Index funds

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#290 Stop Trying to Beat the Market: Use Index Funds

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Stop trying to beat the market, because you can't. That sage advice comes from investment legend Charley Ellis, who has been keeping tabs on the debate between active and passive investment management for five decades. In his new book “Index Revolution: Why Investors Should Join it Now” Charley argues that indexing is the most efficient and cost effective way to achieve your long term financial goals. He states it clearly: “The stunning reality is that most actively managed mutual funds fail to keep up with index funds.”

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Ellis founded Greenwich Associates in 1972, creating a financial industry consulting firm that would become a go-to resource for the biggest fund managers and Wall Street firms. One of his many claims to fame is that he was the first industry insider to publicly proclaim that most active portfolio managers do not keep up with the benchmarks they are trying to beat, and that investors are better off in low-cost index funds. That admission occurred in 1975, when he wrote a timeless article, titled The Loser’s Game. In the article, he explained the quandary that active managers face and quantified their disappointing results. It was the same year that Vanguard launched the first index mutual fund. In addition to writing and talking about the industry, Charlie serves on as an Investment Committee member of Rebalance IRA.

Thanks to everyone who participated this week, especially Mark, the Best Producer/Music Curator in the World. Here's how to contact us:

  • Call 855-411-JILL and we'll schedule time to get you on the show LIVE 
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Join the Index Fund Revolution!

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When he entered the investment world fifty yeas ago, Charles (“Charley”) Ellis fund that diligent financial analysts and portfolio managers could routinely outperform the stock market. But as the investment industry changed, information became ubiquitous and institutions replaced individuals, it has become “unrealistic to try to beat today’s market.” I recently had the pleasure of talking to Charley about his amazing career and his new book “Index Revolution: Why Investors Should Join it Now”. The book and the conversation left me even more convinced that investors are spinning their wheels using anything but index funds to achieve their long-term financial planning goals and objectives.

It is quite stunning to hear this message from a man who began his life on Wall Street in the early 1960’s as an analyst and then as a financial industry consultant at Greenwich Associates, the firm that he founded in 1972. Perhaps because Charlie became a go-to resource for the biggest fund managers and Wall Street firms, his early view that most active portfolio managers could not keep up with the benchmarks they are trying to beat -- and that investors are better off in low-cost index funds – was so fascinating. That admission occurred in 1975, when Charley penned the now-prescient article “The Loser’s Game”. His view about the virtues of indexing has become stronger and clearer 40 years hence.

In his 18th book, Charley is beating the drum for index funds. “The stunning reality is that most actively managed mutual funds fail to keep up with index funds.” The most recent evidence from S&P Global proves the point: the S&P Indices Versus Active (Spiva) scorecard shows that 90.2 percent of actively managed US funds failed to beat their benchmarks, when their returns are calculated net of fees.

These types of reports have been available for years, yet index or passive funds still only account for a third of mutual fund assets. Sure, that’s up from a quarter three years ago, but a majority of individuals and professionals, some of whom owe fiduciary duties to their clients, “refuse to accept the objective data or insist on looking past it.”

Why do people delude themselves about beating the market, when as Nobel Laureate in Economics Daniel Kahneman, notes “They’re just not going to do it. It’s not going to happen.” Maybe investors want to believe that someone, some firm or some algorithm can beat the market, because the industry has told them that it is possible.

Early on, the asset management business condescendingly proclaimed that “indexing was for losers” and that investing in an index fund would be tantamount to confining your performance to just “average”. The industry’s marketing tactics has evolved, but even today, companies make big ad buys and trot out their analysts to tout “market-beating” funds, when the plain fact is that over time, they will not deliver consistent market-beating performance.

Charley notes that in making their case for active management, these folks rarely mention risk, nor do they adjust their data for taxes. Even the term “passive” can invoke a subliminal, negative connotation. After all, “Who wants to be passive?” asks Charlie. “Nobody will ever know just how much harm was done by wrapping the term passive around investing.”

