Mutual funds continue to control a dominant portion of individual investor assets, especially in 401K and other types of retirement plans. Mutual funds are great because they offer instant diversification especially for the small investor. Mutual funds are investment vehicles that hold a "basket" of, most commonly, stocks, bonds or a combination of the two with just about every theme and strategy imaginable. There are thousands of mutual funds to choose from, in fact there are more mutual fund choices than there are listed individual stocks.
Sounds good doesn't it? What could be wrong with mutual funds? Plenty, but I will just discuss the biggest problem with mutual funds, cost.
- The cost of mutual funds average between 1 and 1.5% based on what they publish as their expense ratio. But that is only what is required to be made available to investors.
- There is another document, Statement of Additional Information (SAI), which most people don't know about. This document outlines additional expenses in mutual funds for trading and operational costs which average another 1 to 1.5%.
- Not only that if you buy your mutual funds through a commission based broker you could pay an additional 5% fee. - Not only this but if you hold your mutual funds in a non-tax deferred account you could pay capital gains tax annually even if don't sell! The reason for this is because the manager of the mutual funds buys and sells stocks throughout the year and passes on those capital gains to you. Sometimes these capital gains taxes can be more than 10%.
- All these expenses can add up and significantly affect your return and is the biggest problem with mutual funds.
To be fair, not all mutual funds have the problems described above, but most of these issues are more common than not. So, when you consider investing in mutual funds you need to take a closer look at the fine print. Unfortunately, the fine print is not easy to decipher.
Okay, so I told you what is wrong with mutual funds, that's great but where else do you find a diversified investment choice? A great alternative to mutual funds are Exchange Traded Funds, or ETFs. ETFs are very similar to mutual funds in that they typically hold a diversified basket of stocks and/or bonds.
The major difference is that mutual funds trade assets within the fund more actively partially because they need to make trades when investors buy or redeem shares. ETFs hold a basket of assets based on a theme, most commonly an index, and the investor buys or sells those shares on an exchange rather than through a mutual fund company. For this reason ETFs are on average much cheaper than the average cost incurred by mutual funds.
ETFs average less than 0.4% and for most ETFs they generate little or no capital gains unless the investor sells shares. There are some niche strategy ETFs that have come out recently that do generate huge capital gains but I don't recommend these investments unless you understand them fully. But the majority of ETFs have had minimal capital gains compared to stock mutual funds.
ETFs have been stealing market share from mutual funds over the last few years and look to continue in that direction in the future. Unfortunately, ETFs have not been a significant option in 401ks and other retirement plans which many investors participate in so mutual funds may be some investors only option. I believe that ETFs will begin to invade the retirement plan arena as investors demand a reduction in excessive fees associated with mutual funds.
Saturday, May 2, 2009
Tuesday, April 21, 2009
Investing vs. Speculating
Many people mistake the difference between investing and speculating. The key to distinguishing the difference is "risk".
Speculating is investing in something that has a greater possibility of both gain or loss. For example, when an individual stock goes through tough times and the price is very low, individuals look at this as a great opportunity to buy low and sell when the price returns to its former high valuation. This is called "bottom fishing" by Wall Street. The problem with this is two fold. One, there may be a good reason for an under performing stock to be priced low and it may not come back any time soon if ever! Two, if it does come back it could take many years causing the speculator to loss patience or not get the best return for their money. Through the years I have observed that those who speculate more often than not loss money.
The problem with speculating is that the enticement of the great possibilities of financial gain clouds the very real possibilities of losses. Any investment that has a high probability of losing all your money is speculation. If you want to speculate for fun or for the possibility of riches just understand that you could loss everything. If you can't accept losing everything don't do it.
Another example of speculation that I often see people salivate over is the promise of a new technology. You know that small company that is riding on one product that will revolutionize the way we do something-or-other. It's a great idea and the speculator can't see any downside to the investment. In reality there are many downsides, two in particular. First of all it is likely that many others have the pie-in-the-sky visions of this new product and the price is based on that optimistic outlook. Interpretation, the stock is overpriced. Since this company is basing it's future on this one product if anything goes wrong that's the end of it's life and your investment.
