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The Pros and Cons of Index Investing

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What Are Index Funds?

If you are tired of trying to beat the stock market, index investing may be the best solution for you. Index funds work by investing your money into an index of stocks. (You may have heard of S&P 500 or the Dow.) When you put money into an index fund, you are investing in all of the companies that make up that particular index’s portfolio.

This is an alternative to choosing and investing in particular stocks. The same risks exist for you as those who buy stocks individually. However, investing in an index can provide broad diversification for your equity investments. Instead of putting your eggs in a few baskets, you’re putting one egg in 500 baskets (using the S&P 500 as an example).

Pros:  

They are inexpensive

There are usually no hidden fees or sales commissions with index funds. They have low annual fees- much more insignificant than the large fees that hedge funds and other alternatives charge. You can also increase your investments regularly without facing additional charges. Avoid indexes that do charge investors extra.

They Allow You to Invest in A Diverse Selection of Stocks

A well-balanced portfolio is key, and index funds aim to achieve this. As an individual, our investment opportunities are far more limited. By teaming up in an index fund we are able to share in the investments of many different stock companies. This is a much more attainable goal when we are part of an index fund.

They’re Efficient

Index funds financially outperform the majority of mutual funds. Although solo investors enjoy trying to “beat” the stock market and outsmart the institution, research has shown time after time that index fund earnings are much more consistent.

On top of bringing in more earnings, they are also user-friendly and easy. You can link your bank account to the index fund and it will automatically withdraw on a regular basis for you. No work on your part at all! Not only do you avoid having to study the stock market, but you also do not have to move the money over regularly.

It’s A No-Brainer

For anyone who is a newbie when it comes to investing, index funds are a life-saver. You don’t have to pick individual stocks or worry about the market rising and falling. All you have to do is provide the money, and the market should grow over time.

Cons of index investing: 

They Can be Vague

The assets making up a fund’s portfolio are constantly changing. It can be difficult to see exactly what you own and exactly how much you have made by investing. This is due to the fluctuating values in the underlying stocks and the index itself.

Limited Upside

Although investing in individual stocks can be messy and dangerous, some investors have a special eye for it. The professionals can often beat the market and get ahead of the game. In an index fund, you will never beat the market, because you will only grow consistently alongside it.

You’re Not in Charge

If you like to be in control, it could be difficult to learn to trust your money with strangers. Your index fund managers will be the ones in charge of what the fund gains in assets. You will likely never be personally able to call the shots in an index fund, and that is something you will have to come to terms with.

Not Suitable For All Investors

One of the most obvious cons of index investing is the “blanket” suitability for all investors. That’s, simply, not the case. The risk/return relationship suggests that higher return investments usually involve higher risk. Index funds are typically designed to capture the median performance of markets such as the S&P 500 or the Russell 2000.

As a result, they usually return market performance – no more and no less. If you want a very risky investment strategy, say, for example, investing in reverse convertible bonds, you likely won’t find index funds a suitable investment vehicle.

There Can be Fees

Some index funds do charge high fees and commissions. Be sure to stay clear of these.

My Concern

Generally speaking, index funds are great. They offer broad exposure to the market and do an incredible job at limiting fees.

But, in my mind, there are two more cons of index investing:

  1. Accidental concentration – As the market ebbs and flows, some sectors and industries will do better than others. For example, over the last 10+ years, the technology sector has outperformed the broader market by a large margin. As a result, tech makes up a greater portion of the index. If that sector experiences a pullback, the index as a whole will fall.
  2. Liquidity concerns – This mainly applies to index ETFs, but if the market, as a whole, drops, inexperienced investors will sell out of their positions to limit their losses. When there is a rush for liquidity, these ETFs need to sell underlying positions to provide investors with that liquidity. This can lead to an acceleration of losses. Investors sell, portfolio managers sell to give individuals their money, so underlying assets drop. This can cause more investors to sell, and again, portfolio managers to sell more. It’s a domino effect

Related reading:

Can you afford not to use index funds?

Robo-advisers: What I like and what I don’t like

How To Pump Up Your Finances

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By “pump up,” I mean to do something that improves your financial situation in any way. Reduce expenses, start a rainy day fund, invest for the future, etc.

With that said, let’s take a look at some simple strategies to pump up your finances.

Cut the fat

I’d start by creating a budget. Look at the past three months of income and expenses. Total the expenses, total your income and compare the two. This will give you a clear picture of how much you are spending versus how much you make.

After that, you can go back with a magnifying glass and see exactly where your money is going, and stop spending money where it is necessary, or at least reduce it.

