulting defaults on muni bonds. The media has wasted no time giving the scary forecasts plenty of coverage. Will the dire predictions come true? Balanced views are hard to find, but the best I've seen are the articles below from Dimensional Fund Advisors and Larry Swedroe’s CBS MoneyWatch column:

Municipal Bond Worries -- The bottom line: There are risks, as always, but not as great as the recent media attention would make it seem.

Municipal Bonds: Was Meredith Whitney Right? – Additional evidence that the media seems to have overstated its case. 

A May 4 Bloomberg Television “Taking Stock” interview with financial author Larry Swedroe offers insights on housing, commodities and other topics of recent interest. Swedroe’s interview provides light where most others offer only heat.

Q: I have a four-year-old. Is a 529 plan the best way to save for her college education?

A: For most people, a 529 plan is the logical starting point for their college savings because earnings in the 529 plan are Federal (and sometimes state) income tax-free if spent on qualified educational expenses at a qualifying educational institution. But for most people the 529 should not be the only funding vehicle, and it can pay to seek some objective, expert advice before proceeding.

What is a 529 plan, anyway?

In brief, a 529 plan can be an attractive college savings vehicle because investment earnings in the plan are tax-free if spent on tuition, fees, books, supplies, equipment (including computers), and room and board, at a qualifying educational institution, for a qualifying beneficiary. This can get technical, but in our brief space here, suffice it to say that the balance in the 529 can be used to pay most college expenses. The term “qualifying educational institution” is very broad, too, and includes almost all colleges (including some colleges in other countries, some trade schools and even a couple of golf schools).

The best thing about a 529 plan is that it enables you to set aside money for a child’s college without losing control of the money. By way of contrast, many people use an UTMA (Uniform Transfer to Minors Act) trust to provide a segregated account for a child’s college expenses, but the balance in an UTMA becomes the unrestricted property of the child at majority (age 21 in Texas). Thus, if the child decides not to go to Harvard and spends her UTMA on a Harley instead, there is nothing to be done about it. In contrast, you control expenditures from the 529 plan, so you can be sure that the balance will be used only as you intended.

By the by, you don’t get a tax deduction for money you contribute to a 529 plan.

What’s the catch?

The biggest catch is that, if the money in the 529 plan is withdrawn but not spent on educational expenses – for example, if you withdraw the balance to fund your retirement – investment earnings in the plan are subject to ordinary income tax plus a 10% penalty. So if your child doesn’t attend college – or selects a lower-cost institution than originally planned – you may have a significant amount of money stranded in her 529 plan. For this reason, I typically recommend saving no more than about 60% of anticipated college expenses in a 529. Yes, it may be possible to designate a different beneficiary but this may or may not work as you’d hoped for either. As any parent knows, including this one, our offspring don’t always perform exactly as predicted!

Where to save the remaining 40% of your anticipated college expenses? You can establish a separate taxable investment account for the college savings, or you can simply blend it in with the rest of your taxable savings and do some mental accounting to track it.

Additional angles

If you establish a 529 plan for a child and she doesn’t go to college, all may not be lost; you can shift the 529 plan to a sibling. Or, you may leave the balance alone, let it grow, and hope that eventually a grandchild can use it for college expenses.

Grandparents’ note: You designate a beneficiary when you establish the 529 plan. People usually designate their children, but the beneficiary can be anyone. Thus a 529 plan offers a great way for a grandparent to give to their grandchildren (and the balance of a 529 plan owned by a grandparent generally will not count against the child for purposes of colleges’ financial aid calculations, so generally the existence of the plan won’t reduce financial aid, as it will if it’s owned by the child or the parent). A 529 plan can even be a way for you to save for yourself, if you’re planning to return to college. Keep in mind, though, that the beneficiary can only be changed to another family member of the original beneficiary. So if you establish a 529 plan for a friend’s child, you can’t change the beneficiary to your own child.

Another tip: Some states offer a state income tax break for contributions to their 529 plans. (Because Texas doesn’t have an income tax, Texas doesn’t offer an income tax break for contributions to college savings plans.)

And an additional caution. Many people assume that the federal income tax break makes every 529 plan a good deal. Not so. Remember if you buy a 529 plan from a broker, a commission will be involved, reducing the benefit of the plan to the beneficiary. And as with 401(k) plans, there are management fees and plan expenses built into 529 plans. These costs are not always so obvious, and sometimes they are destructively burdensome. Say you’re paying 2% to 3% per year among commissions, the program fee and fund fees. You have to overcome all these expenses before you even begin to break even – and a positive return is not guaranteed with any investment. Some 529 plans’ expenses may result in higher hurdles than if you simply invested the same amounts in a taxable account. You can compare costs at www.savingforcollege.com.

