Professional investment advice (and why you should ignore it)

This article is from J.D. Roth, who founded Get Rich Slowly in 2006. J.D. recently appeared on the Microblogger podcast, where he talked about taking control of his financial life, moving from debt to wealth.In January, I accompanied Kim to an appointment with Paul, her investment adviser from Edward Jones. Paul’s brother was my best friend in grade school and junior high, and we have many mutual friends. I sat and listened while Kim and Paul talked about her investments and how she ought to invest for retirement. I didn’t participate much, though, because this is Kim’s money, and I didn’t feel like it was right for me to take an active role.I did ask some questions about index funds, though. Kim’s money is …

via Get Rich Slowly – Personal Finance That Makes Sense.:

This article is from J.D. Roth, who founded Get Rich Slowly in 2006. J.D. recently appeared on the Microblogger podcast, where he talked about taking control of his financial life, moving from debt to wealth.

In January, I accompanied Kim to an appointment with Paul, her investment adviser from Edward Jones. Paul’s brother was my best friend in grade school and junior high, and we have many mutual friends. I sat and listened while Kim and Paul talked about her investments and how she ought to invest for retirement. I didn’t participate much, though, because this is Kim’s money, and I didn’t feel like it was right for me to take an active role.

I did ask some questions about index funds, though. Kim’s money is entirely in individual stocks (like Apple) and expensive load-bearing funds such as VFCAX (Federated Clover Value Fund), which has an expense ratio of 1.19 percent and a sales load of 5.5 percent.

Paul argued against index funds, saying:

• Mutual-fund managers earn back the sales load (and high expense ratio) in time so that, long term, actively managed mutual funds outperform index funds. (Note: Studies show that, in general, this is not true.)


• Part of the reason people pay him to manage their investment accounts is because he protects them from making foolish emotional decisions about the market and he alerts them to possible opportunities.

Afterward, I asked Kim what she thought of the meeting. She got the gist of things, but found a lot of it confusing. No surprise. I know this stuff and still found some of the presentation confusing.

“What do you think I should do?” she asked.

“Well, I still think you should be in index funds,” I said, but I didn’t push it. Again, we’ve been dating almost two years, but it’s not like we’re married. I didn’t feel comfortable making this decision for her.

Over the next few weeks, I wrote the investment chapter for my ebook. And then I rewrote the chapter. And then I rewrote it again. (This ebook will finally see the light of day at the end of April, by the way.)

As I wrote, I realized that I truly believe index funds are the right way for most people to invest. And it’s not just me. Warren Buffett believes this, as do many other well-known investors. The evidence is overwhelming. The smartest way for the average person to invest is to put all of their money in broad-based, low-cost index funds and never touch it. End of story.

Meet the new adviser — same as the old adviser

Between January and March, Kim switched jobs. Her new employer also contributes to retirement, but uses a different investment adviser. Last week, we met with the new guy, Evan. This time, I asked Kim how she viewed my role before the meeting. “I want you to speak up,” she said. “I want you to act like you’re my husband.” Well then, OK.

The meeting with Evan started very much like the meeting with Paul. Evan talked about how much Kim needs to save to meet her retirement goals (answer: a lot!). He also talked about where she should put the money. He agreed with me that it’s probably best not to shift around Kim’s existing investments (although I can’t help thinking we’re falling victim to a sunk-cost fallacy by not moving to index funds). He recommended that all of her new money should go into shiny new mutual funds that his company sells — funds that carry loads of 5.75 percent.

Note: These mutual funds are from American Funds, and I’m very familiar with them. When I was married, Kris put a lot of her savings into the American Funds family.)

“How are you compensated?” I asked.

“Great question,” Evan said. “I’m paid out of the sales charge, out of the front-end load of the mutual funds. A part of that goes to me, a part of that goes to my company, and a part of that goes to the mutual fund company itself.”

After a few minutes of discussing these new funds, I decided to speak up.

“Look,” I said. “I write about money. I’m not an investment guru and I don’t have any specific training, but I’ve read and written a lot about investing over the past few years. Everything I’ve read says that the only reliable indicator of future mutual fund performance comes from a fund’s fees. The lower they are, the better the fund is likely to perform in the future.”

“That may be so,” Evan said, “but that’s only part of the story. With proper management, a traditional fund can outperform an index fund. Besides, index funds only work if you’re able to control your emotions. Studies show that most investors earn returns far below those of the market because they make poor choices under the influence of emotion.”

“Sure,” I said. “The Dalbar study shows that every year.” I cite this study over and over again in the articles and books I write. “But investor behavior is only one part of the problem. The other part is costs.”

Evan protested. I didn’t blame him. His livelihood is tied up in this. Besides, I think he truly believes in his funds.

