Monthly Archives: August 2013

Link of the week: Why active fund management is a loser’s game

The last Savers meeting got me on a bit of an investing tear! And it’s been great, because everything I’ve been reading tells me that my current philosophy is ideal, based though it was on meager evidence initially.

I was absently reading the August issue of Kiplinger’s this morning while brushing my teeth, when I stumbled across an article that perfectly illustrated why index funds are better than actively managed portfolios. Every once in a while Kiplinger’s pauses in its stock-picking advice to look directly at the camera and say “But seriously, folks, don’t actually do that.” This article was one of those. And it’s why I still subscribe to Kiplinger’s even though I don’t believe I’ll ever be an active stock trader.

The article, “Fewer Trades, More Gains” by James K. Glassman, is so full of gems, I can’t say it any better myself, so I’ll just share a few of my favorites.

“Investors earn their money not in good times but in bad — when they muster the courage to hang on. The alternative, broadly called “trading,” is bad for your investment health.”

“Trading generates taxes, and taxes, combined with trading costs, erode long-term returns.”

According to researchers Brad Barber and Terrance Odean, “people who traded the most averaged returns that were 30% lower than those of the average customer — and 36% lower than the stock market itself.”

“The cost of trading is one facet of investing that you can control. Those costs apply not just to individual stocks but to mutual funds.”

“Over time, these fees mount up. Consider the Fidelity fund mentioned above. Its expense ratio, at 0.90%, is below average. But if you invest $10,000 and the fund returns an annualized 10% over the next decade, you will pay $1,444 in expenses, or 10.6% of your profits.”

HERE’s a horrifying tidbit, because I thought the expense ratio was the cumulative costs taken from your funds:

“Edelen and his colleagues also found that the costs of trading the securities in the average stock mutual fund (what they call “aggregate costs”) came to another 1.44%. These costs aren’t transparent. You don’t write a check for them each year, and they don’t appear on a line in a fund’s prospectus, as the expense ratio does; they show up only in a fund’s diminished return.”

“Can funds generate returns that overcome those high costs? An expensive BMW performs better than a low-priced Honda, so shouldn’t a high-cost fund deliver better returns than a low-cost one, even after taking all expenses into account? With regard to total costs, the Edelen study confirms what other research has shown on the matter of expense ratios: The luxury brands turn out to be clunkers. “We found a strong negative relation,” says the study, “between aggregate trading cost and fund return performance.””

“It’s a rare stock picker who consistently beats the market. So if nearly every fund manager generates gross returns that are close to the market averages, then the fund’s costs become the single most powerful determinant of its net returns — that is, of what you get to keep in your pocket.”

And here’s his closing volley — notice how he plugs index funds even though this entire article was about active trading and actively managed funds:

“Buy and hold is the best advice I can give to someone who buys individual stocks. The same advice applies to fund investors as well. Find a buy-and-hold manager — or buy an index fund — and hang on for the long term. You won’t regret it.”

He recommends some actively managed funds in the article, but after reading, I find it hard to believe anyone wouldn’t go for the cheapest, least active fund they could find. I know I have!

Link roundup: index funds, DIY retirement and investing advice

I’m no expert yet in the retirement side of things, as I’ve said before. But I’ve yet to come across any convincing reason to meet with a professional financial planner. It seems to me the info is out there, if you just go looking for it.

Retirement is still a lower priority for me right now, only because I have so many other financial fires I’m still putting out in my own life. But I knew I needed to be putting at least 10% of our income toward retirement, and I didn’t want to wait ages before I did it. So I did the bare minimum of research just to figure out where to put it. This is what I’ve concluded:

  •  401(k)s are not always the best option for you. If your employer offers a match, it’s a no-brainer to contribute enough to get the maximum match, but if not, it seems like setting up your own retirement fund is better.
  • If you do, there are traditional IRAs and Roth IRAs. Traditional ones are good for the tax benefit you get right away (the money you put into them can be excluded from taxable income on your returns), but you will have to pay taxes on the money when you withdraw it. And I think you get penalized if you withdraw before retirement. Roths are great because even though you pay taxes on your contributions, your earnings are tax-free when you withdraw them. And I believe you can withdraw your contributions before retirement without penalty, so there’s a bit more access to that money if you need it.
  • Index mutual funds are the magic words when you’re looking to invest. If you can find a target-date retirement Roth IRA made up of index mutual funds and the cost is low (see further down), that’s golden because it gives you diversity in your investments and doesn’t eat away a ton of your growth. “Index” funds are typically cheaper and perform better than “actively managed” funds over time.
  • The phantom costs of retirement funds are typically called “expense ratio” or “operating expense” and are usually expressed as a percentage. The lower the percentage the better. 0.18% is very very good; 1% is not great and you can do better; 2% is terrible.
  • Vanguard, founded by John Bogle, is the birthplace of low-cost index mutual funds, and they’re still right up there in terms of low cost and good performance, as far as I have read anywhere.

