Does a Opening a New Credit Card Lower Your Credit Score?

There are tons of articles on the internet about how opening a new credit card will affect your credit score. (For a few, see TheBalance, nerdwallet, and lots of stuff on credit karma)  They are great resources, and in general, will all tell you about the same thing: As soon as you apply for a new card, it will lower your score in the near term, but once you are approved, your score will bounce back.

I’m here to provide you an actual example, showing you how applying for a new card affected my Transunion score, with screenshots to prove it!  Two months after opening a new credit card account, my credit score had increased 21 points, from 756 to 777.  

Note that the score is specific to my particular details, (how many cards I have, my utilization rate (UR), my total credit limit etc.) so your mileage may vary.   I provide some of these details below, but the screenshots really tell you all you need to know. As it turns out, the credit utilization rate is a key part of this story, so below the credit score screenshot, I’ve included a history of my credit utilization rate as well. Below the images I’ll walk you through what happened at each inflection point (numbered in red).

transunion history

Credit Card Utilization - Credit Karma.clipular

1. Pre Application: Score = 756, UR = 5%

After my December 2016 score was posted, I decided to jump on the Chase Sapphire Reserve bandwagon, back when it was a 100,000 point sign up bonus.  Prior to applying for that card, the last card I applied (and was approved) for was in December 2014.  My score had basically been level between January and December 2016.

2. Post Application: Score = 744, UR = 9%

After applying and being approved for the Chase Sapphire Reserve card (Yippee!), the next credit score showed a 12 point dip, from 756 to 744.  No other cards were applied for but I did have above average spending this month so my utilization rate was a bit higher (note that the Chase Sapphire Reserve credit line was not added prior to this score, so my overall credit limit was the same as in inflection point #1).  This drop is primarily the result of the hard inquiry from my card application but could also be slightly influenced by my higher spending that month.

3. First Active Month: Score = 789, UR = 0%

This score update is after I activated my new card and began to use it for purchases. The new card came with a $20,000 credit limit, so I’m assuming the bump in my credit score was the fact that my credit limit went from $95,000 to $115,000. In addition to the an increased overall credit limit, I had below average spending this month (less than 0.5% UR) which could have also influenced the score.

4. Second Active Month: Score = 777, UR = 3%

This score reflects normalized spending and my long term credit score increase (was 776 as of April 2017).  Prior to the new card, my average utilization rate was approximately $4,000/$95,000 or 4.2%.  With the new card and the same amount of spending, my new utilization rate was $4,000/$115,000 or 3.5%.  You can see how just the change in overall credit limit brought down my utilization rate and increased my credit score.

Summary

In the long run, what I found was that in my case (7 open accounts and 2 closed accounts) opening a new credit card actually increased my credit score.  This is best exemplified by looking at my score prior to any application (756) and then after everything had normalized (777).  Typically, your score will drop immediately after you apply for the card (inflection point #2), but then rebound higher than your original score because of the decreased overall utilization rate (inflection point #3).  In the long run, the lowered utilization rate results in a higher credit score than before.

Better Exchange Rate: Credit Card or ATM or Hotel?

This is a follow up to my last post (Better Exchange Rate: Credit Card or ATM?).  In this post I provide another example comparing Credit Card and ATM exchange rates and add one more exchange rate comparison – a Hotel front desk.

The transactions took place in Mauritius where the local currency is the Mauritian Rupee, or MUR.  All transactions occurred on September 14th, 2013.  I haven’t posted the receipts (which I just found cleaning out my desk the other day) but hopefully I’ve shown enough of my receipts in the past that you know I don’t make up any data.

The ATM Transaction from Barclay’s Bank: Using my Charles Schwab Checking account (which reimburses me for all ATM fees), I took out 11,200 MUR  from a Barclay’s ATM in Flic-en-Flac.  Below is a screenshot from my online banking transactions that shows the converted amount was $363.67 USD.  The effective MUR to USD exchange rate was  0.03247.

Schwab ATM Transaction

The Credit Card Transaction:  As always, I use my Capital One Visa credit card for all transactions in foreign currencies because the card has NO foreign transaction fee, and receives the exact rate that is published on Visa’s corporate exchange rate website.  For this purchase, I bought a bunch of groceries from a local supermarket for 2,689.71 MUR.  Below is a screen shot from the Capital One transactions webpage which shows I paid $87.34 in USD.  The effective MUR to USD exchange rate was  0.03247 (same as the ATM rate above!).  Please notice that the exchange rate is for September 16th (posting date) not September 14th.

CapitalOne Transaction

The Hotel Front Desk Currency Exchange:  Just for fun, I took a picture of the exchange rate offered by the hotel when I got back from my grocery shopping trip.   I didn’t actually change any money, because as you will see it was a horrible rate.  The exchange rate from the hotel was .0348 (1/28.771).   If I were to get 11,200 MUR like I did for the ATM, it would cost me 389.28 USD instead of 363.67 from the Barclay’s ATM.  That is $25.61 extra, or a 7% surcharge!