“If Kim were to buy index funds through Vanguard or Fidelity, how would you be compensated?” I asked.

“I’d take 1 percent,” Evan said.

“One percent up front?” I asked. “Or 1 percent per year?”

“One percent per year,” he said. With the roughly 0.25 percent expense ratio for a typical index fund, that would give her a cost of 1.25 percent annually. That beats the expense ratios from the funds Evan was proposing, especially when you factor in the 5.75 percent sales load.

Following my own advice

At the end of the meeting, Kim smiled and shook Evan’s hand. “Thanks for your help,” she said. “We’ll go home and figure this out.”

We walked next door to have a glass of wine while gazing out at the stormy Willamette River. “What do you think I should do?” she asked.

“Do you want to know what I would do if this were my money?” I asked.

“Yes,” she said.

“First, I’d contribute as much to retirement as needed to get the match from your boss. I’d have that put into an index fund, and I’d pay Evan his 1 percent per year. I don’t like it, but that’s your best option to get the match from work.”

“For everything else, though, I’d invest on my own. I wouldn’t do it through Evan. I’d open an account at Vanguard or Fidelity and schedule monthly contributions. He says you need to be putting away $920 per month for the next 20 years in order to have the equivalent of $50,000 per year at retirement. Do that. To be honest, I’d rather you didn’t pay me rent or utilities. I don’t need that money. I’d rather see you put it directly into an investment account every month. It’ll still feel like you’re paying me rent, but it’ll be going to your future instead. Does that make sense?”

Kim nodded. “It does,” she said, “but I still don’t like it.” (We’re still hammering out the financial side of our relationship. She wants to pay her half of things — which I appreciate — but I don’t want to take her money. When she pays me for rent or utilities or anything else, I tuck the money into a “secret” savings account at Capital One 360. That makes both of us happy.)

Unconventional Success

After our meeting with Evan, I began to have bouts of self doubt. It’s one thing to make decisions with my own money; it’s another to make them for somebody else.

To boost my confidence, I turned to books. I re-read the rationale behind investing in index funds. In particular, I turned to David Swensen’s Unconventional Success . During our meeting, Evan had pointed to the Yale University endowment as an example of investing success. Swensen is the mastermind behind that endowment. He’s also a passionate supporter of passive investing.

Unconventional Success contains nearly 400 pages laying out the arguments for index funds as “a fundamental approach to personal investment.” It explores asset allocation, market timing, and security selection before ultimately concluding that “overwhelming evidence proves the failure of the for-profit mutual-fund industry.”

Note: You can read a much shorter version of Swensen’s arguments in his 2011 New York Times editorial about the mutual fund merry-go-round.

Refreshing myself about the evidence in favor of index funds allowed me feel much better about our second meeting with Evan. On Monday night, we returned to his office to explain our decision. In short, we wanted to put all of Kim’s future funds into the following asset allocation using Vanguard index funds:

• 45% into VTSMX, the Vanguard Total Stock Market index fund


• 25% into VGTSX, the Vanguard Total International Stock index fund


• 20% into VBMFX, the Vanguard Total Bond Market index fund


• 10% into VGSIX, the Vanguard REIT index fund (a REIT is like a mutual fund for real estate)

“That’s great,” Evan told us. “We can do that. But there’s just one problem. Our investment platform requires a $25,000 minimum in order to make this happen. Otherwise, it’s not worth our time.”

At first, I thought this was a barrier. Kim doesn’t have $25,000 in new money to invest. But then I hit upon a couple of solutions.

First, we could move our shared “dream fund” from the Capital One 360 savings account where it currently resides. Instead, we could place it in index funds. Sure, this would introduce greater risk, but I’m OK with that. By the time we’re ready to tap this fund, the stock market should be higher than it is today — and it should outperform savings accounts in the meantime.

Second, we could liquidate Kim’s existing mutual funds and move the money to Vanguard funds instead. That’s probably the smartest move anyhow. We had planned to leave her existing accounts at Edwards Jones, but this makes more sense.

In the end, Kim came up with a fun plan. Here’s what we’re going to do:

• We’ll move all of her investment accounts from Edward Jones to the new company.


• We’ll sell half of her existing funds in order to meet the minimum requirements to begin putting money into a Vanguard retirement account. (And because index funds are the better choice.)


• We’ll keep half of her existing funds as they are and allow her new adviser to manage them as he sees fit. Let’s see if he can actually beat a portfolio of index funds.


• Meanwhile, she’ll funnel $460 per month into her employer-sponsored retirement account.


• Finally, she’ll open a personal Roth IRA account at Vanguard. Into this, she’ll contribute $460 per month. This will give her a chance to see what it’s like to manage an investment account on her own.