You can also reduce the fees you pay to invest. Mutual funds and ETFs are the most popular vehicles used today, but they come with a cost. It’s listed as an expense ratio. That ratio should be as low as possible. Ideally, it’ll be under .20%.

A quick tip to cut your expenses – get rid of cable/dish. There are too many services available now. You don’t need to spend $100+ on TV anymore.

Increase savings rate

Hopefully, you are saving something. If you are having trouble setting money aside because of limited resources, give this article a read for some help.

You should be saving in at least two places. An emergency fund and a retirement plan.

  • Emergency fund – Say you are contributing $20 per month. This is a good place to start, but you’re going to want to save more so you have enough in case your car breaks down or you lose your job. After three months of saving $20/month. Increase that amount by $5. After another three months, at which point you’ll have gotten used to not having that extra $5, increase it again. Rinse and repeat.
  • Retirement plan – If you have a retirement plan with your employer and they match, you’ll want to contribute at least enough to get that match. That’s your starting point. Then you’ll follow the same steps as the emergency fund. After a few months, increase the contribution percentage. If you don’t have a plan with your employer, set up an IRA, start contributing what’s comfortable for you, and follow those same steps.

I mentioned you should have AT LEAST these two accounts. Personally, I have several savings accounts. They are set up for different reasons. I have one for holiday spending, one for car repairs, and one for travel expenses. Giving your money a “job” makes it more likely that you’ll use that money for that “job.”

Switch to an online bank

Most online banks have higher interest rates on savings accounts. They also, typically, have lower rates on loans (based on credit score).

If you are saving money for a rainy day and putting it with a brick and mortar bank, you’re most likely earning next to nothing. Better to put that money in an account where you’ll earn a little interest.

Refinance high-interest rate loans

I’m going to dedicate this section to credit cards because that’s what most people think of when they hear high-interest rates.

There are three strategies you can use.

  1. Balance transfer – Many credit card companies offer a 0% APR on balance transfers for a certain period of time. Some have terms for 21 months. The interest rate will jump after the 21st month, though, so make sure your balance is paid off before then.
  2. Personal loan – If you have credit card debt and don’t, or can’t, utilize a 0% balance transfer, then a personal loan is your next option. You get a loan for the total amount of outstanding credit card debt. Then the institution will send a payment to each credit card company and pay off your credit card debt. You’ll be left with one payment. Be advised, credit matters here (also for balance transfers) so if the interest rate on the personal loan is higher than the average interest rate of your credit cards, don’t do it.
  3. The last option is to call the credit card company and ask for a lower rate. More often than not, if it’s available, they’ll give it to you. It won’t lower your payment a whole lot, but it’ll definitely help.

If you want to learn more about credit cards, click here.

Improve your credit

Your credit score makes a difference. It can impact what loans you qualify for, the interest rate, where you live, and where you work.

If you want to start making moves in your financial life, you need to improve your credit.

There are three really simple ways to do this.

  1. Pay more than the minimum on your outstanding debt and pay on time – on time payments is the #1 factor when calculating your score.
  2. Call your utility company and see if they report to the credit agency. It’ll count as another credit account (a factor) and it’ll influence your on-time payments.
  3. Open a secured credit card – You open this type of card with a deposit. The deposit will act as your credit limit. If you deposit $500, you’ll have a credit limit of $500. Make regular, small purchases and pay the entire balance right away. Credit agencies like to so activity and, as I’ve said, on-time payments.

If you want to learn more about improving your credit, click here.

Conclusion

If you want to improve your financial life, it’s actually pretty straight forward. Spend less than you make, save money for the future, pay down debt, and improve your credit. If you do these four things (obviously, easier said than done), goals that once seemed far fetched, can be within reach.

Please visit my website for our disclosures.

 

If reading this blog post makes you want to try your hand at blogging, we have good news for you; you can do exactly that on Saving Advice. Just click here to get started.

How to Make Long-Term Investing Decisions

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One of the most valuable attributes of successful investors is being able to stick to their guns and trust their analysis even when the market is tanking.

How do you invest for the long-term? Are there certain strategies and mindsets that can be used to your advantage?

We’ll explain that and more in the following article.

Know what you are willing to risk

Whether you are someone that allocates your assets between a select few mutual funds but are looking to use a small portion of your account to enhance your returns or an investor that owns a handful of stocks, you need to be wary of how much of your total portfolio is in one security/strategy.

With either scenario, the decision of how much of your portfolio you are willing to risk in an individual security is whatever you are comfortable with. Personally, if I were in your position, I wouldn’t use more than 5% in this type of situation.

Taxes matter

If you are investing in a qualified account (tax-advantaged account) taxes don’t really have any effect on whether you should buy or sell something, or what type of security you invest in.

