Mutual Fund Vs. Index Fund

NOTE: This post is part of an ongoing education series. This information is for educational purposes only. This information does not constitute investment advice. Please consult with your financial advisor before taking any action. For planning advice contact Polaris Financial Planning.

Stock

Before we get into the two main types of Index Funds (Managed vs. Index) I want to take a step back and define what a stock is.  We have this definition from Investopedia...

A type of security that signifies ownership in a corporation and represents a claim on part of the corporation's assets and earnings.  Also known as "shares" or "equity."

In plain English you own a part of a company.  Usually a VERY small part of a company but, you are still an owner.  If the company does very well you can make a lot of money but, if they do poorly you can also lose all of your money. Remember Enron?

Mutual Fund

This is why you don't want to put all of your money into one company (or one stock).  It is risky!  Like the old saying..."Don't put all of your eggs in one basket."

A simple way to reduce specific stock risk (as measure by volatility) is to own more than one stock.  Studies have shown that owning 10 stock can limit your volatility (risk) by half and 30 stocks reduces your stock risk to almost the same level as owning 500 stocks.

For more on the value of diversification read this….

If you bought 30 stocks and invested $10,000 in each one, you would need $300,000 to have a diversified stock portfolio.  Each time you want to add money you would have to buy more shares in one of the stocks (or all 30) and pay commissions.  If you are in a taxable account you have to keep careful records of all of the prices so you don't pay more than required in taxes.

For most people this is just too difficult and they are better off is someone else does the work for them.  This is what a mutual fund does.

According to Investopedia the modern mutual fund began in 1924.

The creation of the Massachusetts Investors’ Trust in Boston, Massachusetts, heralded the arrival of the modern mutual fund in 1924.

A mutual fund allows people with small amount of money (<$10,000) the ability to invest in the stock market and reduce their risk (vs. one stock).  You can easily add (or remove) money and the mutual fund does all of the work.

Wikipedia lists these advantages for mutual funds….

• Increased diversification: A fund must hold many securities. Diversifying reduces risks compared to holding a single stock, bond, other available instruments.
• Daily liquidity: Shareholders may trade their holdings with the fund manager at the close of a trading day based on the closing net asset value of the fund’s holdings.
• Professional investment management: A highly variable aspect of a fund discussed in the prospectus. Actively managed funds funds may have large staffs of analysts who actively trade the fund holdings.
• Ability to participate in investments that may be available only to larger investors: Foreign markets, in particular, are rarely open and affordable for individual investors.

I agree with all of the above points but, they add one more.....

• Ease of comparison: Picking a mutual fund is a lot like judging a dog show. You select the best of the breed which has the qualities you seek.

I disagree. It is very hard to pick a good mutual fund and they can have high costs.

Index Fund

An index fund is a specific type of mutual fund.  Here is their definition of an Index Fund from Investopedia....

A type of mutual fund with a portfolio constructed to match or track the components of a market index, such as the Standard & Poor’s 500 Index (S&P 500). An index mutual fund is said to provide broad market exposure, low operating expenses and low portfolio turnover.

I’m not sure why they say, “… is said to provide…”.  An Index fund actually does these things.  I get some of the numbers below from and I highly recommend "Common Sense on Mutual Funds" by John C. Bogle.  (Note:  The title is indeed a nod to Thomas Paine)

Broad Market Exposure

The S&P index fund invests in 500 stocks.  500 different US companies.  This is very broad exposure.  If one of those 500 stocks goes to $0.00 in just one day it will only bring down your portfolio ~0.2%.  The whole market can move more than that in a day.  This also works on the upside, if one of those 500 stocks double it will only give you about a 0.2% bump.  This broad market exposure effectively eliminates your stock specific volatility (risk).

Low Operating Expenses

The average mutual fund can have many types of expenses.

The first thing you need to look out for is the load (usually a fee you pay to invest) and this can be as high as 8.5%.  This comes out of what you "invested".  You now have to make 9.3% just to break even.

Many managed funds add a fee called 12b-1 and it can be as high a 1%.  Via investopedia...

