NOTE:  This post is part of an ongoing education series.  This information is for educational purposes only.  This information does not constitute investment advice.  No rational person would make investment decisions based on a blog post.  Please consult with your financial advisor before taking any action.

A few weeks ago I did a post on the value of investing in gold.  I was a little surprised by some of the responses that I received.  It was almost like the responses I get when discussing abortion, truthers and birthers.

This graph created by John C. Bogle and is in his book “Common Sense on Mutual Funds (2010).  It shows the returns for several investment classes from 1802 to 2008 in real dollars (real dollars are after an adjustment for inflation) (note2: The total return is a log scale).  John C. Bogle is the founder of Vanguard and is recognized as one of the greatest minds in the investment world. Mr. Bogle also had this to say about gold…

“  …gold is largely a rank speculation, for its price is based solely on market expectations.  Gold provides no internal rate of return.  Unlike stocks and bonds, gold provides none of the intrinsic value that is created for stocks by earnings growth and dividend yields, and for bonds by interest payments.  So in the two centuries plus shown in the chart, the initial $10,000 investment in gold grew to barely $26,000 in real terms.”  Common Sense on Mutual Funds(2010), Page 13.

With this additional support, I stand by my position that gold is not a good long term investment.

NOTE:  This post is part of an ongoing education series.  This information is for educational purposes only.  This information does not constitute investment advice.  No rational person would make investment decisions based on a blog post.  Please consult with your financial advisor before taking any action.  If you do need help with your investments contact us.

Some content and ideas are taken from the Center for Behavioral Finance.  The use of this content is not intended to be an endorsement of the Center for Behavioral Finance or Allianz Global Investors.  It is used as a framework to facilitate discussion on this important topic.

I am always a little worried when an investment company talks about how to work with investors.  I always worry that they are focused on selling product and not actually being helpful.  While I don’t agree with everything in this report from The Center for Behavioral Finance some of the content is very useful.

TWO MINDS….

Kahneman uses the framework of “two minds” to describe the way people make decisions (Stanovich and West, 2000). Each of us behaves as if we have an “intuitive” mind, which forms rapid judgments with great ease and with no conscious input; “knowing” that a new acquaintance is going to become a good friend on first meeting is one such judgment. We often speak of intuitions as “what comes to mind.”We also have a “reflective mind,” which is slow, analytical and requires conscious effort. Financial advisors engage this mind when they sit down with clients and calculate a retirement framework based on their risk profile, current circumstances and future goals.

For this discussion the  Two Mind concept  kinda works when describing some of the behaviors of investors.  First is this comment about the “intuitive” mind.

At the core of many of these powerful but erroneous intuitions is people’s hyper-negative response to potential loss, or “loss aversion,” as described by Prospect Theory (Kahneman and Tversky, 1979). Simply put, losses loom larger than equal-sized gains.

I have seen this many times.  People will buy very bad and complicated products just because they think it will keep them from loosing money.  There are always risks with investing.  If you lower the risk – you will likely lower the returns.  If someone tells you that you can make high returns with very low risk be very careful.

This Warren Buffet quote show us the “reflective mind”.

“Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful.”

One of the reason I like Index funds is that they take away some of the anxiety of when to buy and sell stocks.  The full length version of the  Behavioral report had this great study.

A separate study of transactions in 19 major international stock markets produced equally salutary warnings against the urge to beat the market by too frequently buying and selling securities. Between 1973 and 2004, the average “penalty” for repeated buying and selling as opposed to a buy-and-hold strategy in these markets was 1.5 percent (Dichev, 2007).

The vast majority of investors lose money by trying to beat the market.  It cannot be said enough times – use a buy and hold strategy and use ultra low cost index funds.  If you don’t know how to do this you will be well served to hire a financial advisor.

NOTE:  This post is part of an ongoing education series.  This information is for educational purposes only.  This information does not constitute investment advice.  No rational person would make investment decisions based on a blog post.  Please consult with your financial advisor before taking any action.

from Reuters.

Standard & Poor’s threatened Monday to downgrade the United States’ prized AAA credit rating unless the Obama administration and Congress find a way to slash the yawning federal budget deficit within two years.

“Because the U.S. has, relative to its AAA peers, what we consider to be very large budget deficits and rising government indebtedness, and the path to addressing these is not clear to us, we have revised our outlook on the long-term rating to negative from stable,” S&P said.