So there you have it. That’s why I contribute to my 401(k) enough to get the maximum match, I chose the lowest-cost options my company offers. The rest of my retirement contributions go to a Vanguard Roth IRA target-date retirement fund, and I have the withdrawals automated so I won’t be tempted to not contribute.

But recently I’ve been asked for more in-depth advice about retirement investing, and honestly, I have a very thin base of research that I base my own strategy on. So I thought I’d round up comprehensive articles from reputable sources so I (and you) could look through them and see if we can glean any consistent info from them. I divided them up into two categories: best-performing index funds and DIY portfolio creation.

Best-performing index funds

Money 70: Best mutual funds and ETFs. This article is from CNN Money, which partners with Money and Fortune magazines. It’s their picks of the 70 best funds and clearly lists both performance and expense ratio, and I was pleased that my target-date retirement fund made the cut! It also mentions this at the outset: “Indexing is the cheapest and most reliable way to earn the returns that the market offers. And in the long run, it’s likely to beat the average actively managed fund.” Please also note that actively managed funds are generally much more expensive than the index funds on the list. (There are also another type of fund called “ETFs” on the list, but I don’t know anything about them so I can’t comment on how they stack up, but it does seem like their expense ratios are sometimes even lower than index funds, so maybe something to look into more! Meanwhile, here’s Warren Buffett saying not to bother with ETFs.)

How to Pick the Best Index Funds. This article from Kiplinger is a lot more insider-y, but I can see a lot of similar advice; namely, specific shout-outs to index funds in general and Vanguard funds in particular.

Index Funds: The Key to Saving for Retirement? This PBS article offers some cautionary words about index funds, but mainly for people who want to gamble big for big returns. It says that index funds will never beat the market, as actively managed funds may do sometimes. However, it also gives this bit of insight about long-term performance:  “[MIT lecturer] Kritzman measured a hypothetical stock index fund with an annualized return of 10 percent, an actively managed fund with a return of 13.5 percent and a hedge fund earning 19 percent. At the end of his calculation, he found that the index fund’s average after-expense return was 8.5 percent, compared to 8 percent for the active fund and 7.7 percent for the hedge fund.” That means even if an index fund doesn’t show as much growth, you may get to keep more of the money because of the lower cost.

Index Fund Portfolios Reign Superior. This Forbes article doesn’t beat around the bush! And the first paragraph is just as strongly worded: “Mutual fund portfolios that hold only index funds have a far greater chance for higher returns than those holding actively-managed funds. The evidence in favor of all index funds, all of the time, is irrefutable, overwhelming and important to all investors.”

DIY portfolio creation

Should I hire a financial adviser or go it alone? CNN Money again, this time with a fairly straightforward article about asset allocation and other issues having to do with retirement. I didn’t check all the links, but they direct you to useful-sounding places such as Morningstar to figure out your ideal mix of investment types.

Do It Yourself Investing. Forbes weighs in with an equally accessible article, this one with a step-by-step plan to follow to set up and maintain your investment portfolio.

Three-fund portfolio. This is a wiki on the “Bogleheads” site (a large and active group of John Bogle fans and investment enthusiasts) about a simple way to approach asset allocation.

So that’s it! I’m happy that I’ve done a bit more research and I haven’t seen anything that says I’m doing things terribly wrong, even if there’s maybe more I could do with setting up my own fund allocation and rebalancing. But at the moment and with the level of knowledge I’m at, I’m still very comfortable with my current choices after skimming all these articles.

Nest with eggs, get it?

Image courtesy of renjith krishnan /

Financial housekeeping: a checklist

I’m one of those people who’s hopeless at housework. If I were in charge of my  home’s cleanliness and organization, it would be a painful process. Thankfully I have family members who have a much better handle on it; they seem to have mental checklists that keep everything moving like clockwork: dishes, laundry, tidying, organizing. I contribute some, but I definitely don’t have a routine in place, and that’s such an important part of keeping a household in order.

A household’s financial life is like another home, one that needs to be kept clean and organized. And like housework, if you let one part of it slip for too long, it’ll get out of control and will take much more effort to fix than if you tackled it periodically.

This household, our financial one, is the one I’m in charge of. And I run a tight ship! I probably (OK, definitely) go too far; the scare we had six or seven years ago seems to have permanently affected me, and now I’m overly scrupulous about neatening every little corner of our financial home. But, I enjoy it, and it has helped us make great strides toward financial security. And really, I’m glad I enjoy it. If I liked doing actual housework this much, our condo would be immaculate!