Back in the early days of the mutual fund business, the 12b-1 fee was thought to help investors. It was believed that by marketing a mutual fund, its assets would increase and management could lower expenses because of economies of scale. This has yet to be proved. With mutual fund assets passing the $10 trillion mark and growing steadily, critics of this fee, which today is mainly used to reward intermediaries for selling a fund's shares, are seriously questioning the justification for using it. As a commission paid to salespersons, it is currently believed to do nothing to enhance the performance of a fund.

To manage your money the mutual fund collects a fee called the "Expense Ratio".  The industry average is 1.50% per year and 25% of all stock funds are above 2.20% per year.  There is no limit on how high this fee can be.  As of 6/30/14 there were 220 Mutual funds with a fee of 3.00% with the highest at a stunning 23.00%!  You can get the Vanguard Total Stock Market Index for an Expense Ratio of 0.05%!

Trading Costs

Every time your mutual fund buys or sells, you pay the fees.  This is not listed anywhere and it is hard to calculate but for the average fund this costs you an additional 0.50%.

Taxes

If you are in a taxable account trading can really hurt your performance.  If a stock is held for more than a year than you will only pay capital gains of 0%-20%.  However, a stock sold in less than a year can be taxed from 10% to 39.6% (depending on your income level)!  An S&P index fund may change only 2-4 % of the funds in a given year.  An average mutual fund can change 100% or more of its stocks in one year.  Even if your managed fund beats the market you may get killed on taxes.

Return Of Premium Term Life Insurance

NOTE: This post is part of an ongoing education series. This information is for educational purposes only. This information does not constitute investment advice. Please consult with your financial advisor before taking any action. For planning advice contact Polaris Financial Planning.

Return Of Premium Term Life Insurance

Insurance is a sensitive topic and there can be a lot of emotion wrapped in the decision about how much to buy and what kind you should get. I will not talk about why you may need insurance or how much to get in this post. You can see my previous post of term vs. whole life here.

Today we will assume that you have already decided to buy insurance in the amount of $500,000 and you want 30 year level pay. Level pay means that you will pay the same amount for 30 years. Because it is term you insurance, it will end after 30 years.

Just for an example, lets assume that you are 35 years old, do not smoke or engage in risky activities and you are in really good health. I looked around the web and I estimate that the cost for this life insurance is $538 per year (Your findings will likely be different - this is simply for a demonstration and is not a quote). The total cost over 30 years is $16,140. Not bad for $500,000 of life insurance.

You could also get a another product. It is called Return Of Premium Term or ROP Term. It costs a little more but after 30 years you get all of the money back! The cost for our example is $1,100 per year for a total of $33,000 over 30 years. Sure it’s a little more but you get all of the money back. Sounds good!

So… is this a good product for you?

Before we go on, I want to look at a few of my basic investing rules. You should not break these rules.

1 If it sounds too good to be true – It probably is.

2 KISS = Keep It Simple Silly. Think of this as the Financial Occam’s Razor. The product with fewer variables is likely the better product.

3 Only buy what you understand. If it is confusing, you should say NO. If you understand it later – you can buy it then.

4 Buy term and invest the rest.

How does Return of premium term stack up to my rules?

1. Getting all of your money back sure does sound too good to be true.

2. This is not simple! It has more variables and may have more conditions in the prospectus.

3. This product is not that hard to understand. (maybe that is why it sells so well)

4. It is not really term.

Looks like it breaks 3 of the 4 rules.

Here is some math….

If you follow rule 4 above you would just get the term and invest the rest. You could take the $562 you save each year and put it in a long-term bond index fund. In a long-term bond index you could get 5% (it was even higher in the past). If you make 5% every year, you will have $39,205.56 after 30 years. Greater than the $33,000 they would give back (if you get it back). Plus you can take out the money any time you need it.

If you are a more aggressive you could put the $562 into nice stock index fund. If you make an annual return of 10% will have $101,690.20 after 30 years.

So…. which one do you want now?

Should I Use A Fee-Only 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. Please consult with your financial advisor before taking any action. For planning advice contact Polaris Financial Planning. It can be argued that the best way to invest is to do all of the work yourself, for some people this is true. If you are really interested the subject and willing to spend the time needed 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. If you aren't careful with your investments you can make big mistakes. In a busy life, we often use experts to help us. Instead of learning all of the legal details, you can hire an attorney to create a will. Instead or working on your own car you can hire a mechanic. You can do these things if you spend the time needed to acquire the skills or, you can hire an expert and have more time to do the things you want to do. I see investing the same way.