This process illustrated some of the problems the typical investor faces. First, she receives self-serving advice from advisers (even when they don’t intend to be self-serving). Second, even when she knows the right thing to do, it can be tough to stick to her guns in the face of trained expertise. Third, there can be barriers to making smart choices, barriers like high minimums and additional fees.

In the end, it’s important to make your own informed investment decisions. Remember: Nobody cares more about your money than you do. If you don’t take the time to educate yourself, you can’t expect anyone else to make the right decisions for you.

For more info: Professional investment advice (and why you should ignore it)

Get Rich Slowly – Personal Finance That Makes Sense.

Professional investment advice (and why you should ignore it)

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The Sheep and the Wolves: Smart investing made simple

Note: This article is from J.D. Roth, who founded Get Rich Slowly in 2006. J.D.’s non-financial writing can be found at More Than Money, where he recently wrote about winning the jackpot.Imagine that you’re a farmer. You live in a rural county where everybody raises sheep.The county’s farmers, on the whole, prosper. Their flocks tend to grow by 10 percent every year. Some years are better than others. In the best years, the sheep population in the county grows by 40 percent. Little lambs are everywhere! But in the worst years — years filled with frost, famine, and disease — the sheep population can collapse to half of what it was before.Further imagine that the county becomes home to vicious predators. Wolves, perhaps. …

via Get Rich Slowly – Personal Finance That Makes Sense.:

Note: This article is from J.D. Roth, who founded Get Rich Slowly in 2006. J.D.’s non-financial writing can be found at More Than Money, where he recently wrote about winning the jackpot.

Imagine that you’re a farmer. You live in a rural county where everybody raises sheep.

The county’s farmers, on the whole, prosper. Their flocks tend to grow by 10 percent every year. Some years are better than others. In the best years, the sheep population in the county grows by 40 percent. Little lambs are everywhere! But in the worst years — years filled with frost, famine, and disease — the sheep population can collapse to half of what it was before.

Further imagine that the county becomes home to vicious predators. Wolves, perhaps. The wolves descend from the mountains and begin to eat the sheep. Some farmers protect themselves from loss, but others don’t know how — and some don’t even realize their flocks are being attacked.

The farmers who take precautions aren’t able to prevent all losses, but they come close. On farms with vigilant shepherds, only 0.10 percent of sheep are lost to wolves every year. For every thousand sheep, the wolves pick off one animal.

The farmers who don’t take precautions, on the other hand, suffer terrible losses. During the initial onslaught they lose 5 percent of their sheep. (Plus, every time they add more sheep to their herds, the wolves manage to grab another 5 percent.) To make matters worse, the wolves steadily steal 2 percent of the beasts every year. For every thousand sheep, this group of farmers loses 50 in the initial attack, and 20 more each year thereafter.

Think of it: After the first year, the smart farmers will have lost just one of every thousand sheep. The other shepherds will have lost 70 sheep.

If the county’s flocks each grew at the long-term 10 percent average during that first year, the vigilant folks would now have 1,099 sheep for every thousand they started with. The unwary farmers would have 1,024 sheep.

Now imagine that in the second year, the same pattern continues. All flocks grow at the long-term average of 10 percent, and the wolves snatch 2 percent of the animals from those farmers who aren’t paying attention. At the end of the second year, the wolf-free flocks would have grown to 1,208 sheep for every thousand that were present at the start. The flocks where the wolves run wild would have just 1,104 sheep.

Both populations of farmers enjoy the same growth rate among their flocks. The difference is that one group loses fewer sheep to the wolves.

And at the end of 10 years following this pattern? The wolf-less flocks would have grown from 1,000 to 2,566 sheep. Those under attack would still have increased, but at a much slower rate. They’d have 2,013 sheep.

Things are even worse when you look at the farmers who add more animals to their farms every year. Remember that I said the wolves slaughter 5 percent of the sheep added to the unlucky flocks? Well, assume that wealthy farmers from both populations are able to buy 100 new sheep every year — but that the wolves snatch five of these from the one group.

At the end of a decade, these wealthy farmers will have contributed a total of 2,000 sheep to their flocks for each 1,000 sheep they started with. With average long-term growth, these flocks will have grown to 4,154 animals for the lucky shepherds and 3,374 sheep for those ravaged by wolves.

Which population of farmers would you prefer to join?

I won’t belabor this analogy any longer. I think most of you get my point.

Stock-market investors are like these sheep farmers. Collectively, they enjoy investment returns of roughly 10 percent per year. Individually, however, things are different. Most investors suffer severe losses from the wolves of Wall Street. Wolves, by the way, who don sheep’s clothing to convince investors to trust them. (These investors also have a tendency to make things worse by selling their flocks when sheep prices fall and expanding them when prices rise.)

