New Year’s Checklists: What Is Your Financial Priority List?

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Updated for 2017. You’ve worked hard and you have some money to put away for your future self. What should you do with your money? There is no definitive list, but each person can create their own with common components. You may also want to revisit it again every year.

You can find some examples in this Vanguard blog and see what I had down in this 2006 blog post. Here’s my current list:

  1. Invest in your 401(k) or similar plan up until any match. Company matches typically offer you 50 cents to a dollar for each dollar that you contribute yourself, up to a certain amount. Add in the tax deferral benefits, and it adds up to a great deal. Estimated annual return: 25% to 100%. Even if you are unable to anything else in this list, try to do this one as it can also serve as an “emergency” emergency fund.
  2. Pay down your high-interest debt (credit cards, personal loans, car loans). If you pay down a loan at 12% interest, that’s the same as earning a 12% return on your money and higher than the average historical stock market return. Estimated annual return: 10-20%.
  3. Create an emergency fund with at least 3 months of expenses. It can be difficult, but I’ve tried to describe the high potential value of an emergency fund. For example, a bank overdraft or late payment penalty can be much higher than 10% of the original bill. Estimated return: Varies.
  4. Fund your Traditional or Roth IRA up to the maximum allowed. You can invest in stocks or bonds at any brokerage firm, and the tax advantages let you keep more of your money. Estimated annual return: 8%. Even if you think you are ineligible due to income limits, you can contribute to a non-deductible Traditional IRA and then roll it over to a Roth (aka Backdoor Roth IRA).
  5. Continue funding your 401(k) or similar to the maximum allowed. There are both Traditional and Roth 401(k) options now, although your investment options may be limited as long as you are with that employer. Estimated annual return: 8%.
  6. Save towards a house down payment. This is another harder one to quantify. Buying a house is partially a lifestyle choice, but if you don’t move too often and pay off that mortgage, you’ll have lower expenses afterward. Estimated return: Qualify of life + imputed rent.
  7. Fully fund a Health Savings Account. If you have an eligible health insurance plan, you can use an HSA effectively as a “Healthcare Roth IRA
    where your contributions can be invested in mutual funds and grow tax-deferred for decades with tax-free withdrawals when used towards eligible health expenses.
  8. Invest money in taxable accounts. Sure you’ll have to pay taxes, but if you invest efficiently then long-term capital gains rates aren’t too bad. Estimated annual return: 6%.
  9. Pay down any other lower-interest debt (2% car loans, educational loans, mortgage debt). There are some forms of lower-interest and/or tax-deductible debt that can be lower priority, but must still be addressed. Estimated annual return: 2-6%.
  10. Save for your children’s education. You should take care of your own retirement before paying off your children’s tuition. There are many ways to fund an education, but it’s harder to get your kids to fund your retirement. 529 plans are one option if you are lucky enough to have reached this step. Estimated return: Depends.

I wasn’t sure where to put this, but you should also make sure you have adequate insurance (health, disability, and term life insurance if you have dependents). The goal of most optional insurance is to cover catastrophic events, so ideally you’ll pay a small amount and hope to never make a claim.

What If You Invested $10,000 Every Year For the Last 10 Years? 2007-2016 Edition

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Instead of just looking at one year of returns, here’s an annual exercise that helps you look at the bigger picture. You may know the 10-year historical return of the S&P 500, but most of us didn’t just invest a big lump sum of money in 2007, and most of us don’t just invest in the S&P 500.

Investment benchmark. There are many possible choices for an investment benchmark, but I chose the Vanguard Target Retirement 2045 Fund. This all-in-one fund is low-cost, highly-diversified, and available in many employer retirement plans as well open to anyone with an IRA. In the early accumulation phase, this fund is 90% stocks (both domestic and international) and 10% bonds (investment-grade domestic and international). I think it’s a solid default choice where you could easily do worse over the long run.

