Now you may be asking, how can he be offering advice on something he doesn’t even own?  Well, here is how he can say that.

He is primarily giving this advice to individual investors who aren’t interested in stock picking.  He’s also giving this advice to people who don’t have the resources or expertise to have sophisticated investment strategies.

This is the reason he recommends these.  All index funds track a particular index.  For example, a Dow Jones Index Fund tracks the DJIA.

The Dow has proven itself to grow over time.  That’s huge when many mutual funds are falling prey in the market.  It’s also significant because so many investment strategies that are set to beat the market rarely actually do.  This way, you are not trying to beat the market.  You are trying to grow with the market.  There’s a huge difference.

The financial statistics tell us that this is actually one of the best ways to earn a reasonable return over time.  Many other investments can’t promise you that nor give you reasonable arguments based on hard historical data that it will grow.

The other reason he recommends index funds is because investors then don’t have to go out and do stock picking.  That can be a very arduous, tedious, and time consuming project for most people.  That’s not to mention that most people don’t want to or can’t do it properly.

If you want to check out a good fund, check out the S&P 500 Index Fund.  Well, there are several of them.  The S&P 500 is said to be a more accurate picture of the US economy and stock market because they use more companies in their roster.

Following are four useful metrics to use when comparing competing index funds.

Low Expenses

The single most important attribute to consider when choosing an index fund, and the primary source of their advantage over actively-managed mutual funds, is its expense ratio.  Everything else is secondary.  All else being equal, the index fund with the lowest expense ratio will always outperform other funds tracking the same index by the amount of its cost advantage.  Sadly, there are plenty of expensive index funds out there, so be sure to check before buying.  The quickest and easiest way to check a fund’s expense ratio and other basic characteristics is by signing up for a free Morningstar account and typing the fund’s name or ticker symbol into the search box.

The Index Being Tracked

An index funds will share the investment characteristics of whichever market segment it happens to be tracking.  That is, a small-cap international index fund will perform poorly whenever small-cap international stocks in general are performing poorly, regardless of how large-cap domestic stocks happen to be performing at the time.

There also exist indices constructed in such a way they cost investors money, such as the Russell 2000 index.  The structure of the Russell 2000, for example, encourages large institutional investors to buy and sell at known intervals to take advantage of arbitrage opportunities when securities being added or subtracted from the index, leading investors in Russell 2000 funds to owe larger tax obligations than they otherwise would.  David F. Swensen gives a detailed account of this particular phenomenon in his book Unconventional Success:  A Fundamental Approach To Personal Investment.

Portfolio Turnover

Portfolio turnover is a measure of how often a fund buys and sells securities.  A turnover of 25% means the fund “turns over” approximately 25% of its portfolio every year.  Put another way, it means the fund’s average holding period is about 4 years.  By the same token, a 10% turnover indicates the fund owns the average stock in its portfolio about 10 years.

The higher a fund’s portfolio turnover, the higher its transaction costs in the form of brokerage commissions and the more capital gains are generated (leading to a higher tax bill).  All else being equal, the lower a fund’s portfolio turnover, the lower its total investment expenses (many of which aren’t reflected in the expense ratio figure above).  Portfolio turnover statistics are another benefit available to those with a free Morningstar account.

Reputation Of The Fund Company

Some fund companies are above reproach while others engage in questionable business practices.  More to the point, some fund companies are more likely to raise fund expenses in the future while others are likely to lower them.  Since switching funds in a taxable account involves significant tax costs, it makes sense to keep an eye on the future when making purchase decisions.  Vanguard funds, for example, are likely to be less expensive in the future than they are today because of Vanguard’s unique corporate structure.  Several Vanguard competitors such as Fidelity and Schwab currently have a slight cost advantage over comparable Vanguard funds, however, these for-profit companies are likely operating these funds at a loss in an effort to attract more business to their more profitable actively-managed funds.  What happens when these companies decide it’s no longer worth the effort?  That’s right, you’re stuck in an expensive fund.  So long as the overall current cost difference is minimal, it makes sense to consider the future.

You don’t need to be a financial wiz, be able to analyze the details of an obscure firm’s financial statements, or understand the difference between alpha and beta to invest you portfolio every bit as well as the pros.  After all, at the end of the day most pros can’t beat the market either.  You can do at least that well with index funds.

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What Really Matters In Investing?

There are really only two things you need to worry about when it comes to investing:  diversification and expenses.  You can read my post on portfolio theory for more on the basics of diversification and why it’s a good idea, but for now simply take my word for it.  As for expenses, lower is better.

The Least You Need To Be Diversified

It’s easy to go over-board diversifying your portfolio (just check out my retirement portfolio), but there are really only three asset classes you absolutely must have.