You’re either taxed before you deposit the funds or you pay taxes when you withdraw, otherwise the account grows tax-deferred.

If you’re investing in a non-qualified account (standard brokerage/investment account) the taxes and what securities you invest in, matters.

For example, when you invest in a mutual fund, at the end of the year, that fund will pass capital gains to the investors. It’ll come in similar to a dividend, but a much bigger number (depending on the year). You have to pay taxes on that, just like you would a dividend.

Another example, if you invest in a security and sell it for more than you bought it, you have a capital gain. If you held the security for less than 1 year, it’s a short-term capital gain. If you held it for more than 1 year, it’s a long-term capital gain. A long-term capital gain is taxed at a lower rate than a short-term gain.

Asset allocation is important

Stocks/bonds/cash. They are the three most important asset classes in investing.

I’ve written about stocks and bonds before, but the cliff notes version is stocks are risky and can reward you with high returns. They get hit hard during bear markets.

Bonds are generally less risky so you usually get a lower return. However, they tend to hold up a little better during bear markets.

Depending on where you are in life and what you’re comfortable with determines how much (by percentage) you should have in each asset class.

Someone in their 20s should have almost all stocks and a little in bonds. Maybe 90/10 or 80/20. I’d only recommend cash if they were waiting for a significant pullback and wanted to put money to work at lower prices.

Conversely, someone in their 60s that has less time to make back what they lose, would be much more conservative. Their allocation could be 40/50/10 or somewhere around there.

Keep in mind these are general rules of thumb. The most important thing with any investment is your comfort level. If you are 25 and aren’t comfortable with hanging on to your stocks during a 40% decline, be more conservative.

Fees will eat your returns

There’s no denying that trading fees, advisor fees, and the various other types of fees will reduce your returns over the long-term.

On average, expense ratios on mutual funds are much higher than expense ratios on ETFs. Though I believe paying your advisor their fee (I don’t think it should be higher than 1%) is well worth the expense, not everyone needs an advisor.

If your financial situation is relatively simple, you’re comfortable and confident with how you handle things, and you don’t foresee making any significant changes, then it’s probably not worth it.

However, it might not be a terrible idea to see one every few years to have an objective set of eyes review everything.

What’s your exit strategy?

When you invest in a security, and this is more than just asset allocation, you need to have your exit already planned. Too often, people will invest in a stock, see it climb 10% higher and then fall back down. Instead of selling with a small gain or at cost, they’ll hang onto it in hopes it’ll climb back up, even if it keeps falling.

Our emotions and our behavior is our worst enemy in investing. Having a plan and a strategy in place before you even get started is a great way to help mitigate those things from getting in the way.

Regular contributions

If you have time to ride out down markets and are comfortable with the investments you chose/the asset allocation you picked, then hang onto what you have.

An added bonus is if you are regularly contributing and adding to those positions. In a down market, those securities you invested in will get cheaper. When you regularly invest at lower prices, you effectively lower your average purchase price.

Conclusion

Investing can be very difficult, but it doesn’t have to be. In my opinion, keeping your investment plan as simple as possible paired with a unique ability to keep your emotions out of the equation is a recipe for success.

For more information about investing and for my disclosures, visit www.crgfinancialservices.com.

 

If reading this blog post makes you want to try your hand at blogging, we have good news for you; you can do exactly that on Saving Advice. Just click here to get started.

Personal Capital Review: What’s Good and What to Watch Out For

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personal capital review Most of us are familiar with the idea that there is no free lunch – but tech companies are very, very good at convincing us that this is not the case. If you’ve seen the news lately, you may have noticed that Facebook & Google have been in hot water because of the controversial use of their data. I don’t want to put Personal Capital in the same category, but don’t think for a second that they create and maintain all of their neat tools as a gesture of goodwill. Wondering how Personal Capital works and if it’s worth the cost? Here’s our review.

Personal Capital Review: How Does it Work?

Personal Capital’s crown jewel is an account aggregation system – a very unsexy term for something that actually does a bunch of really cool things. Essentially, you hook up all of your financial accounts – think credit cards, checking, investments, 401k from work, even your house! Personal Capital automatically crunches that data for you and lets you everything from what your total net worth is to your potential capital gains tax exposure. It’s like a financial Oracle – you after you’ve fed it your personal data, you can pretty much ask it any question you want to.

Here’s the thing – You aren’t the only one asking! Personal Capital anonymizes its data, so no one else is looking at your actual account numbers, but what they are looking at is how much you have, where you have it, and if Personal Capital can manage it. Personal Capital is actually a Registered Investment Advisor, which is a type of investment company that manages assets on a fiduciary basis (in your best interest).