Speculating is a losing game, especially if done repeatedly. The reason is that you need to be right every time. Most speculators get burned the first time they make speculative "investments" which is to their benefit. Because it diminishes the possibility of them doing it a second time. I only say "diminishes" because many are unitised to speculate over and over, again only considering the benefits and not the risks. Take this scenario. You see a great opportunity to buy XYZ Corporation that is trading at it's lows and you buy $1,000 worth of the stock. A month later it shoots through the roof and it is now worth $10,000. You are a shrewed speculator so you sell it at the high and buy the next undervalued company with your $10,000. This next investment goes bust and you lose the $10,000. Not only did you lose this first investment but you lost them both since you no longer have the money you invested in the first place.
As Warren Buffett once said, "The first rule of investing is to not lose money." Many people don't want to take the slow route of growing rich slowly but by trying to get rich fast they more often than not are postponing their financial success through speculation.
Investing on the other hand is purchasing a well researched and/or diverse sampling of assets for the intention of long term growth. The key term here is "diverse" since diversification provides a greater probability for the investor to not loss all their money. With diversification if one component of the investment under performs it will not hurt the entire investment.
Speculating is investing in something that has a greater possibility of both gain or loss. For example, when an individual stock goes through tough times and the price is very low, individuals look at this as a great opportunity to buy low and sell when the price returns to its former high valuation. This is called "bottom fishing" by Wall Street. The problem with this is two fold. One, there may be a good reason for an under performing stock to be priced low and it may not come back any time soon if ever! Two, if it does come back it could take many years causing the speculator to loss patience or not get the best return for their money. Through the years I have observed that those who speculate more often than not loss money.
The problem with speculating is that the enticement of the great possibilities of financial gain clouds the very real possibilities of losses. Any investment that has a high probability of losing all your money is speculation. If you want to speculate for fun or for the possibility of riches just understand that you could loss everything. If you can't accept losing everything don't do it.
Another example of speculation that I often see people salivate over is the promise of a new technology. You know that small company that is riding on one product that will revolutionize the way we do something-or-other. It's a great idea and the speculator can't see any downside to the investment. In reality there are many downsides, two in particular. First of all it is likely that many others have the pie-in-the-sky visions of this new product and the price is based on that optimistic outlook. Interpretation, the stock is overpriced. Since this company is basing it's future on this one product if anything goes wrong that's the end of it's life and your investment.
Speculating is a losing game, especially if done repeatedly. The reason is that you need to be right every time. Most speculators get burned the first time they make speculative "investments" which is to their benefit. Because it diminishes the possibility of them doing it a second time. I only say "diminishes" because many are unitised to speculate over and over, again only considering the benefits and not the risks. Take this scenario. You see a great opportunity to buy XYZ Corporation that is trading at it's lows and you buy $1,000 worth of the stock. A month later it shoots through the roof and it is now worth $10,000. You are a shrewed speculator so you sell it at the high and buy the next undervalued company with your $10,000. This next investment goes bust and you lose the $10,000. Not only did you lose this first investment but you lost them both since you no longer have the money you invested in the first place.
As Warren Buffett once said, "The first rule of investing is to not lose money." Many people don't want to take the slow route of growing rich slowly but by trying to get rich fast they more often than not are postponing their financial success through speculation.
Investing on the other hand is purchasing a well researched and/or diverse sampling of assets for the intention of long term growth. The key term here is "diverse" since diversification provides a greater probability for the investor to not loss all their money. With diversification if one component of the investment under performs it will not hurt the entire investment.
Tuesday, March 31, 2009
Your "number"
This subject scares me more than anything else. I know, I know everyone has heard that the U.S. savings rates are close to zero and the amount we have saved for retirement, even those getting very close to that date, is much less than sufficient. So doesn't anyone really care? Why aren't we doing anything about it? Are we in denial? I think the problem is due to lack of real understanding of the significance. Most of us do not know what our "number" is? What do I mean by "number"? The "number" is what we need financially to be able to retire. Yes, everyone's number is different depending on how they plan to journey through retirement, sit on the porch and watch the cows or travel the world and live large.