Hotel Exchange

Comparing the Three Methods:  It should come as no surprise that exchanging money at a Hotel is a bad deal.  However, similar to the previous post comparing ATM and Credit Card Exchange rates, it turns out that getting money from an ATM or paying with your credit card is almost the same when it comes to exchange rates.  In the previous post, comparing the ATM to credit card was a little difficult because the credit card transaction was posted a day later than the ATM transaction.  In this particular case, making the transactions on a Saturday actually worked in our favor, which means we can compare the rates apples to apples.

As explained on Visa’s currency exchange FAQ page, “Every day—except weekends, Memorial Day, Christmas Day and New Year’s Day—Visa calculates the rate for the next day’s transactions.”   That means on Friday September 13th, 2013, Visa calculated the exchange rates for Saturday the 14th, Sunday the 15th, and Monday the 16th.  I checked on the corporate exchange rate to make sure, and the rate was the same for all three days.  So even though the transaction occurred on the 14th and was posted on the 16th, the exchange rate was the same.

The fact that the ATM exchange rate is exactly the same (to the 5th decimal point) as the Visa exchange rate makes me think that my Charles Schwab debit card – which is also a Visa – probably uses the Visa corporate webpage rates as well.

Better Exchange Rate: Credit Card or ATM?

I’ve spent a lot of time researching how Credit Card companies come up with their currency exchange rate (see my post on How Capital One calculates its exchange rate and my post on How Visa calculates its exchange rate).  Now that we know how the rates are determined, its time to decide if using the credit card is the best way to pay when traveling as a tourist.  In the past few months of travel I’ve experimented with different methods of currency exchange.  In today’s post, I’m comparing credit cards with ATMs.  Both exchanges took place on January 24th, 2014 at Geneva’s International Airport in Switzerland.

The ATM Transaction from UBS Bank:  Using my Charles Schwab Checking account (which reimburses me for all ATM fees), I took out 400 CHF (Swiss Francs) from the UBS ATM in Geneva (receipt below).   Also below is a screenshot from my online banking transactions that shows the converted amount was $446.34 USD.  The effective CHF to USD exchange rate was  1.11585.

ATM Transaction

Schwab Transaction

The Credit Card Currency Exchange:  By now it should be clear that I am using a Capital One Visa credit card for all my foreign currency purchases.  This particular card has NO foreign transaction fee, and receives the exact rate that is published on Visa’s currency exchange website.  For this purchase, I bought a bottle of water for 4.oo CHF (I know, super expensive).  The receipt is below as well as a screen shot from the Capital One transactions webpage which shows I paid $4.49 in USD.  The effective CHF to USD exchange rate was  1.1225.

Credit Card Geneva

Capital One Transaction

Comparing the Two Methods:  Unfortunately, the credit card transaction posted on January 25th even though it occurred on the 24th.  The ATM transaction was posted on the same day it occurred (the 24th), which means we won’t be able to compare the exchange rates apples to apples – but we can come close.  This is a an important thing to note – often the exchange rate used by the credit card is the rate from the day after the transaction.   This can be either good or bad depending on how the exchange rate changes in a day, but usually won’t result in a huge difference.   It is however, something to keep in mind if you are making a big purchase and really in tune with the global currency markets.

Below is a chart comparing the exchange rates on Friday January 24th.  Because we know my Capital One Credit Card will get its exchange rate from Visa’s corporate exchange rate website, we can easily tell what the exchange rate would have been if the credit card transaction was posted on the 24th instead of the 25th.   The ATM rate and Credit Card rates are different by 0.0001, which is basically nothing.   I threw in a few other bench marks to see how the exchange rates compare, but the take away here is that the ATM and Credit Card exchange rates are essentially the same.

Friday Exchange Rates

Just for fun, I also made a chart for exchange rates on Saturday January 25th.  I don’t know what Schwab’s exchange rate would have been on January 25th, but I included the chart to point out a key point.  According to my credit card statement, the exchange rate was 1.225, however, on the Visa corporate website the rate was 1.1234.  As you see in the chart, this discrepancy makes no difference when looking at a 4.00 CHF purchase.  I explained why there is a difference between the rate you see on the statement and what you see on the corporate webpage in a previous post, I just didn’t want any one to be confused if they looked up the numbers themselves.

Saturday Exchange Rates

Final Thoughts: To answer the original question, it looks like using a credit card or ATM will give you the same good rate.  Okay, using my credit card would have saved 4 cents, but it is so small maybe that would have been different with another transaction on a different date.  One huge caveat though – if you get charged an ATM fee by your bank, then everything changes.  Or if you get charged a foreign transaction fee on your credit card – same thing.  So make sure you are with a good bank, otherwise worrying about this is useless!

MLB Territories in Virginia and Maryland | Should you root for the Nationals or the Orioles?