When you are looking for a financial advisor you need to know, there are two types:

1) Commission

and

2) Fee-Only!

Most advisors collect a commission to sell product to you! However, a small percentage collect a fee from you these are Fee-Only advisors and they are paid by you. Therefore, they work for you. They focus is on getting the best results for their clients, not selling more stuff to make more commissions.

I think About.com summed it up really well....

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.

When selecting an advisor you should ask these two questions:

1) "How are you paid?"

2) "Where do you invest your money?"

An advisor that is paid by commission may have to make choices based on how much commission is paid by a specific investment product. Some complex insurance product may pay an advisor 10-15% commission and a managed mutual fund may pay up to 8.5% commission. Do they want to make 3% or 15% helping you "invest" the $100,000. What would you do? There is the temptation for a commission advisor to put your money in a product that pays the higher commission so they can make more money. They may be able to resist this temptation - but how will you know?

As I have discussed before, one of the single best things to use for investing is low-cost index funds. However, these funds do NOT pay a commission. A commission based advisor would have to choose between getting paid or getting you the best product. I suggest you avoid being put into this situation and get a Fee-Only Advisor!

What Is A Mutual Fund?

What is a Mutual Fund?

NOTE: This post is part of an ongoing education series. This information is for educational purposes only. This information does not constitute investment advice. Please consult with your financial advisor before taking any action. For planning advice contact Polaris Financial Planning.

When I was a kid I loved looking at numbers, charts and graphs. I'm sure it was not the norm for my age but I remember looking at stocks in the news paper. Nothing like the smell of a newspaper and its ink on your fingers.

When you buy a stock, you buy a small piece of a company. If you put all of your money in one company you can make a lot if the company does well but you can also lose all of your money if the company goes broke. Remember Enron?

For more on the value of diversification read this....

According to Investopedia the modern mutual fund began in 1924.

The creation of the Massachusetts Investors' Trust in Boston, Massachusetts, heralded the arrival of the modern mutual fund in 1924.

NOTE: I will be talking about Open-end mutual funds. Closed-end funds are different and I don't recommend them.

A mutual fund allows people with small amount of money (<$10,000) the ability to invest in the stock market and reduce their risk (vs. one stock). Studies have shown that owning just 10 stock can limit your volatility (risk) by half and 30 stocks reduce your stock risk to almost the same level as owning 500 stocks (Standard deviation of 20.87 vs. 19.27). If you had to buy the stocks and invest just $3,000 in each one, you would need $90,000 to have a diversified stock portfolio. Each time you want to add money you would have to buy more shares in one of the stocks and, of course, pay a commission on the trade.

The modern mutual fund solves many of these problems. You can usually start with a few thousand dollars and can add money at any time. This type on investing can help keep your costs down.

Sadly 53% of Americans don't own any stocks.

Wikipedia lists these advantages for mutual funds....

• Increased diversification: A fund must hold many securities. Diversifying reduces risks compared to holding a single stock, bond, other available instruments.
• Daily liquidity: Shareholders may trade their holdings with the fund manager at the close of a trading day based on the closing net asset value of the fund's holdings.
• Professional investment management: A highly variable aspect of a fund discussed in the prospectus. Actively managed funds funds may have large staffs of analysts who actively trade the fund holdings.
• Ability to participate in investments that may be available only to larger investors: Foreign markets, in particular, are rarely open and affordable for individual investors.

I agree with all of the above points.

• Ease of comparison: Picking a mutual fund is a lot like judging a dog show. You select the best of the breed which has the qualities you seek.

I disagree. It is very hard to pick a good mutual fund. Ironically, picking funds that have recently done very well can actually increase your risk. This is why I recommend and put my money in Index Funds.

Investing Skeptically - Women And Investing

Investing Skeptically is an ongoing education series.  This information is for educational purposes only.  This information does not constitute investment advice, legal advice or tax advice.  If you are in the need of financial advice please contact  Polaris Financial Planning.  (Polaris Financial Planning LLC, is a “fee-only” registered investment advisor and does not receive money from anyone other than the paying clients.)