For the sake of simplicity and in the effort for people to begin to really look at what they need for retirement I will provide you with simple math to determine what your "number" is to be able to retire. Here we go.
How much money do you need to live on this year? (Example: $75,000)
Take that number and multiply by 25. (Example: $75,000 * 25 = $1,875,000)
That number is what you need to retire today. (see below for a rational for this calculation)
To figure out how close you are to your number now take the current value of all your assets (not including your house since you have to live somewhere) and subtract all your debts to find your net worth.
Yes, that's a big number if you haven't started to save. In fact considering that we don't know what potential life risks can come to us in the future, I think this number is conservative. And you can't easily take that money out of your home if you have any equity because you do need to live somewhere.
The best course of action is to save regularly and invest prudently. I know that is easier said than done. That is the subject of a future blog.
(How the “number” is calculated? Based on research studies, it is a commonly accepted rule that you have a high probability of not running out of money for the rest of your life if you spend no more than 4% of your total net worth. That assumes you don’t live excessively and you make prudent investment decisions. The number “25” comes from dividing 100% by 4%. This number is in turn used to multiply by your total annual need to get the total amount required to retire. Yes, taxes are an issue and this number will change over the years based on your lifestyle and changes in inflation but this number is a good start. I just want to get people to realize the significant sums of money that are needed to retire. To figure out your specific number consult with your financial advisor)
For the sake of simplicity and in the effort for people to begin to really look at what they need for retirement I will provide you with simple math to determine what your "number" is to be able to retire. Here we go.
How much money do you need to live on this year? (Example: $75,000)
Take that number and multiply by 25. (Example: $75,000 * 25 = $1,875,000)
That number is what you need to retire today. (see below for a rational for this calculation)
To figure out how close you are to your number now take the current value of all your assets (not including your house since you have to live somewhere) and subtract all your debts to find your net worth.
Yes, that's a big number if you haven't started to save. In fact considering that we don't know what potential life risks can come to us in the future, I think this number is conservative. And you can't easily take that money out of your home if you have any equity because you do need to live somewhere.
The best course of action is to save regularly and invest prudently. I know that is easier said than done. That is the subject of a future blog.
(How the “number” is calculated? Based on research studies, it is a commonly accepted rule that you have a high probability of not running out of money for the rest of your life if you spend no more than 4% of your total net worth. That assumes you don’t live excessively and you make prudent investment decisions. The number “25” comes from dividing 100% by 4%. This number is in turn used to multiply by your total annual need to get the total amount required to retire. Yes, taxes are an issue and this number will change over the years based on your lifestyle and changes in inflation but this number is a good start. I just want to get people to realize the significant sums of money that are needed to retire. To figure out your specific number consult with your financial advisor)
Thursday, July 17, 2008
Behavioral Investing
One of my favorite subjects in financial planning is behavioral investing. This is easily the area that causes most investors to under perform or more likely inflict harm on their financial health. And this is not just restricted to the amateur investor but also the professional. In behavioral investing there are 2 extremes that I find most interesting, the under investor and the over investor. Both can be equally damaging.
The under investor is the one who closely watches the market year after year but never actually participates in the market for reasons of fear. If the market is going down this month than they are glad they are not in the market. If the market is hitting one new high after the other then it is not the best time to go in. That's one type of under investor. The other type is the one that doesn't even acknowledge the market because they have heard that people loss money in the market.
The over investor is the one that changes their "plan" based on short-term market trends and media talking heads. This investor will chase last years winner and incur excessive trading costs, and taxable events while underperforming the market.
The under investor is the one who closely watches the market year after year but never actually participates in the market for reasons of fear. If the market is going down this month than they are glad they are not in the market. If the market is hitting one new high after the other then it is not the best time to go in. That's one type of under investor. The other type is the one that doesn't even acknowledge the market because they have heard that people loss money in the market.
The over investor is the one that changes their "plan" based on short-term market trends and media talking heads. This investor will chase last years winner and incur excessive trading costs, and taxable events while underperforming the market.
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