• Large-cap U.S. Stocks
• Large-cap Foreign Stocks
• Intermediate Term U.S. Bond Fund

Real estate, small-cap stocks, commodities, and other esoteric asset classes may very well have a place in your portfolio, but aren’t absolutely necessary.  Owning just these three asset classes in equal proportions will put you ahead of the vast majority of professional portfolio managers.

Expenses Are The #1 Determinant Of Long-Term Returns

Tons of research has shown that expenses are the most accurate predictor of a fund’s (or portfolio’s) long-term performance.  The reason is simple:  the average return of all mutual funds is simply the stock market’s return minus the average expense ratio.  Over the long term, statistically you cannot expect to out-perform the broad market.  You can out-perform the vast majority of other investors, however, by keeping your expenses razor-thin.  The best way to do this is by using index funds; however, there are many quality actively-managed mutual funds out there with expense ratios below 0.75% (the maximum I would recommend).  You can get expense ratio information from Morningstar (I suggest registering for their free account, which gives you access to all their various portfolio tools, stock screeners, and calculators in addition to mutual fund information).  The lower your portfolio’s combined expense ratio, the higher your future returns are likely to be.  It’s very possible to construct a well-diversified portfolio for less than 0.20% per year.

That’s All You Need To Know

That’s it, that’s all you need to know.  Investing in low-cost index funds over the above three asset classes is all you need to do to invest your retirement savings every bit as well as most pros.  It really is that simple.  Of course, older or more risk-adverse investors may choose a higher bond allocation while younger, more risk-inclined investors may choose to go a bit heavier on the stock side, but for the most part very few decisions need to be made.

Lessons From Sweden

As it turns out, the U.S. isn’t the first major industrialized economy to toy with the idea of partial privatization of a public pension system.  Reeling from the pressure of mounting pension obligations, the Swedish government in 2000 instituted a system of personal accounts to shore up the treasury’s balance sheet and give Swedish citizens an ownership stake in their own retirement.  There are a few important lessons we should learn from the Swedish experiment before attempting to implement a personal account system of our own.

• Limit Investment Options – When personal accounts were launched in Sweden, over 400 mutual funds initially participated.  This overabundance of choice paralyzed most Swedes, leaving them unable to make a choice.  Consequently, between 80-90% of all Swedes ended up in the default fund for lack of choosing another.  This same tendency to become paralyzed when confronted with too many options has been prevalent in American 401k accounts as well, so we can be sure the same thing will happen here.  To counter this, investment options should be few in number, preferably much less than 10.
• Broad Index Funds Only- Throughout the Swedish experiment, there was a strong tendency for Swedish investors to allocate heavily to sectors that had had strong showings in the recent past;  that is, Swedish investors participated in performance chasing and market timing, which is a recipe for disaster.  This tendency could be foiled in a privatized U.S. social security system by offering only broad, total market index funds.  Not only would a portfolio of only broad index funds make it impossible to overweight certain sectors, we wouldn’t have to worry about unscrupulous investment managers gaming the system to earn an unfair profit from a hapless public since index funds are by definition extremely low-cost, bare-bones operations.  Investors would get a good deal even as they were protected from themselves.  In fact, the U.S. Government already has such a high-quality, low-cost-index-fund-based retirement plan in the Thrift Savings Plan for government workers.  It could merely be extended to all Americans.
• Life-Cycle Funds Only- Unfortunately for Sweden, this program was implemented just before the tech bubble burst, leading to large losses for most investors.  As it turns out, the default fund (which 80-90% of Swedes were invested in, remember), was invested predominantly in the stock market and fell 30% in the ensuing carnage.  That may not be a big deal for a 25 year old just a few years out of school, but it’s huge for a 60 year old nearing retirement.  This teaches us that the default fund should be chosen very, very carefully since most Americans will probably end up invested in it.  The logical choice for a one-size-fits-all default choice satisfying the vast majority of investors’ needs is a life-cycle fund.  A life-cycle fund is simply one that becomes more conservative over time based on a pre-set formula determined by investment professionals.  If all Americans were enrolled in an age-appropriate life-cycle fund by default, that would eliminate 95% of the possible problems with any privatized social security system right there.  Investors would be prohibited from engaging in self-destructive behaviour like chasing returns, market timing, and the like and would be assured of a well-diversified, balanced portfolio to mitigate against permanent loss.  Such an approach would have worked well even in the current crisis.
• Err On The Side Of Caution – Sweden’s default fund was simply too aggressive for most investors.  The above life-cycle funds should err on the side of caution when making asset allocation decisions.  That is, their overall allocations should be appropriate for the average risk-adverse investor of a given age, not the so-called aggressive investor.  While this does mean less overall growth is possible in personal accounts, it also significantly reduces the chances of catastrophic loss.  After all, social security is supposed to be a safety net.  This arrangement would retain that characteristic, for the most part, since over time a conservatively-allocated portfolio is practically certain to outpace both inflation and the returns possible under the current social security system.