If I were in charge of keeping our real home clean and organized, I’d have to work harder to create schedules and habits that helped me remember all the elements of upkeep. In the past, I’ve turned to checklists in magazines and online to help me figure out what needs doing around the house to make it nice. Financial housekeeping is second nature to me by now. But I realize it’s not so for everyone, so I thought I’d try and come up with a checklist of the parts of financial life that need to be tended to periodically.

  • Balance your checkbook. This one is like doing dishes: It needs to happen frequently or your life will get out of control fast. I don’t keep a traditional checkbook, with records of past purchases; my version is a “future checkbook” spreadsheet that looks forward a month or two. The checking account balance at the top must be current, the bottom line must come out evenly, and the balance after each predicted expense must stay in the black. That’s how I know we’re on track.

I check our bank account usually once a day; I don’t need to, but at this point it’s a comfortable habit. I sometimes let it go for a few days if I’m busy, on vacation or sure nothing’s going to come in or go out during that time. If you keep a small cushion in your checking account or are watching every dollar for another reason, you may want to get in the habit of checking your account online every day or a few times a week. If everything is pretty much in balance and you don’t feel the need to track that precisely, once a week or a couple times a month should do it.

  • Pay your bills. There are a number of ways you can do this, from writing and mailing checks to automatic debit from your checking account. The only constants are that you need to pay on time, and you need to confirm the payment went through.

Having a “future checkbook” like my spreadsheet is immensely helpful in this regard because whether it’s a bill I have to manually set up or whether it will come out of our checking account automatically and just needs to be verified, my spreadsheet reminds me when it’s due so I can take whichever actions are needed for that bill.

  • Check your debt accounts. It’s important to make sure you’re current on your debt payments and not incurring any punitive fees for underpaying or paying late. It’s equally essential (though sometimes painful) to know how much debt you have, how much interest you pay on it and how long it will take you to pay it off.

I used to go through periods where I’d obsessively look at my credit card, mortgage and student loan statements and other times where I’d ignore them completely, hoping they’d eventually go away if I didn’t pay them any mind. I find a balanced approach is better. I check my debts after I’ve made a payment, whether it’s a scheduled minimum bill or an extra payment to principal. I also keep a running list of my debt amounts so that I can feel motivated to see the total balance go down each month.

  • Check your asset accounts. It’s nearly as important to regularly check your savings, 401(k) and other holdings. Even if you don’t actively track their growth rate, you can make sure you’re not forgetting to add to these accounts, and periodically checking for fees and other costs isn’t a bad idea either. (It also ensures you don’t forget about any accounts; it boggles my mind that there are billions of dollars’ worth of abandoned accounts and other unclaimed property in the U.S.)

I check all our assets at least once a month. To remind myself to do it, I have a monthly task where I evaluate our net worth by adding up all our assets, subtracting all our debt, and comparing the remainder with the previous month. This assures me that our net worth is growing overall.

  • Revisit your big picture and your goals. Just as you sometimes step back from the day-to-day of housekeeping and realize that your living-room rug is getting frayed and dingy, or even that your home is no longer serving your needs and it may be time to start looking for a new home, it’s important to pause every once in a while and take a long view of your  financial house. There are many issues, small and enormous, that don’t get dealt with in your everyday money management but need to be addressed periodically. Are you paying any monthly bills that can be eliminated? Are your debts growing or shrinking? Do you have a plan to get debt-free? Are you setting aside money for big future purchases, such as a dream vacation or a replacement car? Are you saving enough for retirement? Do you have an emergency fund and a contingency plan in case you lose your job? Will your loved ones be OK financially if you die suddenly?

I don’t have any strict advice about how frequently you should do any of the above; for myself, I go with my gut, and if I feel like I haven’t touched on an aspect of my financial life for a while, or don’t know exactly where I am in some area, or formulate an ambitious new goal, I look into it. If I had to describe my financial behavior, it would go something like this:

Access checking account and balance my future checkbook daily, or nearly every day.

Check my credit card accounts when I know a purchase has been made. Pay off my credit cards twice a month, on payday.

Check my debt accounts every time a payment is sent, and update overall debt total.

Check my asset accounts once a month, and add them up for a net-worth snapshot.

Make small goals at the beginning of the month and track them throughout; make big goals at the beginning of the year and track them too. Sum up my progress at the end of each month and each year.

Re-evaluate my budget whenever a fixed expense grows or shrinks, or whenever regular income increases or decreases. If there’s more money available, decide where I’m going to put it. If there’s less money to go around, figure out what to cut.

Hold family meetings whenever there’s a big change coming, or a large-scale plan or important decision to be made.

How about you? Do you have an organized method for financial housekeeping? If not, I hope my list has given you a starting point.


Image courtesy of artur84 /