Remember, too, that a 529 plan might not be your only college savings option. In Texas, for example, the prepaid tuition plan is worth considering. With it, you buy a block of college time for future use, locked in at today’s prices. An exploration of prepaid tuition plans warrants a separate article, but suffice to repeat that families planning for college have a number of options to consider.

A final caution: This is only the tip of the informational iceberg on 529 plans. The details are complicated. Professional advice from a fee-only financial advisor is a good idea. Call if we can help.

In last week’s post on investing and economic risk, I recommended a well-diversified, low-cost index fund portfolio as the best stock and bond investment. For the fixed income portion of that portfolio (which, yes, should be a permanent fixture in your long-term portfolio) I have long recommended the use of shorter-term bonds. This is true across a variety of economic conditions, and becomes especially important when inflationary concerns loom large. Let’s explore why.

In the lingo of investing, there are two primary ways to invest: stocks and bonds. A stock is a small ownership stake in a company. A bond is a loan. The bond is less risky because if the business goes bankrupt, bonds have to be paid in full before the stockholders get anything. In addition, bonds generally offer a steady stream of income.

As a general rule, it is wise to allocate a significant percentage of your portfolio to bonds to temper the risk you’re taking with your stocks. Including bonds in your portfolio reduces overall portfolio volatility.

But why shorter-term bonds in particular? After all, long-term bonds offer higher interest rates. If you’re planning to hold onto them for a long time, why not get the bond that pays the most? Because there’s a catch to stretching for that seemingly “free” extra interest.

Consider this image (click on it to view enlarged version):  

At first glance, they’re just a couple of lines intersecting. What do they mean? The blue, bottom line shows increasing risk. Bond values drop when interest rates go up. The longer the term, the greater the drop (and the greater the risk).

The gold, top line is the interest rate. Since 1964 (based on data available), one-month government bonds have averaged a 5.45% return. Five-year bonds have averaged a 7.27% return. This makes sense – five-year bonds have more risk, so they offer a higher return. By extending the bond term from one month to five years, the investor increases risk but gets an additional 1.82% return.

So far so good. But now look where the lines intersect, at about the five-year point. Past a five-year term, the blue line shows that risk continues to increase dramatically. But the gold line shows that the interest rate increases only by a paltry 0.10%!

You have to wonder, why take on the extra risk, when you can expect very little additional return? Answer: There’s really no good reason to take on extra risk unless there is a commensurate expected return. And that’s why I generally recommend short-term bonds instead of long-term bonds.

I will add one final note. There are times when you’d be glad to have long-term bonds – mainly when interest rates are falling, because long-term bonds increase in value when interest rates fall. But with interest rates relatively low these days, and with inflation likely (in my opinion) to push interest rates higher over the next few years, now seems to be a very good time to follow this rule of thumb: Reduce volatility in your stock portfolio with short-term bonds, not long-term bonds.

Turbulent economic conditions are a recurring theme here and abroad -- and it doesn’t look like these concerns will blow away anytime soon.

• Inflation Worries -- As I have described before, I think inflation is likely on its way because the Fed has been pumping new money into the economy, and the monetary base more than doubled from mid-2008 through November 2010.
• Government Debt – U.S. and global indebtedness continue to mount.
• Government Intervention -- Government interventionism in the economy is on the rise, which likely will result in higher business costs and less business efficiency.

So, yes, there are plenty of worries. But what’s an investor to do? Well, if you have a well-diversified, low-cost index fund portfolio, expertly built and properly adjusted to suit your investment time horizon and risk tolerance, simply stick with it. Nobody can predict the future, but the evidence suggests that the long-term returns of a well-diversified index fund portfolio are likely to be more closely related to the returns offered in the capital markets than to economic conditions. Don’t believe it? Read this post: Good News, Bad News and Market Returns.

If you’re not sure whether your portfolio is built to last, this may be an excellent time to seek the advice of a professional fee-only advisor, to ensure you’ve got an appropriate allocation among stocks and fixed income (bonds). And, yes, you want some of each. Even if bonds aren’t exciting, and even if they’re a little scary with inflation on the horizon, they are an important part of the portfolio. They serve to reduce portfolio volatility – because one need only look back a couple of years to see that stocks have both a downside and an upside.

I will give you one additional tip, though: Especially in inflationary times, shorter-term bonds have less risk than long-term bonds. Want to know more about it? I’ll continue the conversation on this subject next week.