Many critics of the current social security system will balk at these suggestions, saying they don’t go far enough.  In their mind, anything but complete freedom to do what they will with their social security contributions is unacceptable.  Those people will never be convinced.  I think my plan represents a fair compromise between the liberal and conservative positions, balancing the possibility of long-term growth of capital and personal ownership against the need to provide a solid safety net for America’s retirees and protect investors against their own worst instincts.

Mutual Fund Expense Ratios

This is your basic mutual fund expense ratio.  It is usually by far the largest fee in your plan and also the most important to look out for.  While most 401k plans are full of expensive, lackluster investment options with little chance of performing well, many also include low-cost, broadly-diversified index funds.  The advantages of index funds are two-fold:  1.)  you never have to worry about  under-performing the market and, 2.)  you save tens of thousands of dollars in investment expenses over your investing career.  That’s not to say you should never buy actively-managed funds, just that the low expenses index funds possess give them an almost unsurmountable advantage over most of their more-expensive brethren.  Great care should be taken to minimize this particular fee and 1% is a reasonable upper-limit on the fees you should be willing to pay.

Plan Administration And Operation Fees

Every plan has a certain amount of administrative overhead:  accountants must be paid, paperwork filed, and salaries paid.  Large employers will often cover the cost of these record-keeping tasks and pass on the savings to plan participants; however, many small employers simply can’t afford to be so generous.  If these expenses aren’t covered by your employer, they must be paid by you, the participant.  To find out whether you or your employer is picking up the tab, get a copy of your plan’s annual report from HR (every company is required by law to make this information available to plan participants) and look under the section titled “Basic Financial Statement.”  Look for a line item called something like “net administrative expense.”  This is the amount of money taken out of the plan before calculating returns to cover plan expenses.  Divide net administrative expense by your plan’s total value (also a line item) to calculate the percentage of your plan’s assets being used to cover plan expenses.  Next, multiply this percentage by your personal account balance to get the percentage of your money being used to pay the bills rather than grow your portfolio.  Remember, these administrative and operation fees are in addition to the stated expense ratios of the mutual funds in the plan.  Just because you’ve chosen low-cost investment options doesn’t mean your plan is inexpensive.  There could be any number of hidden fees you pay but aren’t aware of.

 Individual Service Fees

Many plans offer optional services such as individual investment advice, telephone support, 401k loans, and the like which come with their own fees and expenses born by you and you alone.  Make sure you understand all the fees and financial consequences involved before deciding to take advantage of any of these optional services.

The main reason I like index funds is their rock-bottom expense ratios. Low expenses means you keep more of your investment returns to compound for you over the years. A cost drag of just 1% (about average for an actively-managed fund vs a low-cost index fund) can amount to a nearly 50% hit to your next egg over 40 years. That’s huge.

A Reliable Predictor Of Future Returns

In an attempt to isolate factors most likely to lead to superior portfolio returns, a 2002 study by the Financial Research Corporation analyzed 10 potential predictors of future performance. The conclusion? Low expenses are the one and only reliable predictor of future success. That is, mutual funds with low expense ratios tended to have above-average returns relative to their peers while funds with high expenses tended to have below-average returns. Statistics such as Morningstar ratings, alpha, beta, and manager tenure all had dubious value in predicting future winners. The solution? Allocate at least 80-90% of your portfolio to low-cost index funds. If you insist on trying to beat the market, limit this to a small percentage of your overall wealth.

 I am a financial planner and as long as these Newspaper and Magazine writers only consult with no-load funds like Vanguard for information they are never going to be giving good advice. 

If you are advised everyday that the only way to invest is in the SP500 index and that you should settle for less than average, that is what you will get – less than average. S&P500 Index return minus fees will always be a less than average return.

Let’s see, a financial advisor claiming all the commonly-taught investment advice to invest in index funds, diversify, etc is wrong.  Fair enough.  I bet she would be more than willing to give you “good advice”, though, for just a small fee!  Or maybe a nice fat commission when she invests your money in expensive actively-managed funds with large upfront loads.

