Should you get a Financial Advisor?

The easiest way to manage your money is simply to use a personal financial advisor to do it for you. Banks and brokerages such as Fidelity have advisory firms that they refer clients to or have advisors who work for them. In addition, when perusing financial sites, you’ll see advertisements from companies such as Fisher Investments, touting their services.

The more money you have, the more experienced advisor you’ll be able to get. Fees are usually a fixed percentage of your portfolio, charged every year. If the advisor is part of a company, he will likely show you marketing collateral showing you their performance over the past several years in comparison to the S&P 500 return. Of course, they will show this to you if their firm has been beating the market return. Or if the firm’s objective is to give near market return at a lower risk, they will show returns at around the S&P performance.

In talking to advisors, some will rely on stock picking and advanced trading (e.g. puts/calls) to make trades. Other simply follow a diversified asset allocation model using index funds or ETFs.

One thing we know, is that it’s very hard to beat the market consistently. Even if the financial advisor is able to beat the market return, they have to beat it enough to also cover their fees charged to you. So the advanced knowledge that could enable them to perform slightly better than average is essentially washed away by their fees bringing them close to performing at the market average.

My take: Financial advisors are simply not worth it. Unless you have millions stashed away, then the fees of an advisor are probably negligible to you. But if you have under a few million dollars, you’re better off following a diversified asset allocation model and using available free investing tools from your brokerage and managing your portfolio yourself.

Why are mutual fund real returns not close to stated returns?

One very tricky aspect to evaluating mutual funds is that the stated performance of the fund is higher than the actual return you will see. This is because the mutual funds tend to tout the performance of the fund before taxes and expenses are considered. Taxes will affect you even if you don’t sell the mutual fund as any taxes resulting from selling of stocks owned in the fund will generate taxes that are distributed to all the fund owners. So when evaluating mutual fund performance, be sure to look at the numbers after consideration of taxes and expenses.

The importance of dividends

There are companies that still pay dividends to stockholders based on performance of the company. The dividends can greatly improve the performance of your portfolio. If you own mutual funds or ETFs, it is likely that companies that comprise the fund, pay out dividends. When you purchase a stock or fund, the brokerage will give you an option to reinvest the dividends instead of taking the cash. Reinvesting the dividends is a nice way to dollar cost average the purchase of additional shares. Remember that either way, the dividends will show up your 1099 and have to be reported to Uncle Sam at tax time yearly for taxable accounts.

My Recommendations for Investing

I struggled for years with managing my portfolio, gaining and losing a lot of money by following different advice. The ultimate  investment strategy is one that requires a minimal amount of management time but gives me piece of mind that I’m securing my financial future. I have read hundreds of books on personal finance, attended seminars, read magazines, and more. I came to realize that there is a lot of noise out there not relevant to the average investor. I have boiled down the investment essentials for the average investor to the following:

1. Indexing should be a core strategy for most of your investments. I recommend following an ETF asset allocation model.

Most brokerages have portfolio tools that will select a set of ETFs for you based on your profile (e.g. if you’re a younger investor, you should choose to invest more aggressively than someone approaching retirement.) These tools will take the amount of money you want to invest and based on a strategy matching your profile, will determine  an ETF portfolio and how many shares to buy of each fund. The ETF portfolio will be comprised of a dozen or so funds in different asset classes. You can simply hit one single button to make all the trades. At least once a quarter during the calendar year, you should make sure you are in balance and make trades as needed to get to the original asset allocation.  Fidelity and Schwab have this tool for account holders. Look for ‘ETF Portfolio Builder’ under the section of the website for investment tools.

Alternatively, there are websites such as FutureAdvisor that will not only give you the information about what ETFs to buy,  but will also make trades on your behalf to keep the portfolio in balance. There is a cost for the trading service, but it’s nominal compared to hiring a financial advisor. You can also opt for a lower fee in websites such as JemStep to receive emails about the needed trades and then make the trades yourself. I recommend going this route of receiving email alerts  to minimize the fees and because generally the frequency at which you need to make changes is low (2-3 times a year typically).

Below is a screenshot of an ETF Portfolio Builder tool from Schwab.

2. Restrict stock picking to a relatively small part of your portfolio and to a fixed dollar investment amount.

I don’t recommend the average investor spend time picking individual stock and funds. The track record for average investors picking stocks is not good. Also the average investor won’t put the time in to track those investments on a weekly or even monthly basis and determine when it’s time to sell the position.  If you truly want to stock pick, then assign a fixed amount of money to invest that you’re comfortable losing. For example, I allocated $25,000 as money I would play with for stock picking. I could have invested more but didn’t want to take a chance. So if I really feel strongly about a stock, I can buy it. I just don’t make individual stocks my core strategy.