Perhaps the most damning outcome of spending time and energy focusing your efforts on the fool’s errand of finding the market beating investments is that doing so can divert your attention from the more important financial planning issues in your life. Charlie writes that “Indexing simplifies everything,” and enables people to concentrate on “developing a balanced, objective understanding of themselves and their situation.” Amen.

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How Much Money do you Need to Retire?

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As we conclude National Retirement Planning Week, it’s time to ask the perennial question: How much do you need to retire? The answer depends on a variety of personal factors, starting with how much you need to float your lifestyle today. Because so many people hate the idea of figuring out what they are spending now, they often use an old financial planning calculation to determine their retirement income need: reduce current salary by 20 percent. The rationale behind this strategy is that in retirement, people will no longer be on the hook for payroll taxes, retirement plan contributions or commuting costs.

Of course if you are living on far less than 80 percent of your current pay or some of your big expenses will disappear during retirement (mortgage, school loans), you may want to use a lower monthly need. Then again, according to a report by HealthView Services, the average couple should expect to spend $266,600 throughout retirement on health care. So maybe that 20 percent reduction is not such a bad substitute for your future monthly nut.

Once you have your retirement need in hand, you need to determine how much income you will receive from Social Security and pensions. Any shortfall between your monthly need and your stream of income has to come from your investments.

I continue to emphasize the importance of using a reasonable “withdrawal rate,” which is the percentage that retirees can safely withdraw from their assets annually without depleting their nest eggs. A conservative withdrawal rate is 3 to 3.5 percent on an annual basis. That means every $1 million you save can generate about $30,000 to $35,000 of annual retirement income.

The biggest problem in answering the question of how much do you need to retire, is that it requires a lot of moving parts to operate smoothly over a long period of time. As economist and New York Times columnist Paul Krugman says: “In an idealized world, 25-year-old workers would base their decisions about how much to save on a realistic assessment of what they will need to live comfortably when they’re in their 70s…In the real world, however, many and arguably most working Americans are saving much too little for their retirement. They’re also investing these savings badly.”

How badly are Americans at investing? A recent Bankrate.com study found that just 48 percent of Americans own stocks or stock mutual funds. Of those who don’t participate in the stock market, 53 percent say they simply don’t have the money to invest. Considering that median per capita income, adjusted for inflation, has basically been flat since 2000 and many Americans are still climbing out of a massive hole from the Great Recession, that result is not surprising.

But a whopping 39 percent cite reasons for avoiding stocks that are worrisome: 21 percent don’t know about stocks; 9 percent don’t trust brokers or advisors; 7 percent think stocks are too risky; and 2 percent are afraid of high fees. All of those rationalizations can be resolved without much work, especially in an age of abundant, free information and resources.

In honor of financial literacy month and retirement planning week, here are a few answers to questions that may be keeping people sidelined from the market:

What is a stock/Isn’t owning a stock risky? When you own a share of stock, you are a part owner in a publicly traded company. Stocks as an asset class are risky, which is why when most people invest, they use mutual funds and spread out their risk among different assets, like stocks, bonds, real estate and cash.

What if I don’t trust brokers or advisors and/or want to avoid high fees? To invest without an intermediary in an affordable way, just use no commission index funds. Some of the most inexpensive index funds are offered through Vanguard, Fidelity, T. Rowe Price, TD Ameritrade and Charles Schwab.

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#203 Who's Watching Financial Fiduciaries?

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We always talk about the importance of working with fiduciary advisors, but who's keeping tabs on them? Guest and current FPA President Ed Gjertsen weighs in on the question. He says that the oversight is conducted by a trio of entities: the CFP Board of Standards, the SEC and FINRA. Ed also discussed why he and the FPA remain "fee-neutral".

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Jack from GA needed advice about his future retirement from the military, we discussed in greater detail why revocable trust may not be necessary for most and reviewed new IRA rollover rules for Marilyn.