This puts them ahead of traditional wealth management companies like Merrill Lynch and Morgan Stanley, but they like to sell themselves as being a FinTech company. In reality, their core business is much more similar to that of Fisher Investments, a traditional hard selling RIA firm.  A lot of Personal Capital’s senior management team came from Fisher, so it should not shock you that their company culture is similar.

The Good

  • .89% is a low price to pay for true fiduciary wealth management
  • Personal Capital uses low-cost ETFs and efficient investment vehicles

The OK

  • The amazing set of free tools is counterbalanced by the fact that all of that info is going to Personal Capital – you are a lead in their system

The Not So Good

  • The advice given is highly dependant on who you talk to
  • The financial advisors receive compensation primarily for getting new assets onto the books, not keeping existing clients happy
  • If you don’t take advantage of or don’t want the financial planning aspect, you are paying .89% for no reason
  • Vanguard has a similar experience for only .3% at higher account balances

What You Need to Know about Personal Capital

Personal Capital currently has about $8 Billion of assets under management, which is certainly more money than you or I have, but tiny compared the other giants in the investment space. What they do have, however, is over $674 billion of tracked assets via their app – assets that they’d like to get on their own platform and charge .89% to manage. Because of this, its shiny free to use tools come with a cost. Buried in the fine print which I’m sure you didn’t read is a clause that allows Personal Capital to solicit you for advisory services.

If you have more than $100,000 in financial assets linked to the platform, you’d better expect a call from Personal Capital. You can always block their number or give them a fake phone number when you sign up, but that’s not very nice, is it? Those financial advisors from Personal Capital will be calling to try and get you invested in one of the three options below, depending on how much you have.

Personal Capital operates on a 3 tiered investment plan system – but unless you’ve got over a million dollars or more to invest, there’s no guarantee you’ll talk to a Certified Financial Planner. In a world where there are over 80,000 CFPs, there’s no reason to settle for anything less. It’s important to note that Personal Capital is not a robo advisor. While the advisors will attempt to put you in a managed asset program that may trade on certain automatic triggers, there are humans involved in all investment decisions.

In fact, once you get over $200,000, they will stop investing you in an all ETF strategy and move you into a basket of individual stocks that will act like an index – which can have several advantages.  The ability to tax loss harvest at the individual stock level can increase real returns and should not be discounted. In addition, they offer full financial planning for free (which in my opinion they should position much more strongly).

Is It Worth the Fee?

The truth is that these days you can get an efficient investment allocation for pennies. If you choose the three fund portfolio, the cost for that allocation is something like .05% (the average weighted expense ratio of the funds). If you wanted to dial up the sophistication a bit, you could go to a robo advisor like Wealthfront and pay .25% (plus the expense ratio of the underlying funds) for a portfolio that trades automatically and can also tax loss harvest at the stock level – so why pay .89% for any of Personal Capital’s offerings?

Here’s the key difference – at Personal Capital you are (horror stories notwithstanding) not paying just for the investment management. Personal Capital is not a robo advisor – they even made a whole video explaining they are not a robo:

Now I tend to agree with them that one of the worst deals in finance is investing with a robo advisor. They are charging you a lot for taking a quiz once – and unlike a human advisor, no one’s there to talk you out of buying a bitcoin at $20,000 or letting you know how many years retirement you’ll postpone by if you go ahead and buy the house with the chef’s kitchen. Humans cost more than any robo (though with Vanguard’s Personal Advisor Services, not much more) but the value you get back from them is measurably higher because they serve as a wall between you and your worst impulses.

In addition to the above, a good human advisor can provide counsel to make sure that assets are correctly titled, can advise on trusts and wills, help you open a Donor Advised Fund to give to charities, review your tax return and more. Robo-advisors can only invest the money you’ve given them.

At Personal Capital they claim to offer you a ‘team’ of financial advisors at $100k, two financial advisors at $200k, and access to a Certified Financial Planner once you’ve accumulated a more than a million dollars with them. Because Personal Capital pays its financial advisors mostly for converting assets from off platform to assets under management – every minute their advisors spend talking to current clients is a minute they can’t use to convince potential new clients to join Prospect Capital. Most of these advisors are really just looking to gather up any of your assets that aren’t yet managed – providing them with additional fees and charging you more.

What About Vanguard’s Personal Advisor Services?

Most people know Vanguard as a go-to asset manager of choice for inexpensive, passively managed index ETFs and Mutual Funds. They currently have over $5 Trillion of assets under management – over $1 Trillion of which their discount brokerage account now holds.