3. Maximize contributions to retirement accounts.

Putting as much money as the IRS will allow into retirements accounts will enable you to grow your investment tax-deferred which will net you more money in retirement. Also it will lower your gross income so you pay lower in taxes in the present. Of course, take your company 401K match if it’s offered.

4.  Find a good mutual fund newsletter.

While,  I follow an indexing strategy for most of my portfolio,  indexing can slightly underperform the overall market because of reduced risk in using asset allocation. In other words, asset allocation lowers the riskiness of your portfolio (as it contains bond components and other less aggressive funds). This can lower your overall portfolio return compared to the market average.

I’m willing to take on a little more additional risk with the chance of getting a higher payout by using mutual fund newletter recommendation. Mutual fund newsletters are offered by investment firms. You basically buy the recommended portfolio. Every week, you get an update as to whether or not to make any changes to that portfolio. I follow a newsletter called  “Fidelity Insight and Monitor” for my rollover IRA account.

Hulbert Interactive is newsletter that ranks investment newsletters. You can use this to see the highest rated newsletters. But note, there is no one newsletter that is always on the top.  However, you can still see the newsletters performance compared to others. Check the published performance numbers of the newsletter to help you find a good one.

With Fidelity Insight, I looked at the newsletter performance compared to the S&P 500 performance for the history of the newsletter (over 25 years). There were years where it underperformed the S&P 500 but overall it had more years where it met or exceeded (very slightly) the S&P. Diversifying and buying several funds simply helps you get the market average but with lower risk than if you bought only one fund that tracks the S&P 500 only. Again, you won’t see returns that wildly surpass the market average, but you may achieve the market return or very slightly surpass it with a lower risk than buying an S&P index fund.

5. Own alternative investments like REITs in your IRA.

A good way to diversify your stock portfolio is to own REITs or Real Estate Investment Trusts. These are funds that buy real estate stocks. I follow a simple strategy to buy a REIT index fund, for example Fidelity Real Estate Fund (FRESX). It’s best to own these in your IRA as REITs have a lot of turnover and therefore result in capital gain taxes when the fund sells any of its holdings. In your IRA, you can avoid paying these taxes.

401ks typically don’t offer REITs. So the IRAs would have to be ones like ROTH, Individual, or Rollover IRAs. Again, indexing should be your core strategy. But diversification with REITs gives you some diversification into real estate without dealing with the hassle of buying actual property.

Irrationality of CNBC and Jim Cramer

It’s easy to get intimidated about investing from the incessant commentary on CNBC and other networks offering second-by-second  live reporting on the stock market  movements. Listening to the day-long programming on the stock market ups and downs,  the opinions of ‘experts’,  and news about the economy, can make one feel like if you’re not taking frequent action on your investment portfolio, you must be missing out on something.

Especially annoying for me are the stock tips from Jim Cramer. The recommendations for stock picks never come with accompanying sell recommendations. Of course, the track records of every recommendation are not discussed. This is hype TV, purely entertainment. If you’re the average investor, do not get lured into following the advice unless you’re willing to continue the analysis of the stock and truly understand the fundamentals of the business you are investing in. Quite frankly, this is not behavior of the average investor. The average investor would buy and hold forever or until the money is needed.

Remember, Jim Cramer as well as many other “professional stock pickers” have been wrong and have lost investors a lot of money. Of course, there will be winners amongst recommendations but knowing which will be a winner  is impossible. Also keep in mind that when a stock is hyped and investors follow the herd, the price can get driven up only to allow those already invested to pull out and make a profit at your expense.

The truth about Morningstar ratings

Morningstar has long been the go-to resource to evaluate mutual funds. We’re led to believe that a 5 star fund is supposed to be a good one. But many times,  the 5 star fund of today is the dog fund of tomorrow.  As an example, I bought Janus Oversees Fund (JAOSX) in 2007. It was labeled a risky fund but had a stellar year with a 47% return in 2006 and hence was a 5 star fund.

In 2008, the fund performance was *negative* 52 %! I lost over half my investment. The fund became one of the worst in it’s category and a 2 star fund not long after I purchased it. It went from #1 in it’s category of Foreign Blend fund to #90 in just 1 year.   6 years after  purchasing it, I still haven’t recovered my initial investment. Moral of the story: few funds stay 5 star funds for extended periods

It’s fine to use Morningstar and read their reports. However, keep in mind that the evaluation is a snapshot of *today* not of a few months, a year or years down the line. Most of us buy mutual funds as part of a long term strategy. So keep in mind that you can’t simply take Morningstar ratings at face value.