If you want to be a successful farmer, you have to understand how farming works, and how to protect yourself from the wolves. Fortunately, it’s not as tough as it seems.

The financial industry wants you to believe that investing is difficult. If you buy into their message, if you accept the premise that you need help to invest wisely, they can charge you big bucks to handle your money.

The truth is somewhat different. Investing is simple. In fact, it can be one of the easiest things you do while managing your finances. How simple? Let’s boil it down to just a few sentences.

Here’s how to invest wisely:

• Set aside as much as you can in investment accounts. Prefer tax-advantaged accounts (like a 401(k) or Roth IRA) before taxable accounts.


• Invest all of your money in a low-cost stock index fund, such as Vanguard’s VTSMX or Fidelity’s FSTMX.


• If the stock market makes you nervous, allocate some portion of your money to a bond fund. Or invest instead in a low-cost combo fund like Vanguard’s VGSTX or Fidelity’s FFNOX.


• Continue investing as much money as possible. Never touch it.(Nothing makes a bigger difference to the size of your flock investments than how much you contribute.)


• Ignore the news and ignore your fund.

That’s it. Seriously. That’s all you have to do to earn returns better than 90 percent of other investors.

There are scores of books and published research papers that support this strategy. It’s also the strategy that Warren Buffett (and other top pros) recommend for 99 percent of investors. If you’d like, you can spend days or weeks or months reading about why this works. Or you can trust these folks and do it.

Longer ago, my own flock of sheep was crippled by predators and my own bad behavior. After many mistakes, I got smart. I moved to greener pastures far from danger. Now I can ignore my sheep and go about my daily life, comfortable that the animals will continue reproducing at the long-term average without any intervention on my part. And with no danger of being consumed by wolves.

Note: Photo by James Bowe.

For more info: The Sheep and the Wolves: Smart investing made simple

Get Rich Slowly – Personal Finance That Makes Sense.

The Sheep and the Wolves: Smart investing made simple

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Another Reason Why Vanguard Target Retirement Funds Are Underrated

Another Reason Why Vanguard Target Retirement Funds Are Underrated

via My Money Blog:

Index funds are growing increasingly popular. Yet Carl Richards tweets that over the last 15 years, the actual investor return for the popular Vanguard S&P 500 index fund (VFINX) lags nearly 2% a year behind the fund’s official return. That works out to a final balance that is 24% less. This means that if you account for the timing of actual dollar inflows and outflows, the average investor in the fund actually earned a lot less than they might think. (More explanation on investor returns vs. advertised returns here.)

Here’s the data taken straight from Morningstar. The longer the time period, the worse the relative performance:

As Abnormal Returns put it, “indexing is no panacea“. I think part of the problem is that people use the S&P 500 as a proxy for the overall stock market and thus trade it much more frequently… and poorly. If you were really afraid during the 2008 financial crisis, it was really tempting to sell your stock shares and keep it in something “safe” instead like bonds or cash. You may still be in cash today after missing out on the rebound.

But what about the Vanguard Target Retirement 20XX Funds, which are basically just a mix of different index funds? Specifically, let’s take the Vanguard Target Retirement 2045 Fund (VTIVX). It’s mostly stocks, and mostly US stocks at that, so it should behave similarly to VFINX. Check out the 10-year growth chart comparison with the S&P 500 fund:

However, the average investor returns for the Vanguard Target Retirement 2045 Fund are much closer to the fund returns. The investor return over the 10-year period is actually better than the fund return, although some of that may have to do with the small asset base in 2004.

Why is this? My opinion is that people who own the Vanguard Target Retirement fund trade a lot less frequently. Part of this is self-selection. If you buy this fund, you desire simplicity. Also, if you own an all-in-one fund that holds both stocks and bonds together, you don’t have the problem of seeing one investment drop while the other rises. This is the benefit of buying a “balanced” fund.

You won’t see Vanguard Target Retirement funds being touted very much in the financial media. Their returns are rarely at the top since they are index-based, so magazines and newsletters won’t write about them. Most advisors are supposedly charging you for their “expert” advice, so they will of course recommend something more complicated. Even index fund enthusiasts like myself often don’t invest in them because we like to fine-tune and tinker (sometimes to our detriment).

Despite their boring nature and lack of publicity, I have long recommended Vanguard Target Retirement funds to members of my family. They are simple yet diversified, have very low expenses, and designed to be left alone. You don’t even have to rebalance your holdings; it is done for you automatically. Could you do better? Maybe. Could you do worse? Definitely.