Almost everyone now accepts that the budget deficit is too large.  The big problem is how does one bring it down?  Cutting “small” $200 million programs like NPR and Planned Parenthood are not going to do it.  Here are the five things that need to be done:

1) Get out of Iraq.

2) Close loopholes that allow companies to make billions in profit and pay $0 in taxes. (I’m talking to you GE!)

3)  Tax increase on people making over $250,000 per year.

4)  Get out of Afghanistan.

5)  Start making serious adjustment to large parts of the budget.

The potential upside is that our government gets serious and makes some of these changes.  However….

A downgrade, which would leave Germany and France with a higher rating, would erode the status of the United States as the world’s most powerful economy and the dollar’s role as the dominant global currency.

If investors start demanding higher returns for holding riskier U.S. debt, the rise in bond yields would crank up borrowing costs for consumers and businesses. That would threaten to hurt the economy as it recovers from the worst recession since World War II.

If this is not clear to you – it would be very bad.  The US does have a lot of debt.  It has not been a problem because the interest rate is very low.  If the rate goes up – the problem get a whole lot worse.

NOTE:  This post is part of an ongoing education series.  This information is for educational purposes only.  This information does not constitute investment advice.  No rational person would make investment decisions based on a blog post.  Please consult with your financial advisor before taking any action.

It can be argued that the best way to invest is to do all of the work yourself and for some people this is true.  If you are really interested the subject and keep up on all of your investment options you will likely do well.  However, most people are busy and there are other demand on their time.  Often jobs, kids or other project keep them occupied.  We often use experts to help us.  Instead of learning all of the details about how to write a will, you can hire an attorney.  Instead or working on your own car you can hire a mechanic.  I see investing the same way.  So, if you are not ready to spend the time to learn what you need to know to get the most out of your investments you may be well served in getting a little help.

There are two main types of advisors and the single most important thing you should ask is, “How is my advisor paid?”  There are advisors that are paid by you and there are advisors that are paid by someone else to sell you products….

From About.com

A fee-only financial advisor cannot receive compensation from a brokerage firm, a mutual fund company, an insurance company, or from any other source than you. This means they represent you and your interests when giving you advice. After all, think about where someone’s paycheck comes from, and that will tell you quite a bit about where their loyalty lies.

A fee only advisor is paid by you to do what is best for you.  The amount you will pay is agreed to in advance and then the focus is on getting the best results for the client.

An advisor that is paid by commission may have to make choices based on your need and how much commission is paid by a specific investment.  Some complex insurance product may pay an advisor 8-10% commission and a low load managed mutual fund may only pay 3-5% commission.  There is the temptation for a commission paid advisor to put your money in a product that pays the higher rate.  They may be able to resist this temptation – but how will you know?

One of the single best things to use for investing is low cost index funds.  These funds do NOT pay a commission and a commission base advisor would have to choose between getting paid or getting you the best product.  I suggest you avoid being put into this situation.

NOTE:  This post is part of an ongoing education series.  This information is for educational purposes only.  This information does not constitute investment advice.  No rational person would make investment decisions based on a blog post.  Please consult with your financial advisor before taking any action. 

Before I show you why low investment costs are so important let us define the expense ratio of a mutual fund.

Depending on the type of fund, operating expenses vary widely. The largest component of operating expenses is the fee paid to a fund’s investment manager/advisor. Other costs include recordkeeping, custodial services, taxes, legal expenses, and accounting and auditing fees. Some funds have a marketing cost referred to as a 12b-1 fee, which would also be included in operating expenses. A fund’s trading activity, the buying and selling of portfolio securities, is not included in the calculation of the expense ratio.

In simple terms lets say you invest $100 in stock mutual fund.  If it goes up 10% and has an expense ratio of 1.6% you make $8.4 not $10.  If the expense ratio was just 0.2% you would make $9.8.  Keep in mind that this does not take into account the costs of buying or selling or the higher taxes that you may pay in an active fund.  I will talk more about those in future posts.

The extra $1.40 sure is nice but lets take a look at the effect over time.  We will start with $10,000 and assume a 10% return per year for the next 30 years.  One fund returns a net of 8.4% per year and the other returns 9.8% per year.  After 30 years would would have either $165,223 or $112,429.  A difference of almost $53,000!