In case you missed it, last week was the official start of tax season. Here's last week's CTM segment outlining what you need to know about changes to your tax returns and here's how to stick to your New Year's Financial Resolutions.

Thanks to everyone who participated and to Mark, the BEST producer in the world. Check out Mark's first-producing credit for this CBS Evening News segment that aired recently. If you have a financial question, there are lots of ways to contact us:

  • Call 855-411-JILL and we'll schedule time to get you on the show LIVE 
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#202 Downsizing, Dollar Cost Averaging

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Oh sure, I wanted to call this episode, "Islanders Shutout Rangers," but this is a financial, not a sports show...and after all, I can only torture Mark so much. After a brief recap of the game, we spoke with Tom (a Bruins fan), who needed help deciding whether or not he should downsize prior to retirement.

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Vicky and John sought guidance on putting cash to work, which allowed me to explain how hard it is to time the market and why even if you are risk averse, you may want to allocate a small percentage of your portfolio to stocks.

Jennifer had an interesting question about how to treat her rental properties; Rosetta and an anonymous e-mailer had estate questions; Jeff, JD and Mark asked about index funds vs. ETFs vs. Robo-Advisors; Alan asked about scrubbing his credit report of errors; and Vicky asked about ditching whole like policies for her kids.

Here's last week's CTM segment about weak retail sales and the negative impact on stocks.

Thanks to everyone who participated and to Mark, the BEST producer in the world. Check out Mark's first-producing credit for this CBS Evening News segment that aired recently. If you have a financial question, there are lots of ways to contact us:

  • Call 855-411-JILL and we'll schedule time to get you on the show LIVE 
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#201 New Year's Reallocation, Student Loan Forgiveness

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Forget New Year's resolutions; we're doing New Year REALLOCATIONS! Shane kicked off the conversation with a good problem: What to do with $500K in cash? One easy place to start: A diversified portfolio, that takes into account risk tolerance and time horizon.

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Larry is on the other end of the risk spectrum from Shane, but maybe that's just fine for his situation. Both Carolyn and Jerome asked about how to select a financial advisor.

These questions provided a perfect opportunity for me to explain the different types of advisors and the various ways you can pay for services. For more, you can check out: Protect Against Scams: 10 Questions to Ask Financial Advisors. We also were able to exonerate Brian from his self-described "financial malpractice".

Finally, here's last week's CTM segment about the diving stock and oil markets.

Thanks to everyone who participated and to Mark, the BEST producer in the world. Check out Mark's first-producing credit for this CBS Evening News segment that aired recently. If you have a financial question, there are lots of ways to contact us:

  • Call 855-411-JILL and we'll schedule time to get you on the show LIVE 
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Buy What You Know: A Dangerous Investment Strategy

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Legendary investor Peter Lynch, whose investment management skills helped attract billions of dollars into the Fidelity Magellan Fund from 1977 until 1990, once famously advised small investors, “Buy what you know.” The concept was simple: if you buy what you understand, you are less likely to be led astray.  While it sounds pretty easy, there are some serious flaws with the “Buy what you know” investment strategy. According to Blackrock’s Russ Koesterich, while the Lynch saying sounds reasonable, it can lead some to create a portfolio heavily concentrated in local companies. Koesterich notes, “The fact that a company is headquartered in my hometown probably doesn’t make me any better qualified to judge its investment prospects.”

Even if you were trying hard not to be local, buying what you know may lead to rough results. For example, if you were an average consumer/investor looking to assemble companies that are familiar to you, these are some of the stocks you might choose and their year to date performance through July 25th:

Amazon.com (-18.8%), AT&T (+1.1%), Bank of America (+0.1%), Bed Bath & Beyond (-22.1%), eBay (-3.8%), Facebook (+37.6%) General Motors (-14.2%), LinkedIn (-18.2%), Staples (-30.8%), Wal-Mart (-3.5%). Sure over the long term, these companies are likely to do fine, but while you are spinning your wheels trying to “buy what you know”, you could have simply purchased an S&P 500 index fund, which during the same time horizon, was up 7 percent.