In my previous post, I made a map dividing the entire United States in to 30 Major League Baseball Territories.  The idea was that this map would help you choose which team to root for based on which stadium was closest to where you lived.  In part 2 of my mini research project, I zoom in on the “hotly” contested territories of Virginia and Maryland.  Many Virginians and Washingtonians around my age grew up rooting for the Baltimore Orioles because they were the closest MLB team.  But in 2005, the Montreal Expos moved to Washington D.C. where they became the Washington Nationals.  Baseball fans from Virginia and DC  had a decision to make – should they honor their allegiance to the Orioles, or abandon their old team because the Nationals were in town.  If the locals didn’t root for the Nationals, then who would?

To help answer this question, I made a map that just focused on Virginia and Maryland.  Besides showing the closest MLB stadium, I also included a few other pieces of information that might help someone decide which team to root for.  For example,  I’ve included the locations of all the Orioles and Nationals minor league affiliates (if you live close to one of those teams it may affect your MLB allegiance), and also included the official territory as defined in the MLB constitution (yes they actually have a constitution).   Just for kicks, I also included the area covered by MASN TV network that shows both Orioles and Nationals games.  This was actually the most time-consuming part of the map making process because MASN doesn’t release this information.  Instead I used MLB.TV’s website, and typed in every zip code to see if Orioles’ or Nationals’ games were “blacked out.”   If you live in a zip code where you couldn’t watch an O’s or Nats game on MLB.TV, I assumed it was because your zip code gets the MASN network and MLB.TV is not allowed to steal any of MASN’s potential viewers.  As always, just post a comment if you are curious about anything!

MLB Territories in VA and MD

Major League Baseball Territories

Even though this blog is about researching personal finance topics, sometimes I get caught up in other research projects that have nothing to do with finance.  About a year ago, I became obsessed with the idea of trying to divide the United States into Major League Baseball territories.  The idea was that you should root for whichever team that has the closest stadium to you (as the crow flies). So without further introduction, here is the map.  Hopefully this can help you answer the questions, “Which Major League Baseball team should I root for?” or “Which Major League Baseball Team is closest to me?”   I’m also happy to answer any questions about the methodology – just leave a comment!

Also check out Part 2 of my research project, focusing on the Mid Atlantic region (Orioles and Nationals Territory) with a little more detail and new information.

*UPDATE* After the map made its way on Twitter, a few sharp folks noticed that the some of the territory boundary lines were a little off. It turns out the computer algorithm I used had some bugs.  Obviously I should have checked this by hand, but I guess that’s what you get when you trust the computer too much!  My apologies.  For those of you interested in the mapping process, I included a description of the changes below the revised map.

MLBTerritories140410
Description of Changes: The original boundary lines were produced by running a computer program within a geographic information system software that generates “Thiessen Polygons.”  Without this program, it is extremely time consuming to draw the polygons by hand – especially for a side project.   The mistake I made was assuming that the polygons drawn by the computer were correct, and not double checking by hand. For this revision you see above, I calculated the Thiessen polygons myself using this process (in PDF). I’ve checked and rechecked the distances this time, and I’d say the accuracy is +/- 1,000 meters.  I’ve also updated the population figures. I had some good comments wondering if the the original errors were due to the the projection.  Just FYI – I used a Albers equal-area conic projection, which preserves polygon areas but has some minimal shape/straight line distortion.  As always let me know if you have questions.

 

How does Visa Calculate its Currency Exchange Rate?

In my previous post, I explained exactly how Capital One calculates its currency exchange rate.  As it turns out, Capital One simply uses the exchange rate that is posted on the Visa Corporate Exchange Rates webpage (Link Updated 11/2014).  But what about Visa?  How do they come up with the rate that all Visa branded credit cards use (before the bank foreign transaction fee), and how does that compare with other options for currency exchange?

So how does Visa calculate its currency exchange rate?  Visa.com has a very informative currency exchange FAQ page.  Since it is pretty useful, I just copied and pasted the website’s response to below:

Every day—except weekends, Memorial Day, Christmas Day and New Year’s Day—Visa calculates the rate for the next day’s transactions. The Visa rate is selected from a range of rates available in wholesale currency markets or the government-mandated rate in effect one day prior to the applicable central processing date. Visa makes this rate available to issuing banks, which may adjust the rate when billing cardholders by applying a foreign transaction fee. The rate Visa makes available to issuing banks may vary from the rate Visa itself receives. Most consumers find that using Visa is a convenient and cost-effective way to make purchases and obtain cash when traveling internationally.

How do Visa’s currency exchange rates compare with wholesale currency markets?  If you noticed in the statement above, Visa remained pretty ambiguous about how they come up with each day’s exchange rate.  They only state that “the Visa rate is selected from a range of rates available in the wholesale currency markets…”  Needless to say, I’m curious to know how Visa’s rate compares to this “wholesale currency market. ”  To answer this question, I looked up the currency conversion rate from a number of different sources and put them in the tables below.  With the exception of Master Card and Visa, every source can be considered a player in the wholesale currency market.  The rates listed in Yahoo!Finance, for example, are said to be “bank rates,” while OANDA says its rates reflect interbank rates for transactions of $1 million or more.