It is extremely important to be skeptical whenever somebody tries to tell you commonly-accepted wisdom is wrong.  You should always ask yourself “what does this person stand to gain by convincing me of their point of view?”  In this case, sassy33 stands to gain quite a bit by persuading the public they need “expert” advice to invest their savings properly.  In reality, we know index funds tend to have above-average returns over the long term, contrary to what this dishonest (or incompetent) financial planner says.  So next time somebody gives you financial advice, ask yourself what they stand to gain from the deal.  If the answer is “a lot”, be wary.

Nobody Loves The IRS

Excepting congress, which needs huge sums of tax dollars for important projects like building bridges to nowhere and llama farms for orphan llamas, nobody likes the IRS. I am no exception and if you too share my raw hatred of the IRS you would be wise to think long and hard about asset location.

Asset location is the art of placing different asset classes in different types of accounts depending on a combination of the tax-efficiency of that asset class and the tax characteristics of the type of account in question. Here’s an example to make what I just said make sense. Suppose you have a target asset allocation for your retirement portfolio of 50% stocks and 50% bonds. Furthermore, about half of that portfolio is in your 401K at work and half is in either a regular taxable account or a Roth IRA. The best course of action would be to put the bonds in your 401K and stocks in your taxable account or Roth. The reason for this is that bond interest is taxed as regular income and stock dividends and long-term capital gains are taxed at lower capital-gains rates. Since everything in your 401K will eventually be taxed at normal income tax rates when you liquidate, putting stocks in it would amount to intentionally paying more taxes than necessary. In contrast, bond interest is taxed as income so you lose nothing by putting them in your 401K. Proper asset location can make a huge difference in your long-term returns so it’s well worth paying attention to.

Here is a list of asset classes and the optimal type of account they should be placed in, if possible.

Least tax-efficient
place in tax-deferred account (401k, traditional IRA, etc)

High-yield bonds
TIPS
Taxable Bonds

Medium tax-efficiency
place in tax-free account (Roth IRA, Roth 401k)

REITs
Balanced Funds
Small-cap stock funds
Actively-managed stock funds
Value stock funds
International Stock funds

Most tax-efficient
fine to place in taxable account

Broadly diversified stock index funds
Tax-managed stock funds
I/EE savings bonds
Tax-exempt municipal bonds

1. Switch to Index Funds – Studies show that 70% of actively managed funds fail to beat their benchmark over the long term.  If you can’t beat ‘em, join ‘em.
2. Lower your expenses – Numerous Morningstar studies show that mutual fund expense ratios are the single best predictor of future performance.  All else being equal, a cheaper fund will tend to outperform a more expensive fund.
3. Take advantage of your employer match – If your employer matches 50% of your contributions up to 6% of your salary, which is a typical match, that’s an immediate 50% gain on your investment.  You can’t get that anywhere else.
4. Minimize your taxes – Put tax-inefficient funds such as bond funds, small-cap funds, and actively-managed funds in your tax-advantaged accounts.  Your funds can compound for you at a higher rate without the drag of taxes.
5. Diversify – By not putting all your eggs in one basket you greatly reduce the chances of your portfolio suffering a catastrophic loss from which you won’t be able to recover, increasing your long-term returns.
6. Rebalance – Rebalancing your portfolio annually forces you to buy low and sell high as you trim back your recent winners to buy more of your recent losers which may be poised for a recovery.
7. Don’t cash out your 401k when you change jobs – Cashing out your 401k when you change jobs is financial suicide.  Not only do you pay income taxes on the amount you cash out but also a 10% penalty, not even counting local or state penalties.  Even worse, you are borrowing from your future and will miss out on decades of compounding.  The end result could be a deficit of hundreds of thousands of dollars.  Roll over your401k to an IRA instead.

• 10% Vanguard 500 Index fund (VFINX)
• 10% Vanguard Value Index fund (VIVAX)
• 10% Vanguard Small Cap Index fund (NAESX)
• 10% Vanguard Small Cap Value Index fund (VISVX)
• 10% Vanguard REIT Index fund (VGSIX)
• 10% Vanguard Short Term Treasury fund (VFISX)
• 10% Vanguard FTSE All-World ex-US Index fund (VFWIX)
  
• 10% Vanguard International Value fund (VTRIX)
• 10% Vanguard Emerging Markets Index fund (VEIEX)
• 10% Vanguard FTSE All-World ex-US Small Cap Index fund (VFSVX)

Notice that with the exception of the International Value fund, my Roth IRA portfolio is completely indexed. The reason for the inclusion of the actively manged International Value fund is that, sadly, Vanguard has no indexed option for this asset class. But with a low (for an actively-managed fund) expense ratio of 0.41%, I feel fairly comfortable getting my international large-cap value exposure here. Needless to say, I will swap it out for an index fund if Vanguard ever feels fit to launch one. What do you think? Any suggestions or comments?