Investment amount. For the last decade, the maximum allowable contribution to a Traditional or Roth IRA has been roughly $5,000 per person. (It was $4k in 2007, but has been $5k or higher since.) That means a couple could put away at least $10,000 a year in tax-advantaged accounts. If you have a household income of $67,000, then $10,000 is right at the 15% savings rate mark.

A decade of real-world savings. To create a simple-yet-realistic scenario, what would have happened if you put $10,000 a year into the Vanguard Target Retirement 2045 Fund, every year, for the past 10 years. You’d have put in $100,000 over time, but in more manageable increments. With the handy tools at Morningstar and a quick Google spreadsheet, we get this:

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In this case, I would say that ending up with a gain of over $50,000 for every $10k annual investment is nothing to sneeze at. If you put in $20k every year, your gains would have been over $100,000. Some of that money was invested right before the crash in 2008, and some has only been in the market for a few years. Not every year will have turned out to be a great year to invest, but taking it all together provides a more calm, balanced picture.

Investment Returns By Asset Class, 2016 Year-End Review

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Although I am not always successful, I’ve been trying to pay less attention to the daily, weekly, even monthly movements of the markets. Once every few months, I will update my portfolio spreadsheet and make sure that I am investing new money towards my target asset allocation, but that’s about it. That said, I do enjoy a good year-end review. Here are the trailing 1-year returns for select asset classes as benchmarked by passive mutual funds and ETFs. Return data was taken from Morningstar after market close 12/30/16.

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Commentary. If anything, I think 2016 reminded us that although many people are paid essentially to make predictions, most of them aren’t very good at it. Indeed, the more important skill is explaining why things actually turned out the way they did in hindsight. That way, you have a reason to believe their next prediction…

As 2016 ended, I was a bit surprised to see that every asset class listed above had positive returns. Accordingly, most people who owned a diversified portfolio in 2016 had decent returns. The Vanguard Target Retirement 2045 fund (90% diversified stocks and 10% bonds) was up about 8.9% in 2016. My personal portfolio (overall 70% stocks/30% bonds) was up about 7.8% in 2016.

As I get closer to having to live off of my portfolio, I am increasingly focused on the amount of dividends, interest, and rental distributions that my portfolio gives off. (This is in the low 2% range.) I know that total return is more important, but seeing the cash come in makes me more comfortable. I like the analogy to an investment property. If you get a reliable $2,000 in rent coming in every month like clockwork, you care less about the market value of the house itself.

ETF Tax-Loss Harvesting: 70% Overlap Rule of Thumb for Substantially Identical

calc_10keyTax-loss harvesting (TLH) is a common practice used to improve after-tax returns by realizing losses to either offset realized capital gains or to defer capital gains into the future. Many robo-advisors including Betterment and Wealthfront offer automated tax-loss harvesting as a feature. As nearly all of them hold ETFs, they accomplish this by selling the primary ETF for each asset class and replacing it temporarily with an alternative, secondary ETF. DIY investors can perform a similar maneuver as well.

The IRS wash sale rule states that you can’t deduct a loss by selling a security and immediately replacing it with something “substantially identical”. Instead, harvesters buy an ETF that is slightly different. It’s a grey area, as there is no solid definition of what “substantially identical” means. However, this recent Barron’s article (paywall, use Google News) offered up a rough rule of thumb that I hadn’t seen before (bolding mine):

Although the wash-sale rule remains ambiguous, there may be an alternative standard that investors can use for guidance. In the 1980s, the IRS created the “straddle rules” to address a loophole in hedged long-short portfolios. For tax-loss purposes, the portfolios on the long side couldn’t be “substantially similar” to those on the short, which the IRS defined as having over 70% overlap. “Some people use the straddle-rules definition as a surrogate to apply to the wash-sale rule,” says Eric Fox, a principal at Deloitte Tax. “If two ETFs don’t have more than 70% overlap and they’re not substantially similar, how could they ever be considered substantially identical?” That should give loss harvesters some confidence.