I looked up the currency conversion rates on three different dates, just to see if there were any discrepancies.   The  tables contain the EUR to USD currency exchange rate for a transaction that was posted on the given date.  Each date is sorted by highest cost (in USD) of 50 Euros.  For more information on the sources, please see the bottom of the post.

Currency Rate Comparison

What are the takeaways from these charts? 

  1. The rankings are different on any given day.   On July 30th, Visa had one of the  worst exchange rates, but on September 16th it had one of the best.  To me, this says that on average, Visa rates are a pretty good representation of wholesale markets.  Obviously my sample size of only 3 days makes it impossible to draw any scientific conclusions, but just with this quick look I feel pretty comfortable taking Visa’s word.
  2. Master Card has consistently one of the worst rates for every day.  In the 3 days I looked at, Master Card always had a higher rate than Visa, costing you anywhere from 2 to 29 cents more that Visa on a transaction of 50 Euros.
  3. The OANDA rate is always better than the Visa or Master Card rate.  This, however, is not surprising since the OANDA rates are said to reflect interbank transfers over $1 million dollars.

Conclusion:  While I may not get the same rate as I would when I was transferring millions of dollars, it is pretty clear (again only 3 sample dates) that Visa’s rates are competitive with the wholesale currency markets.  Kudos to Visa for actually telling the truth on their FAQ website!

*Update January 6th 2015*

Based on a recent reader comment, I took a look at the exchange rates to compare Visa vs. Master Card.  In my comparison for rates on January 2nd, 2015, MasterCard rates were better than Visa, which is the opposite of what I found in 2013.  It’s anyones guess as to what may have caused this:  Maybe Master Card will continue the trend of having better rates, or perhaps the better rates swing back and forth between Visa and Master Card from month to month or year to year.  I’ve included a spreadsheet screenshot for the latest analysis so you can see too:

Jan2015 Rates

Description of Sources:

  • Visa: This is the rate used for all EUR to USD transactions, the details are described above.
  • MasterCard: This website has a similar conversion tool to Visa where you input the date and the type of currency.  The website also states the following as a disclosure: “MasterCard uses multiple market sources (such as Bloomberg, Reuters, Central Banks and others) to develop exchange rates. These rates generally reflect either wholesale market rates or government mandated rates that are collected during the daily rate setting process. The displayed rates are derived from the buy and sell rates included in the MasterCard daily rate setting process and do not include any charges or markups applied by the Issuer. Please note that due to possible rounding differences, the displayed rates may not precisely reflect the actual rate applied to the transaction amount when converting to the card holder billing amount. The exchange rate that is applied to a transaction is the exchange rate as of the day of settlement which is the day that MasterCard determines the settlement amount to be exchanged between the acquirer and the issuer. The settlement date is therefore typically different from the date of the actual transaction. MasterCard does not provide the exchange rate when purchases are converted from the local currency by the merchant to the cardholder’s currency at the point of sale.”
  • European Central Bank (ECB):  In order to find the historical rates, you have to navigate to this page which shows the ECB reference exchange rate at 2:15pm CET.  The ECB does not provide rates for Saturdays or Sundays.
  • OANDA:  According to this page, “The prices quoted by the currency converter are based on interbank market rates and generally reflect the exchange rates for transactions of US $1 MILLION or more.”  The rate from this website is the Daily BID rate (as opposed to Ask or midpoint)  because “it more accurately mimics the rate that you would be charged if you were exchanging money.”  Daily is defined as the 24-hour period ending 22:00 UTC on the day prior to posting.  Sunday rates are identical to Monday rates at OANDA.
  • Google Finance:  The daily rates  from Google say they are taken at 23:00.  It does not indicate which time zone.  Google does not provide rates for Saturdays or Sundays.
  • Yahoo! Finance:  The only note on Yahoo’s webpage says that “The exchange rates given are ‘bank rates’.  High street rates may be subject to commission.”  Yahoo! does not provide rates for Saturdays or Sundays.  If you select a Sunday, say October 6th, it will show you the rate for Friday October 4th.
  • XE.com: The rate given by this site is the Mid-market rate as of 16:00 UTC on the specified date.
  • ExchangeRates.Org: This rate is the average rate for the specified date.  Here, Friday and Saturday rates are always the same but Sunday rates are different.

Sources Not Included:

  • Discover Credit Cards:  Unlike, Visa or MasterCard, there is no separate currency conversion webpage for Discover.  This was the only information I could find.
  • American Express Credit Cards:  Perhaps it’s because American Express does a lot of currency conversion (traveler’s checks, kiosks etc.) but I couldn’t find a satisfactory link that listed their currency conversion rates. The only link I found was a link titled “American Express – Currency Converter.”  The link turns out to be basically the same information as the OANDA link above (in fact the site says “powered by OANDA”), except it is just presented in a different format.

 

How does Capital One Calculate its Credit Card Currency Exchange Rate?