Vanguard has taken a similar approach as Personal Capital, using this $1 trillion as a base to source clients for its own managed services program, called Vanguard Personal Advisor Services. There are a couple of key differences. Vanguard’s PAS is closer to a true robo advisor until you get to $500,000 – where you can get a CFP to do one time planning for free. At $1 million under management, you get a dedicated CFP for free.

So What Should You Do?

If you’ve got a million dollars or more, Vanguard seems like the no-brainer option to get a Certified Financial Planner (if you are ok with a call center delivering advice). If you have less than that or want a more experienced CFP focused on building a long-term relationship, try one of the many independent RIA firms out there that will treat you as a client and not a number.

You may pay more, but having a long, lasting relationship with someone who intimately knows your situation easily pays for itself when you need to make big life-changing financial decisions. If you just want investment management from a robo-advisor and to keep the pesky humans away, Schwab and WiseBanyan both offer a 0% fee algorithmic solution (though you will pay a small fee from the ETF expense ratios) – so you might as well skip robo advisors charging any price at this point.

Personal Capital is an underwhelming choice in any of these slots, so unless you really value the tools they offer, it is generally best to take your money elsewhere.

Author Info: Michael V. Spelman is a Certified Financial Planner, and co-owner of Myrmidon Private Capital, an RIA specializing in retirement planning.  He’s also president at The GUL Guy, a specialty life insurance comparison agency.

How to Invest for the Long Term

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Investing is an important part of your financial life. What’s more important is investing for the long-term.

With a long time horizon, you have the ability to ignore short-term market volatility and you have the ability to let your investments compound over time.

Investing this way can be difficult, however, so here are some tips on how to do that.

Pick a strategy and stick with it

You need to pick and stick with what works for you. There are several strategies that you could choose.

Value – A strategy that involves a deep dive into company/industry fundamentals. Companies/industries in this area may or may not be out of favor. All you care about is how the underlying fundamentals look.

Growth – High flyers. Companies with high P/E ratios. Companies that have a strong case for continued growth. Sectors like technology and consumer discretionary are considered growth.

Contrarian – If you buy when others sell or sell when others buy, you may be a contrarian investor. You go against the herd. Someone who does this has a unique ability to be extremely objective.

Momentum – You invest in companies or sectors that are performing well and are fairly likely to continue that trend going forward.

Start early

This is no secret, the earlier you start the better. Albert Einstein once said, “Compounding is the eighth wonder of the world.” It really is amazing what compounding can do. If you have 20, 30, or 40 years to invest, you should be sitting pretty at that finish line.

For example, say you have two investors. One investor starts contributing $1,000 per month to an account and invests in a stock market index ETF, starting out at 25 and stops contributing after 10 years.

Another investor starts contributing $1,000 and that same index ETF, starting at 35 and they contribute until they turn 65. At age 65 person A ends up with 1.49 million, and person B ends up with 1.26 million.

Compounding truly works wonders. Start early and give compounding a chance to work its magic.

Make every move with the future in mind

Every decision that you make needs to be a slow and thoughtful one. It’s particularly important to make decisions with your future self in mind. Delayed gratification is HUGE when investing for the long term.

For example, you have your debts paid off and now have a little extra money each month. You decide that you want to buy a boat. You save up and pay $20,000 for a nice, new boat.

Here’s the flip side. Say it took you three years to save up for that boat. Instead of saving, you deposited $5,500 per year into a Roth IRA (max contribution amount). This is invested in a stock market index ETF we mentioned earlier.

Now, let’s go out 10 years. You still have that boat and have taken good care of it. However, it’s lost over 50% of value over that time period. Conversely, that $16,500 that you invested has grown to $33,600.

Buying the boat may have felt good before, but investing that for the long-term is by far the better financial decision.

Invest in what you know

Peter Lynch famously said, “Invest in what you know and know why you own it.” This is such an important principle within investing. If you are competent in the consumer staples sector, stay in the consumer staples sector.

At times you may see technology stocks return far more than your sector, but you could have easily invested in a technology company that went bust. You don’t know the industry so how would you know what’s good and what isn’t.

By sticking with an industry that you are knowledgeable about, you increase your chances of success.

Contribute regularly

Contributing at regular intervals does two things.

One, you’re saving and investing more, which increases the size of your nest egg.

Two, when the market ebbs and flows, you will continue to invest the same amount each month/year. You’ll buy more when it’s low and buy less when it’s high.

This is called dollar cost averaging. It effectively reduces your cost basis for your entire position, which effectively increases your gain, if your investment is up when you sell it.

Diversify

One of the most effective ways to reduce how much your portfolio reacts to dramatic shifts in the market is to diversify. Hold some stocks, some bonds, some cash, some gold, and some real estate. There are other investment products you could own, but these are usually the big ones.