I was surprised by the conservativeness of this rule of thumb. Most of the TLH articles I have read by both human and software-based advisors implement more aggressive strategies than the 70% maximum overlap suggested above. A traditional advisor quoted in the Barron’s article admitted swapping between the Vanguard Total International Stock ETF (VXUS) and the Vanguard FTSE All-World ex-US ETF (VEU). VXUS and VEU have a 76% overlap by weight, according to this ETFResearchCenter.com Overlap Tool:

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Perhaps more importantly, these two ETFs have a near 100% performance correlation. Here’s a chart of the two ETFs over the last 12 months, per Morningstar (click to enlarge):

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Meanwhile, this Wealthfront whitepaper shows their ETF tax-loss pairings and their correlations. Out of the 7 pairs, 4 have correlations of 97%+ and all of them are over 70%.

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Commentary. There are few firm answers here. If robo-advisors marketing aggressive ETF tax-loss harvesting gather a lot of assets, I suspect the IRS will eventually provide additional guidance. I imagine the worst-case scenario as the IRS classifying past trades as violating the wash sale rule, nullifying your tax losses and possibly imposing additional penalties. I guess current practitioners don’t see a big risk of that happening. They essentially see a nearly free lunch by substituting these similar ETFs. Still, when you market something publicly as 99% correlated, aren’t you basically admitting that they are “substantially identical”?

Year-End Portfolio Rebalancing: Impact on Returns vs. Risk

scaleAs we close in on the end of the year, it is a good time to take stock of your investment portfolio. If you haven’t already, you should consider rebalancing your portfolio back towards your target asset allocation. Overall, this means selling your recent winners and buying more of your recent losers.

Now, you may think that rebalancing will improve your returns because you are “selling high” and “buying low”. However, the full picture is a bit more nuanced than that. If you think about it, the asset classes with the highest returns should eventually take over the portfolio if you never rebalance. If you started in 1965 with 50% stocks and 50% bonds and did nothing to 50 years, your portfolio in 2015 would have been overwhelmingly stocks. If you kept selling stocks and buying bonds, you would have probably lowered your returns in the long run. So why rebalance?

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In his post How Portfolio Rebalancing Usually Reduces Long-Term Returns (But Is Good Risk Management Anyway), Michael Kitces provide a handy visual to summarize the effect of rebalancing into two scenarios:

  1. When rebalancing between asset classes with similar returns, the likely effect is to help increase your overall returns while not affecting your risk. An example is rebalancing between US and International stocks.
  2. When rebalancing between asset classes with different returns, the likely effect is to help lower your overall risk (improving your risk management in the chart) while decreasing your overall return. An example is rebalancing between stocks and bonds.

In the end, Kitces reminds us while your overall returns probably won’t be enhanced, the net effect of rebalancing is better risk management. I think of it similarly as preventing my portfolio from getting “out of control”. This is why people create “rebalancing bands” that let their portfolios wander a bit but not too much. For example, a 20% target allocation can vary from 15% to 25% before being rebalanced back towards the target number.

How To Become a Venture Capitalist for $100

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How would you like to add “Venture Capitalist” to your social media profiles?

Indiegogo and Microventures have teamed up to offer equity stakes in startups to virtually anyone for as little as $100. Here is an Indiegogo blog post and a NY Times article covering the announcement. Previously, only accredited investors were allowed access in such markets, and that required an annual income of $200,000+ or a net worth of $1 million+.

This is different from Kickstarter crowdfunding where you put up monetary support and at most get an early product sample or some form of personal recognition. This is an actual investment with the opportunity to earn a significant return. (Or you might never see it again.)

I decided to look more closely at one of the available investments. Republic Restoratives is an urban, small batch distillery and craft cocktail bar in Washington, D.C. You can invest as little as $100, which will get you the perk of being “periodically invited to special parties, happy hours and previews”. If you invest at least $250, you’ll also get a founders signed bottle of CIVIC Vodka.