Typically, when you use an american credit card to buy a product in a different currency, the credit card company will charge you a 2-3% fee right away – called the foreign transaction fee – before it converts the currency according to the latest exchange rate.  If you travel a lot, the foreign transaction fees can add up very quickly.  Fortunately, there are a number of credit cards, including all Capital One cards, that charge NO foreign transaction fees. For a list of these cards, use this post from Nerd Wallet .   If you are reading my post, however, I’ll assume you already know about the no transaction fee credit cards, and are interested in some more in depth questions like: How does the credit card company determine their currency exchange rate, and can the credit card company use the exchange rate to charge hidden fees?

The best way to answer these questions is to use an actual credit card transaction with my Capital One Visa card as an example.  I will provide copies of my receipt and credit card statement of one  transaction in Part 1.  In Part 2, I’ll answer questions about the currency exchange.

Part 1 – The Transaction Documents:

I am a proud owner of a Capital One Visa card precisley because of its no foreign transaction fee.  I have taken the liberty of posting photos of 1. my actual paper receipt, 2. a screenshot of my credit card Statement, and 3. a screenshot of my transaction list from Capital One’s website.  All of these documents contain information about a customs tax transaction that I made in Hannover, Germany on February 1st, 2013.

1. Actual paper receipt: Below is a photo copy of my receipt (Quittung) from the Customs Office (Hauptzollamt) in Hannover, Germany.  The important information here is the Total (Summe) I paid, which was 37.80 Euros, and the date (Einzahlungstag), which was 01.02.2013.  Please note that the date on this receipt is in DD.MM.YYYY format, which is typical in Germany.    

Paper Reciept

2. Screenshot from my Captial One Credit Card Statement: When I paid  37.80 Euro for the custom tax, I used my Capital One credit card where I have an account in the United States.  Since my account is in US Dollars, the transaction had to be converted from EUR to USD before it showed up on my statement.  Below is a screenshot of a small part of my February Credit Card Statement (my account number is blacked out) where it lists the transaction “Nebenzollzahlstelle HannoHannover” and the exchange rate used.  You can see that my 37.80 Euro transaction became a 51.84 US dollar transaction once the exchange rate was applied.

CaptialOne Statement

3. Screenshot from my transactions list on Capital One’s website:  Below is a screenshot of my transactions list that you can find by logging into your Capital One online account.  The transactions listed here are exactly the same as the transactions that show up in your monthly credit card statement, with one notable difference.   In the online transaction viewer, you can click the “+” button next to the transaction date and it will show you both the Transaction date, and the Posting date  In my example, it shows that while the transaction actually occurred on February 1st, the transaction did not post until February 2nd.  This is an important distinction because Capital One (and most credit card companies) calculate the exchange rate based on the date of the posted transaction.

Transaction and Details

 

Part 2 – The Currency Exchange:

How does Capital One determine its currency exchange rate? The answer is pretty simple actually.  Capital One uses the exact exchange rate that is posted on the Visa Corporate Exchange Rates webpage (Link updated 11/2014).   This is based on my conversations with Capital One customer service, other credit card message boards like here, and – most importantly – checking the data for myself.  Below are two screen shots of Visa’s webpage (the input screen on top and the output screen on the bottom) that show Visa’s exchange rate for February 2nd, 2013.

Visa Input Page

Visa Output Page

You should take note two things.  First, is that I set the the bank foreign transaction fee to 0%.  Second, is that Visa’s exchange rate is the inverse exchange rate of what was provided on my credit card statement.  The  exchange rate  on my credit card statement was in USD to EUR, whereas the Visa exchange rate is given in EUR to USD.  In order to compare apples to apples, I converted Capital One’s exchange rate to a  EUR to USD rate.  This is done simply by taking the inverse:  1 / 0.72916667 = 1.371429.  In the end, the exchange rates do not match exactly – Capital One  has an exchange rate that is .005% (five thousandths of one percent) higher.   The difference, however, is negligible, since both exchange rates result in a final cost of $51.84 after rounding.

InverseConversion

Does Capital One hide extra fees in its exchange rate? No, not that I can tell.  A lot of people are skeptical when they hear Capital One say “No Foreign Transaction Fees!”  They think that maybe Capital One makes up for the 0% transaction fee by having a higher currency exchange rate than other cards that are Visa sponsored.  In fact, you might look at the extra .005% that is added in my example above and say “Aha! thats how they get you!”  But that would that be really silly for Capital One, who makes entire advertising campaigns on “No Fees.”  If they were going to try and recoup the money they lost by having a 0% foreign transaction fee, wouldn’t they increase your exchange rate by a lot more that .005%?  After all, other banks charge up to 3% foreign transaction fees.

After reviewing a few of my other credit card transactions,  I found that the difference between Visa’s exchange rate and Capital One’s exchange rate varied for every transaction.  Capital One does not up-charge .005% for every transaction, in fact, sometimes the Capital One exchange rate is lower than Visa’s.  I’ve compared three of my transactions below, two of which were posted on the same date.  Interestingly, Capital One listed two different exchange rates for the two transactions that were posted on the same day.  I won’t post screenshots of my statements and receipts like the first example for the sake of brevity – you’ll just have to take my word for it.