Be objective

Try to take your emotions completely out of it.

When the market starts to sell off, you need to objectively look at your positions. Look at the characteristics of the business. Has anything changed? Or is it just declining due to a broader market selloff?

If it’s the latter, take some of that cash you have and buy that baby at a discount.

Use stocks

Over the long-term, stocks are the best investment to a) outpace inflation and b) effectively appreciate the money that you’ve saved.

Utilize various products

There are a variety of vehicles out there for your investments. Take advantage of as many as you can.

401(k) is an employer-sponsored retirement plan. Money saved in it can lower your taxable income and investments grow tax-deferred.

Traditional IRA – Individual retirement account. You open it up and save in it. Tax-deductible contributions. Investments grow tax-deferred.

Roth IRA – Similar to a Traditional IRA, except money contributed is not tax deductible, but money withdrawn is tax-free (money withdrawn from 401k and IRA is taxed).

These are just a few of the vehicles that can be used to save for retirement.

Next week I will dive deeper into the various products available.

Say no to penny stocks

These are stocks that cost less than $5 per share. More often than not, these are very risky and the companies themselves have a much higher probability of going out of business than other companies with higher stock prices.

Don’t invest via “hot tips”

Your friend says, “A stock I invested in last week is already up 100%, you need to get in on this before it goes any higher.”

When you hear this, just let it filter out of your brain. Odds are, the dramatic increase in price is pure behavior related, and no stock can sustain that kind of growth. That stock will come crumbling down at some point.

Think of the tech bubble from the 2000s. There were companies with literally no information about them, and they were going from $10/share to $200/share within a matter of weeks.

Just 48% of companies from the dot-com bubble survived past 2004. (Source)

Conclusion

Investing for the long-term is your greatest chance for financial success. Starting early, contributing regularly, and ignoring the noise are only a few great tips discussed here, but they are probably the most important.

If you would like to hear more about long-term investing and/or for our disclosures visit www.crgfinancialservices.com.

Rates of return are hypothetical, are provided for illustrative purposes only, and do not reflect the performance of an actual investment. All investments involve the risk of potential investment losses and no strategy can assure a profit. Past performance does not guarantee future results. Diversification seeks to reduce the volatility of a portfolio by investing in a variety of asset classes. Neither asset allocation nor diversification guarantee against market loss or greater or more consistent returns.

 

If reading this blog post makes you want to try your hand at blogging, we have good news for you; you can do exactly that on Saving Advice. Just click here to get started.

Jemstep Portfolio Manager Review: Finding the Asset Allocation Middle Ground

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How do you review your investments? We give Jemstep a test-drive to see if it’s worth your time and money.

As OG bemoaned last week when writing about his broken garage door, at some point, calling a professional is the right move. In the comments, there were some wonderful discussions about finding “experts” without consulting with a person locally by using YouTube videos, better online tools and calling trusted friends.



The Middle Ground in Asset Allocation

There’s plenty of middle ground between wingin’ it and hiring a financial advisor when picking the right basket of investments. One tool I’ve had the opportunity to test drive is Jemstep. After meeting a Jemstep rep at FINCON last year, I was impressed enough with the product to have Simon Roy, the firm’s president, on our 2 Guys & Your Money podcast. He informed me that they were upgrading the product, and now it’s available.

The “New” Jemstep Portfolio Manager

Jemstep is a program that helps you diversify your investments. You know that dartboard you’ve been throwing at? No longer. Jemstep takes the guesswork out of discovering which investments you should be using and pinpoints suitable replacements for duds (or, surprisingly, good investments in asset classes that really don’t meet your investment needs). During my trial run, JemStep told me some things I’d (shamefully) already knew: I’d let my winners run a little too long, and Jemstep recommended cutting back in those “overgrown” areas where the risks now exceeded the chance for rewards.

How Jemstep Portfolio Manager Works

The Jemstep approach is consistent with that of an advisor. First, JemStep asks you questions about your goals. What do you need your portfolio to do? It asks questions about how far away the goal is, how much you may need to access at a time, and other relevant questions. I found this process fun. The interface is intuitive and the style of the website draws you in.

Jemstep Portfolio Manager Review at The Free Financial Advisor

Jemstep asks you for information about your retirement goal, among others. The interface is easy to use, and the blue lines below tell you just how far you still have to go: I have to still fill in information on my finances and investment preferences.

Once you’ve answered goal-related questions, you can upload your portfolio directly from your broker or add in funds manually. Finally, JemStep does it’s work and voila….gives you the correct asset allocation for your goal.