In addition, you should not compare the rating one fund with another unless the funds are in the same category of investment type.  For example, a bond fund will be measured for performance against other similar bond funds. A  European stock fund will be measured against other European stock fund. You can not compare ratings of a domestic fund to an emerging markets stock fund to pick the best investment for your portfolio.

Bottom line:  Morningstar ratings help you compare funds in the same category and rank funds. However, ratings can change so don’t choose to invest in a fund solely because of it’s rating.

Taxable vs. Tax-Deferred Accounts

It’s important to consider the types of investments you make in your taxable and tax-deferred accounts. Tax-deferred accounts include retirement portfolios such as 401ks and IRAs. Everything else is generally a taxable account. The difference between taxable and  tax-deferred accounts is that you can defer or avoid all together paying taxes (in the case of Roth IRAs)  until you are ready to withdraw the money at retirement. This means you can freely defer taxes on any profits. This is advantageous because you can reinvest the money you would have otherwise paid taxes on and therefore grow your investments even more. For some (not all), your tax rate at retirement will be lower assuming you are withdrawing less from your IRA than what you made when you were salaried.

Tax-deferred account are an ideal account to hold mutual funds that tend to generate a lot of distributions. As an example, funds that have a lot of turnover (changing of stocks that comprise the fund), will generate distributions when selling the existing positions in the fund. As a result, even if you personally don’t sell the mutual fund, you will be required to pay taxes on the distributions since the distributions are shared amongst all investors in the fund. For example, REIT funds tend to have high turnover. So personally, I own all my REITS in my IRA accounts and not in my taxable account. Furthermore, it’s preferable to own ETFs in your taxable accounts over equivalent mutual funds since ETFs are treated like regular stocks where you only pay taxes when *you*  sell and have a gain (as opposed to being taxed on distributions in the mutual fund even when you don’t sell the fund).

The Simplest Investment Strategies

It is very important to not take a random approach to investing. In talking to many average investors about their strategies, I found that often  a random approach is taken when selecting what to invest in for 401Ks and other investment accounts. This is perpetuated  by the overwhelming amount of information about stock picks, mutual fund and ETF options. Between all the books, TV programs, and friendly-advice, it can become very confusing determining the best approach for you.

There are some simple strategies that you can follow. While these strategies may not outperform the market, they are still very effective. Remember it’s very hard to outperform the market average even for the most experienced investors. Rather than figuring out how to beat the market, instead focus on how to get the market average with the lowest possible risk.

Target Date Funds

This is the simplest strategy. You only have to invest in one mutual fund that has a specific retirement date. These are offered by all the major brokerages. For example, Vanguard offers Vanguard 2040 (VFORX) which is optimized for those planning to retire in 2040. The fund is a composition as of 12/31/13 is 63% of the Vanguard Total Stock Market Index Fund,  27%  Vanguard International Stock Index Fund,  8.1% Vanguard Total Bond Index Fund,  and 1.9%  Vanguard Total International Bond Index Fund.  As the years progress, the allocation will change to be less aggressive with more invested in bonds.

Not all target funds are created equally.  So choose the target fund offering carefully. You should find a target fund with expense ratio under 1% and one that relies on indexing.

The nice thing about target funds is that it’s the closest to a ‘set and forget’ strategy that you can find. You don’t have to concern yourself with rebalancing as it’s done for you. You can easily set up an automatic investment schedule where you regularly schedule purchases of the target fund in order to dollar cost average your new investments.

Three Fund Diversified Portfolio

This is a simple strategy recommended by books such as Armchair Millionaire and several books written by Daniel Solin. The idea is to maintain a portfolio of 3 index funds. One fund is a domestic US stock fund, an international fund, and a bond fund. There are varying levels of percentages to own in each fund depending on how aggressive a portfolio you desire. Check out the book by Daniel Solin called “The Smartest Investment Book You’ll Ever Read” for specific fund recommendations.

Diversified ETF Portfolio

ETFs are touted as a way to reduce expenses since management fees are usually less than equivalent mutual funds. Several online website and brokerages offer free ETF portfolio builders to help you select the exact funds to own and how many shares to buy based on your desired investment profile. These portfolios are usually comprised of 10-12 ETF in a variety of sectors including US domestic stocks, bonds, emerging markets, real estate, European stocks, and commodities. You basically purchase shares to meet a specified allocation in each sector. As ETF values change, eventually you will fall out of balance within your asset allocations. For a nominal monthly subscription fee, some of these tools such as MarketRiders  will  alert you when you go out of balance in any of your asset allocations and send you specific alerts about what to buy and sell in your account to get back to a balanced portfolio. For a higher fee, some services will make the rebalancing trades for you. Or you could choose to manually check your portfolio every quarter and determine if your portfolio is still balanced to the original allocations.