Transaction Comparison

Why the variation in Capital One Exchange Rates?  The difference in exchange rates appears to be the result of Capital One trying to avoid having to deal with tenths or hundreths of a cent.  Allow me to explain.   In transaction 2, when you multiply 409.60 Euros by 1.307666  (Capital One’s inverse exchange rate), you get $535.6199997.  When rounding up at a precision of 6 decimal places, you end up with $535.620000 exactly.   As shown in the screenshot below, all of Capital One’s currency exchanges result in perfectly whole numbers (no fractional cents) when you round and use a precision of 6 decimal places.

Decimal Precision

I assume that this means that Capital One uses 6 decimal points for all of their banking transactions.  If they used Visa’s exact exchange rate instead and rounded with a precision of 6 decimal places, they would have charged me $535.616307.  Since I am only going to pay Capital One exactly $535.62, they would in effect be losing $0.003693 ($535.620000 – $535.616307) for that transaction.  When you think about the millions of transactions that they process every year, that small amount could end up being pretty big – just ask the characters in the movie Office Space.  For me, as the credit card holder, the slight difference from Visa’s currency exchange rate doesn’t matter because I always end up paying the correct amount and don’t have to worry about fractional cents.

In the end, the important thing to know is that Capital One really does just use the exact exchange rate posted by Visa.  This is also supported by the nerd wallet study, which shows that while foreign transaction fees can vary among credit card companies, the exchange rates don’t.  Now that you know exactly how Capital One does it, you are probably curious how Visa comes up with their rates and how they compare with other methods of currency exchange.  These questions are tackled in the next post How does Visa Calculate its Currency Exchange Rate?

How often should I rebalance?

I was originally going to write this post on how to maximize returns through rebalancing.  My underlying assumption was that rebalancing helps your portfolio by “buying low and selling high,” and that I only needed to figure out the best rebalancing interval (monthly, yearly, etc.) that would maximize my returns. Through my research, however, I was able to have some sense knocked into me by a couple of enlightening articles, and one fantastic quote by a Vanguard research report “Best Practices for Portfolio Rebalancing”  July, 2010:

“It is important to recognize that the goal of portfolio rebalancing is to minimize risk (tracking error) relative to a target asset allocation, rather than to maximize returns.”

This was such a great reminder for me.  The whole point of rebalancing is to make sure your portfolio reflects the level of risk that you are comfortable with.  If at the outset, you say you want 60% stocks and 40% bonds, then even a slight 0.1% shift towards stocks means your portfolio has more risk than you want it to.  Rebalancing for any other reason than to minimize tracking error is a form of active trading, which by now, it should be pretty clear I am against.

Should I rebalance every day then? Theoretically, Yes.  In reality, No.  In reality, it usually costs money to make trades.  Even if it doesn’t (like if you have a Schwab account and only buy Schwab ETFs), making these trades takes time.  So the real question is how much tracking error are you willing to accept in your portfolio, and how much time are you willing to take to maintain it.

How often should I rebalance in reality?  The industry standard is to rebalance every year, and that is a perfectly good approach.  In the Vanguard report linked above, Vanguard has a slightly more nuanced approach that I think makes the most sense.  The report suggests that you monitor your portfolio semi-annually or annually, and only rebalance when an asset drifts more than 5% from its target percentage.  They go on to say that this approach “is likely to produce a reasonable balance between risk control and cost minimization for most investors. Annual rebalancing is likely to be preferred when taxes or substantial time/costs are involved.”

I would also suggest that you rebalance every time you add money to your account. Recently I’ve been putting money into a “house downpayment” account where I buy a number of index funds.  Since this is the type of account that I don’t make automatic deposits from my paycheck every month, I usually wait a few months and make a large contribution to portfolio and use the contribution to buy more shares of the 5 different ETFs that make up the portfolio.   Since I have to place orders anyway, I might as well make sure that my portfolio will reflect my preferred asset allocation after I finish the new trades.  This is an easy way to rebalance more than just once a year without requiring extra effort.

Does rebalancing help you get higher returns?  Ok, lets say you agree to the basic premise that rebalancing is only for the purpose of minimizing tracking error.  But does rebalancing actually get higher returns?  Is there is a rebalancing time interval (or threshold) that historically offers the best returns?  If so, then you would want to know, right?  The  answer  unfortunately depends on who you ask.

In the Vanguard study (mentioned twice and linked above), the summary states that, “Our findings indicate that there is no optimal frequency or threshold when selecting a rebalancing strategy. This paper demonstrates that the risk-adjusted returns are not meaningfully different whether a portfolio is rebalanced monthly, quarterly, or annually; however, the number of rebalancing events and resulting costs (taxes, time, and labor) increase significantly.”

Another financial advisor explains it in a different way.  The author says that when rebalancing, you are just as likely to “buy high and sell low” as it is the other way around.  He says that rebalancing can increase your returns – but only if you get the timing right.  In other words, you either have to be lucky, or trying your hand at market timing, which from my perspective is a losing proposition.  Two great posts explaining this can be found here and here.