In terms of financial upside, you have to look closely at the investment terms:

Security Type: Secured Promissory Notes
Round Size: Min: $50,000; Max: $300,000
Interest Rate: Revenue sharing agreement which provides the investors 10% of the Company’s gross revenue, up to the repayment amount of 1.5x of their investment
Length of Term: Until the repayment amount of 1.5x investment is repaid
Conversion Provisions: None

In this case, you don’t actually get equity. You have a promissory note that says you have dibs on part of future gross revenue, but only up to 150% of your initial investment. For example, if they raise $100,000 and they manage to bring in $1,500,000 in gross revenue, they’ll pay out $150,000. If you invested $100, you’ll then get at most $150 back. Even if they take over the world and become the next Pappy Van Winkle brand, you’ll get the same amount back. Too bad, I’d rather be able to say that I am partial owner of a bar. 😉

A brief look at another investment option, BeatStars, shows that you have the possibility of owning preferred shares of the business if the note converts.

Bottom line. In financial terms, equity crowdfunding is very risky. The businesses available are unproven and have decided not to go the traditional VC route. To put it bluntly, you really shouldn’t expect to see your money again. In my opinion, the benefits are mostly psychological. You get to feel good about supporting a business you want to succeed. You may get personal recognition via your name on a wall or a signed bottle of vodka. I like the idea of telling people that I “provide venture capital to startups” instead of my real job.

Why Regular, Monthly Investments Are The Best Way To Build Wealth

automateHere’s another post on the topic of creating good habits

A common investing question is whether it is better to invest your money all at once (lump-sum) or gradually over time (dollar-cost averaging). The standard answer is that lump-sum is generally a better choice than dollar-cost averaging. This is mostly simple mathematics; If something goes up on average, then you’ll want your money in as early as possible.

However, in this Financial Planning magazine article Does investing monthly or annually beat a lump-sum portfolio? by Craig L. Israelsen, he argues that in the real world the best solution is regular, monthly investing. I recommend reading the original piece, but here is how I mentally broke down the concept:

  1. The most important thing to building wealth is saving a lot of money (savings rate).
  2. The best way to save a lot is to save often over time.
  3. The best way to save often is to develop a regular habit of it, so that it becomes effortless over the years.
  4. The hardest part about developing a habit is at the very beginning. You need an initial streak that is uninterrupted.
  5. The most likely thing to interrupt your streak is seeing a big drop when you look at your monthly account statements. That is scary. As humans, we like to focus on that number.
  6. With lump-sum contributions, you are much more likely to see a drop on a month-to-month basis. You have committed your money, and it is now subject to the market’s whims. You are also given a lot of time to think between actions, and you’ll have to muster up the motivation to make another lump-sum investment later.
  7. With regular, monthly contributions and a small portfolio size, you will hardly ever see an account balance drop.

Historical data from 1980-2015. Consider a diversified portfolio of stocks and bonds (details in the article). The following chart has three columns that compare overall market returns, an annual investment of $3,600 made each year on January 1st, and a monthly investment of $300 made at the start of each month.

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In the beginning, your account balance “feels” like it is always growing, even though the market itself may be flat or even dropping. This is the benefit of regular, monthly contributions. The positive reinforcement will hopefully let an investing habit form. As your portfolio gets bigger, the difference between dollar-cost averaging and lump-sum investing becomes relatively insignificant.

Bottom line. Building the habit is the most important thing. If at all possible, you should make automatic, monthly investments. When your account is small, systematic investments make it more likely that the number on your monthly statement keeps rising every month. By the time that your portfolio starts to get big enough that it doesn’t help anymore, you’ll have already built the habit and be on the path to solid wealth. By the way, if you invest as soon as you have the money available (i.e. when you get your paycheck) then you already are getting your money in the market as soon as possible.