Let’s say you’ve taken my advice and most of your portfolio is comprised of low-cost, passively managed, globally diversified mutual funds. You agree this is the right way to go but, let’s face it, sometimes the tried-and-true can be boring.

Now a friend of yours is really excited about an Initial Public Offering (IPO). In an IPO, a privately owned company issues shares of its stock to the public for the first time. It’s tempting to think of an IPO as the ground floor of a great opportunity, like Apple when it was still operating out of Steve Jobs’ and Steve Wozniak’s garage. The siren song of vast profits tempts us.

So do IPOs make sense as part of the average investor’s investment strategy? Sorry, the answer is no, and here are a couple of reasons why.

As a group, IPOs’ performance disappoints. A seminal paper published in The Journal of Finance looked at IPOs from 1970 to 1990. During the five years after issuance, investors in these IPOs got average annual returns of only 5%.(1) By contrast, the overall stock market’s average annual return from 1970 to 1990 was more than double that figure, at 10.8%. To put this in perspective, $1,000 invested at 5% for 20 years would have generated $2,653, while $1,000 invested at 10.8% would have generated $7,777, almost three times as much.

The subpar return on IPOs makes sense when you realize that the issue price for the shares is set by the issuer and the investment bank it hires to market the shares. Both obviously know more about the stock than the public does, and both have financial incentive to charge the maximum price the market will bear. Moreover, IPOs tend to come out at peaks in the market. To illustrate, during the recent financial crisis from 2007 to 2009, there were almost no IPOs. That’s because with the market as low as it was, it didn’t offer enough of a payday to the issuers and investment banks. They wait for better times. Now that the market has almost doubled from its lows in 2009, we are starting to see some IPO activity.

Thus, IPOs as a group are a bad investment when compared with the overall stock market. Sure, you might get lucky, making a killing on the next Microsoft. But that, my friend, is just gambling. And just like gambling in Las Vegas, gambling in IPOs is a loser’s game. On average, over time, the odds are against you.

(1) Loughran, Tim and Ritter, Jay R., The New Issues Puzzle. JOURNAL OF FINANCE, VOL. 50, NO. 1, MARCH 1995. One of the study’s authors later updated the data to take in the period 1980-2008. The updated study showed similar results, demonstrating that IPOs underperformed other firms of the same size (market capitalization) by an average of 3.5% per year during the five years after issuance. Interestingly, the author excluded from performance the stock’s first-day return because so few investors actually can buy on the first day.

Remember those 33 Chilean miners from last fall? As they endured 69 days underground, the whole world followed their harrowing rescue.

So what ever happened to those guys? I heard that one of them ran in the New York Marathon. Good for him! Beyond that, no news.

Stock market coverage is like that – in your face today, gone tomorrow. Especially around the new year, hundreds of talking heads offer thousands of “sure-fire” predictions on what’s hot and what’s not for your next big investment move. Buy Acme Inc.! Sell Beta Corp.! Large-caps are where it’s at!

But I challenge you to track what happens to those predictions a year, or even a quarter, later. A recent Wall Street Journal article checked to see how the stock market predictions of top analysts actually performed. It tracked the performance of the 10 stocks that stock analysts rated most highly, as well as the 10 they most loathed, for each of the past three years, 2008–2010. These years encompassed the worst of the Great Recession and the recovery that followed.

The results, please:

Analyst Stock Picks* and the S&P 500

Annualized Returns

 * Stock pick data are subject to survivorship bias, which means stocks that disappeared completely during the period were not included in these returns.

The market average, the S&P 500 Index, beat the picks of the top analysts in two out of three years. And if you had bet against the analysts, you would have been ahead in two out of three years.

The moral of the story? I’m not suggesting you go out and buy the opposite of whatever the analysts are recommending. I’m just saying the analysts’ picks and pans simply aren’t useful. I think it’s best to avoid the stock-picking game entirely by recognizing these talking heads for what they are — entertainment. Nothing more. Certainly not useful for investment advice. To consider my preferred strategy for wealth accumulation, check out this recent blog, Essential Investing.

Theologian and satirist Gilbert Keith Chesterton once observed, “The chief object of education is not to learn things; nay, [it] is to unlearn things.” I don’t think he was specifically referring to investing, but he might as well have been, with so many assumptions there to be “unlearned.”

In my recent quarterly client letter, I refuted one seemingly erroneous assumption that there is a clear, predictable relationship between economic news and market returns. The actual evidence reveals that, if you believe that they always march in close step to one another, you may have some rethinking to do. Or is that “unthinking”? Either way, I thought you’d enjoy a reprint of the report I shared with my clients, below.