Jemstep Portfolio Manager basic recommendations

Here is the basic recommended portfolio. With these changes, I stand to gain over $9,000 per year in retirement. Yee-haw!

The premium version of Jemstep includes lists of what investments you should sell (in many cases only trim back), which investments you should accumulate, and new suggestions for your portfolio (often in asset classes that don’t exist in your portfolio). Here’s what that looks like:

jAction-Plan

Jemstep not only tells me which investments to sell, but alerts me to potential capital gains taxes. Every sell recommendation is accompanied by a detailed reason why this investment is on the chopping block. In this case: Apple is one of my worst performers and I have too much individual stock for a portfolio of this size.

The Cost

The Jemstep pricing model isn’t surprising. You can access basic advice for free (this includes the asset allocation you should be using, plus the differences between your portfolio and the suggested one). The premium model, which includes continuous tracking, rebalancing advice, a detailed breakdown of recommended sale quantities and investments, is also free for people just starting out. Pricing begins at $17.99 per month for portfolios over $25,000, and increases based on the amount of money Jemstep is helping you manage. While some who are looking for a freebie might be turned off by the price, this is less than the 1% fee often charged by a financial pro. Want professional advice in your corner without having to sit in an office with some team of people? Great. Jemstep won’t call you with hot stock tips and is there when you need it. In exchange, you’ll pay a model comparable to those used by seasoned investors for less than half the cost.

What I Like, What I Don’t

Here’s what I love: this asset allocation is a proven winner that points you toward the low cost, high return investments in a balanced portfolio. If you’ve ever wanted to have a well-managed portfolio but didn’t know where to start, Jemstep is a great place to begin. Different than some generic asset allocation models that I’ve used, JemStep points you toward specific investment options. For the person who wants to make sure they have low cost investments with a proven track record, Jemstep is for you.

Jemstep partnered with Windham Capital Management to create their recommendations. When back-tested against the S&P 500, Jemstep’s recommended portfolio was impressive: all five of their model portfolios outperformed the S&P 500 over the last 14 years with significantly less risk.

Here’s what I don’t like: results. Yes, JemStep provides impressive results, but will you use them? As I’ve stated before, financial advisors exist for one reason: to make sure that the job is finished. When people left my office, the portfolio moves were complete and people could go about their lives, knowing that the important decisions had been made. A JemStep rep was excited to tell me that 12% of JemStep users actually made changes to their portfolio “because it’s so hard to get people to take action.”

She’s right on.

While 12% usage is a great number for an often-free tool used by people on the internet, you should examine yourself. Are you going to follow through and actually take the advice on JemStep? If you don’t trust yourself to do the job, pay more and hire a human being who’ll give you a shove.

Overall Impression

If you’re managing your own money and aren’t sure how to do it well, give Jemstep a shot and follow the recommendations. If you don’t like your advisor or wonder if the recommendations you’re receiving are any good, take the time to use JemStep to give yourself a “second opinion.” The tool is robust enough that you’ll know immediately if your advisor isn’t diversifying your portfolio in a way that makes sense for your goals.

Jemstep can be found at Jemstep.com. I am not an affiliate of Jemstep and was not compensated for this review.

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Investors Beware: What the 3 Biggest Brokerages Really Do With Investor Money

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Today’s guest post comes from Susan Lyon, financial analyst with NerdWallet. Thanks, Susan!

What do E-trade, Schwab, and TD Ameritrade all have in common?  Aside from being the three largest online brokerages and some of the biggest brand names in investing, they also all charge investors upwards of $7.99 or more on the typical stock trade.

 

Think this doesn’t sound so bad?  Think again.  A recent study by NerdWallet found that over 17 million investors are overpaying $1.8 billion every year on unnecessary (and sometimes very complicated or hidden) fees with the largest brokerages.

 

In light of the ongoing ETF price wars, you’d think a little of this competitive spirit would trickle down into the trading sphere – but this remains to be seen.

 

Where Is My Money Really Going?

Brokerages all make money by charging commission: that much is plain and simple.  But how much is too much, and is the peace of mind that comes from trading with a brand name broker worth it, NerdWallet asks?  The data says otherwise.

 

It’s easy to assume that a brand name brokerage is giving you top-notch treatment and the best money can buy, but NerdWallet’s study breaks down the top 3 brokerages’ financial statements to question this assumption.  The key findings:

 

  • The big 3 online brokers spend a smaller percentage of their money on trade execution – what benefits the investor – compared to the little guys.
  • The big 3 spend far more on advertising and overhead expenses.