Other researchers have tried to empirically prove that a certain method of rebalancing can increase returns, like this study by a Managing Director at TD Ameritrade. This study shows that there are “significant advantages of opportunistic rebalancing (look frequently and rebalance only when you need to) over traditional annual or quarterly rebalancing.”  In this approach, there is a complex method to determine whether you should initiate a rebalancing.  The approach outlined in the study is time consuming (it requires frequent portfolio checking) and borders on being an active trading strategy, but at least makes for an interesting read.

These three different takes are by no means an exhaustive inventory of all the views on rebalancing, but I think they are representative of the types of research you will find.  While you might find a complex method of rebalancing that can add a few basis points on your annual return, don’t forget that the point of rebalancing is simply to reduce your risk.

How often do Vanguard Target Date Funds rebalance?

I’ve been doing a lot of research lately on portfolio rebalancing and it got me wondering about Vanguard’s rebalancing strategy for its own target date funds.  After reviewing the fund’s prospectus, I decided to give Vanguard a call directly using their customer service line and ended up speaking with a representative named Robert.  I asked Robert two primary questions:

How often does my target date fund (VFIFX) rebalance?  Robert first searched through the prospectus and couldn’t find anything there so he had to place me on hold and speak with another department.  When he came back he told me that Vanguard rebalances daily just by properly managing the money coming into the fund from new investors/re-investors and the money going out of the fund from withdrawals.  He also told me that if the portfolio skews more than 2 or 3 percent from its target allocation, the fund will actively buy or sell shares of its underlying holdings to rebalance.  I pressed Robert on this point by asking him if it was an automatic 2% trigger or if the fund would only make an active adjustment during set time periods.  In other words, did the manager check the fund every quarter and only rebalance if the assets were more than 2% off, or would the manager rebalance any time the the assets were 2% off – even if it meant making trades every other day (like in a volatile market)?

Robert’s response to this was interesting – although in retrospect unsurprising.  He said that Vanguard does not release that information because of the potential for abuse.  If it was public knowledge that Vanguard rebalanced its funds on certain dates, then traders could take advantage of that fact by manipulating the price of the underlying funds that the VFIFX would have to buy in order to rebalance (In this case, VFIFX has 3 underlying funds: the Vanguard total stock market index, the Vanguard total international stock market index, and the Vanguard total bond index).  I’m not entirely sure how someone could benefit from this knowledge, but I’m guessing it is related to the ways in which a hedge fund manager can manipulate stock prices.

Does my target date fund shift its asset allocation on a continuous basis?  Robert pointed me to the graphic on the Vanguard Target Retirement fund site (which I’ve also linked to in previous posts).  When you click on a fund under the heading  “Decide which fund is right for you,” you will see a graphic similar to the one below.  This particular graphic corresponds to the 2050 fund (VFIFX).

As you move the slider left or right, it will tell you the asset mix that the fund will have at that time.  My question to Robert was whether the asset allocation changed continuously as the graph indicates (meaning a smooth line), or if it changed at stepped intervals – like every five years that corresponds to the Target fund offerings (there is no target date fund for 2051).  Robert said that the graphic essentially represented how the allocations would change, but didn’t go into much further detail.

I took a screenshot below showing the allocation change that occurred by moving the slider slightly to the right.  From what the graph tells me (by playing with the slider for a few minutes) the asset allocation changes every year. Presumably that is the answer – Vanguard Target Date Funds adjust their allocation every year.  Although, conceivably Vanguard could adjust the allocation daily by hundredths of a percent to create an even more continuous risk reduction instead of adjusting just once a year.

What is the best way to invest money for 5 years?

Like many people around this time of year, I received a nice little check from the IRS for my 2011 tax return.  I started thinking of all the things I could do with the extra money – a 47″ plasma TV, maybe an iPad, or  some new ice hockey goalie equipment.  You know, the important things in life.  Also on the list of things I want, however, is a luxury condominium with a sweet view of downtown.  Except that costs more than any tax return that I will ever see.   I figure I’ll be ready to buy a home in about 5 years (because 5 year plans never go wrong) and as a result, it is probably about time that I start saving for it.  So I decided to put my big screen TV hopes on hold and put the tax return money towards my future home.  But that was as far as I got before I realized I didn’t know where to put it.

Where should I put money that I need in 5 years?  The 5 year investment is tricky, because it is short enough that you can’t afford the stock market risk like you can with a 20 year investment horizon, but long enough that it would be silly to let it sit in a non-interest bearing account.  There are a couple of basic options out there.  There are your standard savings and rewards checking accounts, Certificates of Deposit (CDs), and finally, investment accounts.  These days savings accounts won’t get you much more than 0.75% APY, and even the best 5 year CD will only get you 1.80% APY – all according to bankrate.com.  (Also check out Smartmoney.com’s take on the best short term investments).  These options don’t even keep up with inflation, so 5 years from now your spending power will actually be reduced as a result of putting your money in these low yield accounts.  If you want the chance of earning interest greater than inflation, you are stuck with investment accounts – which is kind of scary.