But how much does a strong or weak economy affect stock market returns?  Less than you might think.

As a case in point, take Brazil.  In the late 1980’s, the Brazilian government was deeply in debt.  From 1988 to 1994, Brazil experienced extreme hyperinflation of the nightmare variety, averaging more than 1,100% per year.  Total inflation over the period was more than four billion percent. Yes, that’s billion, with a “b.”  Holders of cash in Brazil were decimated; in 1988, a billion Brazilian cruzados were worth $13,950 in US dollars.  Seven years later, a billion cruzados were worth $22. (1) 

Brazilian stock market investors must have lost their shirts, too, right?  Actually, no.  While inflation rose by four billion percent from 1988-94, Brazilian stocks rose by thirteen billion percent.  Adjusted for inflation, Brazilian stock values in local currency tripled, averaging a return of 17% per year. (2)

Of course not every market from every country in crisis is going to perform so well. But let’s explore the Brazilian phenomenon, and how you might apply lessons learned there to the current U.S. and world economy.

For decades, the U.S. government has taken a bigger and bigger slice of our nation’s economic pie, with much of its largesse funded by borrowing.  This trend shows no signs of slowing.  Today, government indebtedness has grown to 90 percent of Gross Domestic Product.  In other words, our government's debt is almost as much as the value that the U.S. economy produces in a year.  Many other governments around the globe owe similar amounts relative to their economic footprints, as shown below. (3) 

Why does government debt matter?  Because the money the government borrows has to come from someplace.  Economic studies show that demands for debt funding by government can crimp availability of debt funding for private enterprises, resulting in slower economic growth. (4) The more indebted the government becomes, the more of a drag its debt becomes on the nation’s economy. 

So increasing U.S. government debt may result in slower U.S. economic growth.  What’s an investor to do? 

At first impression, you might assume that slower economic growth would dictate lower stock market returns.  The evidence suggests, however, that a country’s economy and its stock market march to different drummers.  Brazil is only one example.

The illustration below compares stock market returns in high-growth countries vs. low-growth countries.  Notice how stocks in the slow-growth countries, shown in blue, delivered higher average annual returns than their high-growth brethren shown in pink. (5)

Thus, a country’s economy and its stock market do not move in lock-step.  Market returns are most highly correlated with risk:  More risk, more return.  For those who are familiar with the phenomenon of smaller and value (higher-stressed) companies delivering higher expected returns as compensation for their higher perceived risk, this shouldn’t come as a complete surprise. Just as with individual stocks and general asset classes, when a country is on the ropes, investors demand a higher expected return before they’ll stay invested in that country’s future.

The investor’s best response to the uncertainty created by high U.S. government indebtedness is simple:  Stay invested in a well-diversified worldwide portfolio of stocks and bonds, designed with your risk tolerance and investment objectives in mind. 

Of course there’s nothing wrong with keeping an eye on the economy. After all, whether or not it impacts your investment portfolio, it does affect many other facets of your life. But let’s not let the economy overtake the larger goal of living our lives.

The numbers are in, so let’s take a last look at 2010. In retrospect, we can readily see the year-round events that caused us grief, both emotionally and financially. To name a few:

• A prominent researcher who had predicted the Great Recession, predicted the “biggest co-ordinated asset bust ever” for 2010.
• A January Economist cover story warning of asset price bubbles asserted that US stocks were “nearly 50% overvalued.”
• The “January Indicator” signaled negative stock market returns for the year.
• The Gulf oil spill threatened US shores, along with global market stability amidst the uncertainty.
• The May 6 “Flash Crash,” a sudden and unexpected plunge of about 700 points in the Dow, bewildered investors. 
• Hundreds of bank failures signaled continued weakness in the financial system.
• A divided Congress passed a complex and expensive healthcare reform bill.
• Residential housing remained weak.
• The “Hindenburg Omen” generated a “sell” signal in August, portending disaster in the markets.
• North Korea launched a deadly artillery assault against South Korea’s Yeonpyeong Island.
• A financial crisis with no clear resolution gripped governments in Greece, Portugal and Ireland.

Retrospect lets us neatly summarize a year of stomach-wrenching headlines. But it also affords us a better view of the end results. You bet, there were a lot of dips, dives, false starts and dashed hopes. But in the end, the U.S. stock market delivered a satisfying, nearly 17 percent annualized return.

Similarly, world markets (as measured by the MSCI All Country World Index) yielded just under 13 percent annualized returns. But – and this is crucial –investors who reacted to the never-ending onslaught of worrisome news by abandoning or remaining outside of the markets were far less likely to capture what the markets ultimately delivered.