This Simple Game Helps Explain Stock Market Investing

quarterHere’s a very simple game that does a great job of illustrating the pitfalls of investing, despite the long-term odds being in your favor.

  • Imagine that you are given $25 that you can bet on a coin toss for 30 minutes.
  • You know that the coin will come up heads 60% of the time, and tails 40% of the time.
  • You can bet as little or as much of your available cash on each flip. You double your wager if you are correct. You lose all of your wager if you are wrong.

There are many ways you could play this game. You could bet your entire $25 at once since you have an edge. But then there is a 40% chance you’d be instantly broke. You could bet nothing, as that would guarantee yourself $25 at the end of the session. You could vary your bets according to instinct. You could use mathematical theory to form an optimal solution.

Stock market investing works in a similar manner. People invest because the long-term odds are in our favor. Things look good over the long run, but there is volatility in the short run. Some people instead choose to take zero risk, but their money stagnates. Some people trade based on their intuition. Some people trade based on pre-set strategies.

The ideal result? If everyone bet optimally, they would have had a 95% chance of reaching 1000% of their initial wager (real-world maximum payout of $250). A mathematical formula called the Kelly Criterion tells you to bet a constant 20% of your bankroll every time. This is the optimal balance between the reward upside and keeping enough padding to avoid bankruptcy.

The actual results? The average ending balance was only $75. 33% of the participants actually lost money. 28% went completely broke! This comes from a research paper draft authored by Victor Haghani and Richard Dewey, who conducted this experiment on 61 “quantitatively trained test subjects” (appears to be finance workers that showed up for a hedge panel talk). Here’s a quote from the paper:

Given that many of our subjects received formal training in finance, we were surprised that the Kelly Criterion was virtually unknown and that they didn?t seem to possess the analytical tool-kit to lead them to constant proportion betting as an intuitively appealing heuristic. Without a Kelly-like framework to rely upon, we found that our subjects exhibited a menu of widely documented behavioral biases such as illusion of control, anchoring, over-betting, sunk- cost bias, and gambler?s fallacy.

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That certainly sounds like real-world investing to me. Even in a situation with a clear advantage, people still mess it up all the time due to behaviorial and cognitive biases. People can argue whether volatility is a good proxy for risk, but the bottom line is that volatility in this game directly causes bad behavior. Big drops are always scary.

John Rekenthaler of Morningstar argues that the results of this experiment support the idea of auto-pilot investing.

My takeaways? Like this game, long-term investing is simple but not easy. You need to risk enough of your portfolio in order to expose yourself to the upside potential. However, you also need to keep enough safe such that you won’t flame out during a losing streak. I think that auto-pilot might work well in many situations, but people can also turn off autopilot in times of crisis if they don’t understand what’s “inside the box”. It’s best to calmly figure out an investment plan based on both market history and your personal situation, and then stick with it. Just winging it usually turns out poorly.

Morningstar Top 529 College Savings Plan Rankings 2016

mstarlogoInvestment research firm Morningstar has released their annual 529 College Savings Plans Research Paper and Industry Survey. While the full survey appears restricted to paid premium members, they did release their top-rated plans for 2016. This is still useful as while there are currently 84 different 529 plan options nationwide, the majority are mediocre and can quickly be dismissed.

Remember to first consider your state-specific tax benefits that may outweigh other factors. If you don’t have anything compelling available, you can open a 529 plan from any state (although I would only pick from the ones listed below). Also, if you grab some tax benefits now but they are discontinued later, you can roll over your funds into another 529 from any state.

Here are the Gold-rated plans for 2016 (no particular order). Morningstar uses a Gold, Silver, or Bronze rating scale for the top plans and Neutral or Negative for the rest.

Newcomer Virginia529 inVEST was upgraded from Silver to Gold, helped by a recent management fee reduction. Missing from last year are the T. Rowe Price College Savings Plan of Alaska and the Maryland College Investment Plan (T. Rowe Price), which were downgraded from Gold to Silver. Reasons for this include fees staying average when the competition overall got cheaper, while at the same time some of the underlying actively-managed funds received lower Morningstar fund ratings.