At least with the savings accounts or CDs you know that in 5 years your money will actually be there.  But if you invest in stocks and the market goes bad… that luxury condo you’ve been dreaming of quickly turns into a suburban town home.  Just because you open an investment account, however, doesn’t mean that you have to invest in all stocks.  In fact, you probably shouldn’t.  As described in the my asset allocation post, a sound retirement portfolio will include bonds and treasury notes in addition to stocks.  Those who are 40 years from retirement can afford to take on much higher risk (because they have a long time to make up potential losses) and are recommended (according to Vanguard’s target date funds) to invest in 90% stocks and 10% bonds.  Those who are only 10 years from retirement are recommended to invest 66% stocks, 32% in bonds and 2% in cash. You can see the increase in bonds (in blue) as you get closer to the retirement goal in the graphic below from Vanguard’s website.

What asset allocation is best for a 5 year investment?  When I started thinking of the Target Date Fund’s progression to less risky assets, it suddenly hit me.  The 5 year investment is an awful lot like your target date fund investments when you are in retirement.  And think about it: When you are in retirement you certainly can’t afford for your nest egg to take a big hit in the market, but you need continued appreciation to try and live off the nest egg’s interest.  So what exactly does an in-retirement asset allocation look like?  I went straight to Vanguard’s website and copied down the asset percentages for the 4 funds shown below.  On the chart, the risk and expected rate of return decreases from left to right.  I’ve included two target date funds that have a target retirement date close to 2012 just as a comparison, but it is the allocation percentages from the Vanguard In-retirement fund (VTINX) that you will want to use.  While I was looking on the website I came across Vanguard’s “Life Strategy” funds, which believe it or not, have a fund specifically designed for 3-5 year investment horizon (VASIX).  This would also be an reasonable asset allocation, though it is more conservative than VTINX;   likely due to to the fact that that it is meant to be used to save for something as soon as 3 years away.

What kind of return can I expect from these funds? Keep in mind that because this is an investment in the stock market and bond market, there is no way to predict your annual yield over 5 years.  BUT, based on the asset types in each fund we can make an educated guess about what kind of returns to expect over the long run – like 20 plus years.  I know in some ways that is not helpful because we are looking at a 5 year window, but that is the best we can do; it is impossible to predict an investment’s 5 year return with any accuracy.  With that said, over the long run, I figure that these funds will average a 4% return annually.   Why is that? The goal of most in-retirement funds (at least Vanguard’s) is to get a 4% return.  The idea is that while in retirement, you can spend 4% of your nest egg every year, but by earning 4% through investments, your nest egg never loses value.  Since Vanguard advocates for using the 4% rule in retirement planning calculations, I have assumed that their retirement investments (such as VTINX) are structured to provide roughly the same return.  As it turns out (see graph below) VTINX has actually averaged a 5.30% average annual return since its inception (which was only 8 years ago so the numbers don’t mean that much).

Morningstar.com provides the actual (not average) annual return in each year since 2003.  This look shows how volatile the annual yield can be, ranging from  negative 10.93% in 2008 to a positive 14.28% return in 2009. What I’m trying to say is this:  if you invest in VTINX and keep it for 30 years, your average annual return would probably be around 4%.  However, it is entirely possible that for the 5 year window between 2012-2017 (when you own the fund) the fund would have an average annual return of 10%, or even 1%.  It is riskier than a CD, for sure,  but it is certainly well managed risk.  And besides, 4% return on my investment sounds pretty good to me, especially when I can only get 1.8% with a CD.

OK. You’ve convinced me.  But I don’t have an investment account, so what do I do? It is pretty easy:

  1. Open a Vanguard or Schwab investment account.  Make sure that you are opening an investment account and not a retirement account like an IRA, Roth IRA or 401(k).  Why those two firms? Both Vanguard and Schwab allow you to buy their brand of ETF index funds (which have the lowest expense ratios) for free.  FOR FREE!  There are no other investment firms out there with this kind of access to index funds, and as explained in my Target Date Fund Series, I think buying index funds (not individual stocks) is the smartest thing you can do.  In addition I’m consistently impressed with the advice and service that I get from both these firms (yes, I have accounts at both).
  2. If you open a Vanguard account and are going to invest more than $1,000, then you can simply buy the VTINX ($1,000 minimum) or VASIX ($3,000 minimum) fund mentioned above.  If you are starting out with less money you will have to buy 3 or 4 index fund ETFs to mimic the asset allocation of either VTINX or VASIX.  But don’t worry, I’ve made it easy for you – take a look at the chart at the bottom of the post.  It gives you the symbol of the ETF you should buy (right hand side) along with the percentage of your investment that you should spend on each ETF.   Two quick notes if you want to mimic the VTINX asset allocation: First, To put 5% in cash, you won’t have to buy a particular fund, just leave 5% of your savings unspent in the account.  Second, if you have a Vanguard account they don’t have an ETF for inflation protected securities, so just put that extra 20% in the BND fund.
  3. Keep adding to your investment account (use the same percentages detailed in step 2).
  4. Rebalance every year.
  5. Buy a home! (or whatever else you have been saving for)