Young adults in the US have very low rates of financial literacy and only four states require a class on personal finance in High School.  When I give talks about investing I am often surprised by people of all ages that know very little about investing.  If you don't know how the system works it can be very hard to succeed.

This can make investing difficult for the average American but, women have some additional challenges and that is the point of this post.

Lower Wages

Data continually suggests that women make less than men.  Based on data from the Bureau Of Labor Statistics...

...in 2010, women’s earnings were 81 percent of men’s.

Forbes (the online magazine) makes the argument that the actual gap is only 13.5% not 19%.  It is an interesting way to look at it but the result is that women DO make less and are likely to make less in the future.  I don't want to have a deep philosophical discussion about why this is but, this is the case.  Saving money is harder if you make less of it.

Longer Life Expectancy

Women tend to live longer than men.  Based on data from the CDC women should expect to live about 5 years longer than men.  Of course, it is great to live 5 extra years but,  you don't want to run out of money.

Lower Financial Literacy

Lower income and longer life create a challenge but according to FINRA women also know less about investing.  (FINRA, the Financial Industry Regulatory Authority, is an independent regulatory organization empowered by the federal government to ensure that America’s 90 million investors are protected.)

Women consistently score lower than men on measures of financial literacy, and this gender-based gap can negatively impact the financial well-being of women.  For example, financial literacy has been linked to several outcomes, including wealth accumulation, stock market participation, retirement planning...

FINRA's conclusion is based on research performed on RAND Labor and Population data.  Here is the study....

What Explains the Gender Gap in Financial Literacy?

The Role of Household Decision-Making

Raquel Fonseca, Kathleen Mullen, Gema Zamarro, and Julie Zissimopoulos

RAND June 2010

Here are a few highlights of the report.

Women tend to live longer than men, have shorter work experiences, lower earnings and levels of pension or survivors’ benefits.

These factors put women at a higher risk than men of having financial problems and of approaching retirement with little or no savings.

A contributing factor to low wealth levels of divorced women compared to men near retirement may be a lack of adequate financial literacy.

There is a burgeoning literature documenting low levels of financial literacy population-wide and the relationship between literacy and savings behavior.

The financial literacy index for women is about 0.7 standard deviations lower than for men (p < 0.01).

Conclusion

These factors can all compound and result in the premature depletion of  retirement funds for women.

Examples

Let me give two examples and make a couple of  little graphs. (Note:  These are just theoretical examples and oversimplify reality)

The first example is for a theoretical man:

- starts investing today at age 22 and retires at 62.

- income $60,000 per year. (while working)

- saves 10% ($6,000 per year).

- Makes a 10% return per year while working.

- changes to a more conservative portfolio in retirement, making 8% per year.

- He collects $18,000 per year from Social Security in retirement and another $42,000 from his investments. (total of $60,000)

- His funds last until to age 108 - long past his expected life span of 76.  (note:  inflation is assumed to be 3% and income numbers at retirement are adjusted by this factor)

The second example is a theoretical woman:

- starts investing today at age 22 and retires at 62.

- income $54,000 per year. (10% less than the man - actual difference is likely greater)

- saves 9% ($4,860 per year) (Low financial literacy often leads to lower savings)

- Makes a 9% return per year while working. (Low financial literacy often leads to lower savings)

- Changes to a more conservative portfolio in retirement, making 8% per year.

- She collects $16,200 per year from Social Security (Her SS is lower because it is tied to your income and she made less) in retirement and another $37,800 from her investments.  (Note:  She only trying to match her working income of $54,000 not the $60,000 the man enjoys)

- Despite her smaller withdrawals, the funds only last until to age 77 - short of her expected life span of 81.  After age 77 she will have to live on just the Social Security of $16,200.    (note:  inflation is assumed to be 3% and income numbers at retirement are adjusted by this factor)

What to do?

Get a financial education and higher a "Fee Only" Financial advisor.

I would start with the book "Common Sense On Mutual Funds" by John C. Bogle.  It has a little math but you can handle it.  Mr. Bogle is a financial genius and founder of the Vanguard Mutual fund company.  (NOTE:  I do not get ANY payment or commissions from Vanguard )

You can also pick up magazines like Kiplinger.  I would not follow any of the specific advice that they give but it will help you learn the language.  This will help you make better choices.

If you need any other ideas or suggestions let me know.