Here are the consistently top-rated plans from 2010-2016. This means they were rated either Gold or Silver (or equivalent) for every year the rankings were done from 2010 through 2016.

  • T. Rowe Price College Savings Plan, Alaska
  • Maryland College Investment Plan
  • Vanguard 529 College Savings Plan, Nevada
  • CollegeAdvantage 529 Savings Plan, Ohio
  • CollegeAmerica Plan, Virginia (Advisor-sold)

The trend here is consistency. There was no change in either of the lists above as compared to last year. Utah only missed on out the consistent list because they weren’t top-ranked in 2010.

The “Five P” criteria.

  • People. Who’s behind the plans? Who are the investment consultants picking the underlying investments? Who are the mutual fund managers?
  • Process. Are the asset-allocation glide paths and funds chosen for the age-based options based on solid research? Whether active or passive, how is it implemented?
  • Parent. How is the quality of the program manager (often an asset-management company or board of trustees which has a main role in the investment choices and pricing)? Also refers to state officials and their policies.
  • Performance. Has the plan delivered strong risk-adjusted performance, both during the recent volatility and in the long-term? Is it judged likely to continue?
  • Price. Includes factors like asset-weighted expense ratios and in-state tax benefits.

A broad recommendation is to simply stick with one of the plans listed above unless your in-state plan is offering significant tax breaks. Many other state plans may have specific investments that will work just fine as well. Here are my personal favorites, and why:

  • The Nevada 529 Plan for its low costs, variety of Vanguard investment options, and long-term commitment to consistently lowering costs as their assets grow. The Vanguard co-branding is also a sign of positive stewardship.
  • The Utah 529 plan has low costs, includes a nice selection of Vanguard and DFA funds, and is highly customizable for DIY investors. Over the last few years, the Utah plan has also shown a history of passing on future cost savings to clients.

I feel that a consistent history of consumer-first practices is important as the quality of all 529 plans can change with time. Sure, you can move your funds if needed, but wouldn’t you rather watch your current plan just keep getting better every year?

Free Collection of Investing Books by Meb Faber

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Promotion has ended. Asset manager and author Meb Faber is celebrating his 10th blogiversary by making all of his self-published books free in Kindle format for a limited time (promotion has now ended). Below are direct links to each book. Check first that the Kindle price is $0 (“0.00 to Buy”). Then buy it to own permanently, don’t click “Read for Free”. Grab them now while they are free, and read later. You can read Kindle eBooks on smartphones or on any computer via web browser.

I enjoy reading about these back-tested strategies that worked well in the past. However, before you put your hard-earned money at risk, please realize that even if they continue to work (which is in no way guaranteed), they will still be hard to stick to in real life. At some time, you will underperform other strategies for an extended period of time. You must ride out those low periods in order to achieve any sort of market-beating returns.

His company now offers a software-based portfolio management “robo-advisor” called Cambria Digital Advisor.

LendingClub United Miles Promotion (Both New and Existing Investors)

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LendingClub (LC) is a marketplace lender that offers unsecured personal loans and then sells investment notes backed by those loans. After defaults and fees, they advertise historical returns between 5% and 8%. As an incentive, LC recently started offering up to 100,000 United MileagePlus award miles to investors that bring in at least $2,500 in new money. Here I offer a quick analysis of the investor offer and point out that it is actually available to both new and existing investors, even though that may not be obvious from the website.

Highlights.

  • Offer only valid for taxable Lending Club accounts. (IRAs are not eligible.)
  • Only deposited and invested dollars are eligible for award miles.
  • Lending Club Investor must have UA MileagePlus account activated before investing to qualify. New investors can link online. Existing investors must call or e-mail to manually link your accounts (see below).
  • For existing investors to receive miles, an investor must transfer at least $2,500 of New Funds into an active eligible taxable account and invest the New Funds through the Lending Club platform within 90 days of the commencement of the then-current offer (each, an “Existing Investor Offer Period”).
  • Offer is valid from October 1, 2016 to December 31, 2016 and Mileage Plus miles will only be awarded on new funds transferred and invested through Lending Club during this time period.