Buying what you know may have worked for a couple of individual companies (think of those early Apple users or those who stumbled into a store like Home Depot in the mid-1980’s), but trying to identify a dozen or so stocks in different industries to create a diversified portfolio is very difficult to achieve. Individual stock picking isn’t hard just for retail investors; even pros that oversee managed mutual funds have a tough time consistently beating the index against which they are compared.

S&P Dow Jones Indices issued a research report, which found that not many managed funds were able to consistently reach the top quartile of performance over five successive years. In fact, just 0.7 percent of the funds can stay above the fray for five years.

The good news is that investors are finally embracing the simplicity and strength of index funds, as they realize that it is very difficult to beat the index after factoring in costs and fees. According to the Financial Times, the world’s largest active fund managers, Lynch’s beloved Fidelity Investments and Capital Group, which operates American Funds, are losing out to index funds. “Figures compiled for the Financial Times by Morningstar show that investors withdrew a net $3.5 billion from Fidelity’s US funds in the six months to the end of June, while Capital Group’s American Funds managed inflows of less than $600 million. That compared to $64 billion flowing into Vanguard.”

This is not to say that investors will avoid making mistakes if they use index funds. According to the St. Louis Federal Reserve Bank, the average equity mutual fund investor, whether in a managed fund or an index fund, “tends to buy when past returns are high and sell otherwise.  This is called return-chasing behavior.” There is a steep cost to this behavior: it costs the average U.S. mutual fund investor to “miss around 2 percent return per year, which is very significant.”

How do you avoid return-chasing behavior? It’s the same old mantra: start by building a diversified portfolio, because as Koesterich observes, “over the long term, all the evidence still suggests that diversification – by asset class, geography, and sector – leads to better portfolios; portfolios that produce better returns per unit of risk.” That portfolio should factor in your risk tolerance and time horizon and you should keep expenses low with index funds; and rebalance the portfolio quarterly. Despite the lack of a catchy saying, this seemingly boring philosophy actually works!

Radio Show #137: Debt Deal Done (Now Back to Work!)

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Congress finally got its act together and agreed on a deal to reopen the government and raise the debt ceiling. Sure, we may have to go through this all over again in January and February, but in the mean time, it's back to our regularly scheduled programming!

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Our young listeners are so great, because in answering their questions, I can review some of the basic premises we should all be applying throughout our lives. Leah got us started with questions about rolling over an old retirement plan and whether or not to combine assets with her soon-to-be husband. Aaron's wife wants to buy a house, but is that the best idea at this point in their lives? Steve needed advice about where to invest $5K and Tim and his wife have whole life insurance and want to know whether to exchange it for term -- YES! 29 year old Jaydan wrote such a nice e-mail, that I wanted to give him a shout-out on the show and in the show notes as well.

On the retirement front, Cheryl asked about the nasty provision of Social Security that reduces benefits for federal employees (Windfall EliminationProvision (WEP) and Government Pension Offset (GPO). While there is legislation pending to undo these punitive rules, given the state of affairs in DC, I wouldn't hold my breath for action.

Ena has a wonderful problem: she has saved $1.35 million and needs a strategy to create income from the portfolio in retirement. Now is a good time to interview fee-only advisors. Howard asked about index vs. managed funds (INDEX RULES!), Andy is weighing a lump sum versus an annuity for his wife's retirement account, and Robert asked about the file and suspend strategy for Social Security.

Thanks to everyone who participated and to Mark, the BEST producer in the world. If you have a financial question, there are lots of ways to contact us:

  • Call 855-411-JILL and we'll schedule time to get you on the show LIVE 
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Index funds: STILL the best bet

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“What does your fund manager do?” screamed the headline of the April 8 2013 edition of Barron’s. All I could think was, “What, indeed!” The article says some superstar fund managers “fly around the world, they crunch reams of data, they dissect industries,” and ultimately, they beat the index against which their funds are measured. Here’s the problem: even if there are some diamonds in the rough (and believe me, it’s rough out there in managed mutual fund land!), it may not even be worth trying. The reason is clear: it is very difficult to beat the index after factoring in costs and fees.