Of course a year is a blink of the eye. My three-year-old son may not have figured that out yet, but I sure have. As such, one year of returns that happened to have played in our favor doesn’t necessarily “prove” my case -- no more so than a single year of bad returns would disprove it. But, 2010 does serve as a good, illustrative snapshot of how the market has generally performed over much longer periods.  It seems worth sharing for that reason.

In the short run, the hue and cry is loud, hard to ignore and impossible to predict. In the longer run, U.S. and global markets have delivered positive returns over time. Investors who remain focused on and steadily invested toward the horizon of their own financial goals are far more likely to reach their destination as planned. While capitalism is alive and breathing, investing according to these guidelines seems the best way to manage your personal assets in our global markets.

If I were a betting man, I’d lay odds that inflation lies ahead, with the Fed pumping newly printed money into the economy, and with high government deficits making it difficult for the Fed to stop or reverse the flow.

Given that I expect inflation, am I changing my investment strategy? Buying gold, shorting the dollar and bulking up on fixed-rate loans?

No. Instead of making inflation bets, I’m betting on capitalism by retaining my well-diversified portfolio of stocks and bonds, which has delivered long-term gains across lots of economic environments in both inflationary and non-inflationary times.

Another reason I’m not placing a big bet on inflation is that it is not certain to occur. The following article, reprinted with permission from Dimensional Fund Advisors, shows why. According to monetary theory there should be a strong relationship between expansion of the money supply and increasing inflation. But in reality, so many variables come into play that the “obvious” results of monetary expansion may not be so obvious after all.

So I’m sticking with the tried-and-true investment strategies as the safest bet for continuing to reward disciplined investors over the long run – whether inflation is in the cards or not. Read on to learn more.

Does Monetary Expansion Stoke Inflation?

Since the financial crisis hit in late 2008, the US monetary base has more than doubled, from about $800 billion in mid-2008 to about $2 trillion in November 2010.¹ When the Federal Reserve announced a second round of quantitative easing (QE2), it raised investor concerns that such actions would stoke inflation.

The chart below shows that the US monetary base has spiked since 2009. While inflation has fluctuated considerably, it has not tracked the changes in the monetary base. Although no one can reliably forecast inflation, we think markets do a pretty good job of sorting through all the macroeconomic data. At present (mid December), the markets do not appear to reflect expectations of runaway inflation in the near future.²

US Monetary Policy since 2000

 Source: Federal Reserve Board

Nevertheless, investors may be growing anxious in response to media coverage of the Fed’s continuing expansionary policy. For those who are certain QE2 will be inflationary, perhaps the recent example of Sweden’s monetary base run-up will offer some reassurance.

In the 1990s, Sweden’s central bank, the Riksbank, more than doubled the country’s monetary base during the Nordic banking crisis, but inflation remained moderate during and after the expansionary period. The graph below documents that even as the monetary base jumped from 1994 to late 1996, inflation did not follow suit, and in fact, remained flat before falling in 1996.

Swedish Monetary Policy in the 1990s

Source: Sveriges Riksbank

Sweden’s monetary base expansion is one of several international examples of quantitative easing over the past two decades. These case studies, which include past expansionary periods in the UK, Switzerland, Japan, Australia, New Zealand, and Iceland, are discussed in a recent Federal Reserve Bank of St. Louis review.³ The researchers concluded that doubling or tripling a country’s monetary base does not lead to high inflation if the public views the increase as temporary and expects the central bank to maintain a low-inflation policy.

Of course, many factors may come into play, and we cannot know whether the US will share the same fortune. But at least we know that quantitative easing has occurred without triggering high inflation.

1. Monetary base is the total amount of the liquid currencies circulating in the hands of the public, deposits in financial institutions, and the deposits of the commercial banks in the central bank of the respective country.

2. One indicator of expected future inflation is the difference in rates between US Treasury bonds and Treasury Inflation Protected Securities (TIPS), also known as the TIPS spread. As of December 16, the 10-year zero-coupon TIPS spread was 2.35% (http://www.federalreserve.gov/econresdata/researchdata.htm). Consider, however, that the spread also includes an inflation risk premium, so the spread is not an exact measure of the market’s inflation expectations.

3. Richard G. Anderson, Charles S. Cascon, and Yang Liu, “Doubling Your Monetary Base and Surviving: Some International Experience,” Federal Reserve Bank of St. Louis Review 92, no. 6 (November/December 2010): 481-505.