Mutual Fund Newsletter Recommendations

There are numerous investment newsletters that  provide model portfolios maintained by experienced investment experts. (Note, I don’t recommend stock picking newsletters since these are less diversified). Hulbert Financial Digest regularly ranks newsletters. I personally follow “Fidelity Insight and Monitor” which offers several portfolios with varying degrees of risk that are comprised of 5 Fidelity Investments funds. I follow their moderately aggressive portfolio. There are weekly updates on the stock market along with alerts if trades are planned in the portfolio. In my experience with using the newsletter, there haven’t been more than 2 trades per year usually consisting of selling part are all of one position in a fund in exchange for another. It’s been very easy to follow and the performance has been good.

Portfolio Management Websites

There are now numerous portfolio management websites that provide investing guidance for a nominal cost. I will review these in a future blog entry. The gist is that some sites such as FutureAdvisor and MarketRiders  recommend an ETF portfolio, monitor performance and alert you when it’s time to make a trade. FutureAdvisor will even make the trades for you for additional fees.   Other sites such as Betterment charge a percentage of your portfolio to manage your investments as opposed to giving you specific recommendations to trade. You pay more when the portfolio is managed for you.  The intention of these sites is not to beat the market but to get the market return while managing risk. Trades are thus relatively infrequent.

Why is investing so confusing?

Do-it-yourself portfolio management can be a daunting task.  There is no clear cut strategy to follow yet unlimited advice available.  Stock tips are touted by “stock picking pros” like Jim Cramer. Hundreds of investment books swear by strategies ranging from selecting value stocks to sector momentum models. Dozens of newsletters exist that for a subscription fee will provide stock and mutual fund recommendations. Even simple indexing strategies have many considerations such as  deciding between ETF or mutual fund based portfolios and 3 fund to 12 fund asset allocation models. Morningstar rates funds but with thousands of funds with different focus, there’s no clear path where to start.

Even employer 401K programs which provide a narrowed selection of investment options  still require a strategy in choosing from within the provided choices. Since each person has different goals and priorities especially due to age, multiple investment options are necessary but confuses the selection process. Unfortunately, most employers don’t train employees to understand how to invest retirement money.

Index funds are universally lauded as the best strategy to get a good long term return. But even with indexing, there are questions: how many funds should I own, which funds, what’s the allocation of each fund? It’s definitely  not easy for most of to sort through all of this.

You can choose to hire a  financial advisor. But is it worth forking over a percentage of your portfolio or high fees  even if your portfolio loses money? Are those advisors simple following a routine indexing strategy as opposed to delivering  market-beating performance?

There are some sobering statistics that indicate that despite all the stock maneuvering that professionals or individuals do, for the most part they don’t beat the market. In fact, fewer than 1% of mutual fund managers persistently beat the market.

It’s no wonder that the average investor can get caught in stagnation and from truly strategizing their investment portfolio.  However, As I learned with a little education, it’s not hard to learn enough of the essentials and manage your investments without a lot of pain.

Traits of the Average Investor

For many of us, investment management is inconvenient but necessary. We have money invested in the stock market and are counting on decent returns to meet our financial goals especially for retirement. We are what I define as the ‘average investor’. We’re not finance majors and we’re not spending our hours in the day trading stocks. The following are common traits of the average investor:

1. The average investor is relying on the stock market to help with retirement because he/she knows that saving money under a mattress isn’t enough to meet future needs like retirement.
2. The average investor doesn’t have time or inclination to research thousands of investment options.
3. The average investor uses simplistic devices like Morningstar ratings to make investment decisions.
4. The average investor would prefer to not pay financial advisors to manage their portfolio because of high fees.
5. At some point in time, the average investor has followed a stock tip from TV, a magazine or friend or relative and lost money.
6. The average investor does not make the advertised returns of a mutual fund.
7. The average investor has either a net loss or marginal gain in the stock market (compared to those on Wall Street).
8. The average investor prefers a ‘buy and hold’ stock strategy because he doesn’t have time to track and research the stock to determine when to sell.
9. The average investor is afraid to sell when the stock is up because of the fear or pulling out to early and missing more gains.
10. The average investor is afraid to sell when the stock is going down because it means acknowledging lost investment money.

The average investor is actually the group who relies on Wall Street the most. They are not yielding large bonus checks every year or have a substantial inheritance. This group needs a return that beats inflation to get to their retirement goals. Saving into a 401K at the max rate is likely not going to yield enough income. There are concerns about Social Security benefits being reduced in the near future. It’s important for the average investor to get educated!