Selected quoted text from the landing page:

We’re excited to announce our partnership with United Airlines! Investing on Lending Club just got more rewarding. Right now, receive one United MileagePlus® award mile for every two dollars you invest through Lending Club up to 100,000 miles!

[…] Upon the transfer and investment of the first $2,500 of New Funds, a new investor will qualify to receive 1,250 miles. For every dollar of New Funds transferred and invested in excess of $2,500, a new investor will qualify to receive .5 miles, up to a maximum aggregate bonus of 100,000 miles per calendar year.

The maths. A minimum deposit of $2,500 earns 1,250 United miles. Every dollar above that $2,500 will earn 0.5 miles up to the 100,000 mile limit. If you value United miles at range of 1 cent to 2 cents a mile, 1,250 miles is worth $12.50 to $25. Thus, the bonus value ranges from a 0.5% to 1% bonus on top of the interest you’d already receive.

Existing investors participation details. I confirmed with two different LendingClub representatives that this offer is also available to previous/existing investors. You must first link your United MileagePlus account number with your account. You can contact them via e-mail at EarnMiles@lendingclub.com or phone at 888-596-3159 (7:00am–5:00pm PST, M–F). Provide them with your LC account ID and your UA MileagepPlus Number.

Bottom line. The bonus itself is not big enough to encourage you to invest if you weren’t otherwise interested. However, if you have already decided to invest with LendingClub, definitely don’t miss out on these free miles to boost your overall return. The value is roughly 0.5% to 1% to your investment amount, assuming you bring in at least $2,500 of new money. Link your accounts first before moving over the new money.

As an existing investor myself, I’ve written my share of opinions on LendingClub. I’ll just say two things: Have realistic expectations and diversify. Their advertised historical returns of between 5% and 8% are more realistic than you may have seen elsewhere. As they also note, 99.8% of investors who invest in 100+ Notes of relatively equal size have seen positive returns. It is not coincidence that 100 notes x $25 each = $2,500.

Which Asset Classes Offer True Diversification in Bear Markets?

The financial gurus are always looking for a new “alternative” asset class that both reduces the risk in your portfolio and increases returns. Longboard Funds looked at data from the past 15 years and examined what happened when you added 20% of various asset classes to a traditional 60/40 stock/bond portfolio. Below is a chart of the results based on two factors:

  • Did the asset class have a lower or higher correlation in declining markets? This reduces maximum drawdown.
  • Did the asset class improve overall historical return?

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The 6 asset classes that both lowered max drawdown and increased overall return were:

  • Trend Following (SG Trend Index)
  • U.S. Treasuries (Barclays 1-3 Yr US Treasury TR Index)
  • MLPs (Alerian MLP TR Index)
  • Municipal bonds (Barclays Municipal TR Index)
  • Gold (S&P GSCI Gold Index)
  • TIPS (Barclays Gbl Infl Linked US TIPS TR Index)

I would add that your next consideration should be to research each asset class and determine which ones you have strong faith in over the long term. As diversifiers, these asset classes will have long periods of poor performance during bull markets. You must be able to hold onto these asset classes so that they can eventually help you in a bear market.

Personally, I do not have faith in trend-following, I don’t understand the fundamentals of gold (seems heavily based on speculation), and I don’t like the various complexities of Master Limited Partnerships. You may feel differently. That leaves me with the classic high-quality bonds: US Treasury bonds, Municipal bonds, and TIPS (also backed by US Treasury). Munis seem to be the best relative deal right now depending on tax bracket (and perhaps also I Savings Bonds?). None of these offer a ton of yield, but most importantly I’m okay holding them through these lean times.