A recent survey by the London investment firm Style Research analyzed 425 global equity funds versus the MSCI World index. Without fees, 59 percent of the managers beat the index. However, after investor fees were included, only 31 percent beat the index last year.

And it gets harder to beat year after year, because investors tend to pile into the good funds only after they have beaten their relative indexes. Once new money flows into these funds, costs tend to rise and the funds can get too large and cumbersome for the manager, which together make outperformance more difficult to achieve in the future.

There has been some good news on fees: According to the Investment Company Institute, all mutual fund fees have been trending lower. The average expense ratios for equity funds have fallen from 0.99 percent in 1990 to 0.79 percent in 2011, a decline of 20 percent. But a good chunk of that decline may be attributable to the shift towards no-load (no commission) funds. Actively managed equity funds still have average fees of 0.93 percent, while index equity funds have average fees of 0.13 percent.

How do you find the good ones? It will take some work: you will need to identify active managers with a proven track record, who can consistently stick to an articulated and prudent strategy. You will also want to look for a fund that maintains low investment costs, administrative and advisory fees, plus costs due to portfolio turnover, commissions, and execution.

If you prefer to spend your time in other ways and want to make your investment life a little easier, there’s a simple solution: instead of trying to beat the index, just buy the index! Last month, index fund pioneer Vanguard issued a research report comparing index versus managed funds, and noted “persistence of performance among past [managed fund] winners is no more predictable than a flip of a coin…low-cost index funds have displayed a greater probability of outperforming higher-cost actively managed funds.”

Index funds have been around since the early 1970’s, but suffered from a definitive “un-cool” status for a long time. It was much more fun to think that some manager held the keys to the investment kingdom and your financial freedom, then to imagine that all you needed was a few index funds in different asset classes. And there was no massive brokerage sales force and marketing campaign blazing the trail for the stodgy index fund. Of course the commission-based broker who was touting managed mutual funds had a great incentive: only the expensive, loaded mutual funds would pay them.

But in the aftermath of the financial crisis, boring has become a bit more attractive. Many investors dumped their managed funds and decided that they would prefer to start the investing year with the extra 0.80 percent in their own pockets. According to fund-tracking firm Morningstar, assets in U.S. index mutual funds and exchange-traded funds (ETFs) accounted for 34 percent of equity and 18 percent of fixed income funds as of year-end 2012.

My hope is to see those levels steadily rise, as do-it-yourself investors wise up or as investors who work with advisors choose fee-only or fee-based professionals who tend to adhere to a strategy of indexing.

Distributed by Tribune Media Services

Radio Show #126: Rush HEARTS Jill on Money!

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Sometimes fans come from out of the blue…we are grateful that a radio legend discovered Jill on Money!

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Meanwhile, back on the show, our regulars kept us busy. Mike from NY needs advice on how to break up with his current advisor; Kristen from TX asked about hardship withdrawals from retirement accounts; and Wanda from KY and Kathryn from MN are each weighing under what conditions to consider long term care insurance.

We love hearing from our young listeners too! Justin from MA is strategizing about student loan pay downs; Joe from VA has an 18-year-old son, who needs guidance about which kind of accounts to open; and Rainey’s 29-year-old granddaughter is considering a low-minimum investment vehicle for her Roth IRA.

We fielded a variety of investment questions from John, Ed, Mim and Raymond covered a lot of ground in terms of general research and protecting against emotions.

Mark asked about rolling over an old retirement plan and Pat inquired about dollar cost averaging.

Thanks to everyone who participated and to Mark, the BEST producer in the world, who was alone while Christina the intern was on vacation. If you have a financial question, there are lots of ways to contact us:

  • Call 855-411-JILL and we'll schedule time to get you on the show LIVE