 

This data breaks down expenses at major brokerages by trade execution (what matters to the investor the most) versus advertising, employees, physical, legal and indirect costs:

 

Lesson learned: active traders can meet their needs just as well by bringing their business to a new firm.  The average investor doesn’t need most of the “extras” offered by the big 3 anyways.  Why pay for something you aren’t even using?

 

Investors Can Avoid Fees By Shopping Around

The typical investor with these companies makes between 1 and 2 trades per month, so while a one off expense might not seem like a lot, we did the math and it really adds up.  If the typical investor makes only one stock trade per month, of approximately 100 shares, their annual fees at the largest 3 brokers come out to be:

 

  • E-trade $119.88
  • TD Ameritrade $119.88
  • Schwab $107.40

 

To make shopping around for better deals quicker and easier, NerdWallet’s new brokerage comparison tool allows investors to compare their many options side-by-side to find the right fit for them.

 

How Do I Decide on the Best Fit for Me?

NerdWallet’s new tool allows users to do their research before they invest, so they are made aware of all hidden and unpublished fees upfront to avoid unpleasant surprises later on.  Investors can search among the 74 brokerage accounts in the search tool by price, research, or data tools – whichever matters most to them personally.

 

The takeaway: just like in all personal finance situations, make sure to explore all your options before transferring your money.

Photo credit: Joybot

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How I Chose My High Yield Bond Fund

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Last week I described the ultra-thrilling process of how high yield bond funds work. The reason I penned that particular post was simple. I was in the process of buying one.

In today’s entry, lets look “over my shoulder” to see the method I used to pick my new fund. Many people don’t get to see how someone with 16 years of professional experience chooses an investment in their portfolio. Choosing a high yield mutual fund is a little like exploring through a wasteland of worthless investments (as you’ll soon see), and I think there’s a few crucial basics beginners can learn from my adventure.

Why? Like reading a map, you’re going to be surprised by how straightforward and simple the process is. Buying funds isn’t complicated and you too can find a good mutual fund within minutes while feeling comfortable that you performed adequate due diligence.

The key part of the process is spending some good time with the map first. If you know what you’re looking for, exploring for the fund is the easy part.

Leading up to choosing a fund, I determined the following:

  1. I knew my end goal. I wasn’t just throwing money in the general direction of my problems or praying for high returns. I didn’t use a “more is better” approach. That usually lands investors in an ugly spot, when their greed turns profits to huge losses. I was looking for retirement, and needed to maintain at least a 6 percent return to get there.
  2. I had already determined my asset mix to reach my goal. On our podcast and in previous posts, I’ve discussed finding the appropriate diversified asset mix for your goals. Mine included high yield bonds, mostly because they have a history of achieving my target return.
  3. I knew how much money I needed in high yield bonds to meet my goal. Normally, I’m not a fan of mutual funds. But, because it was a small amount and a manager can oversee the process of avoiding defaults, I decided one mutual fund would do the trick. For more sizable chunks, I’d hire multiple managers or switch from a mutual fund to individual bonds.

Why is it important to determine these three criteria first?

Like deciding which size ice cream cone you’re getting, it’s best to look at your current situation, or waistline, first. Plus, there’s another, overreaching reason:

I’m lazy.

Could you imagine the horror of searching through a gazillion mutual funds in a trillion different asset classes to find the one that fit my needs? Why would I spend countless hours oogling different investments I’ll never buy. I want to narrow the search as much as possible before investing. Why waste all that time I could be watching Cake Boss or Millionaire Matchmaker sorting through countless asset classes that I’ll never use?

I’m not going to waste time searching for investments. I’ll figure out the map first and then choose the right vehicle to get me to my goal.

…and that, class, is how we reached this point: choosing the vehicle.

Let’s begin.

My search began at TD Ameritrade. That’s because the IRA holding the cash I was going to use is housed there. If you’re not familiar with IRA custodians, you have a choice between many different places. Some decide on a bank, others a financial brokerage firm. I chose TD Ameritrade because I’m comfortable choosing investments alone but appreciate their stock and bond tools. They aren’t the cheapest provider, but I’m comfortable with the fee structure.

Fees

 

Just like a trip to the grocery store, every asset search begins with a discussion of “how much is this going to cost.” In many cases, I don’t want a mutual fund at all because they’re expensive, but in the high yield asset class, I want one. I don’t want to guess if one of the companies I own is going to go bankrupt. I also don’t want to do the homework necessary to avoid picking a loser (remember the lazy part above?).

Some mutual funds manage your cash for a reasonable fee, while others might as well be carrying a gun and wearing a mask.

But they’re not the only robbers.

It turns out that TD Ameritrade also is in on the “let’s gouge our customer” game. They’ve forged deals with some fund companies to offer their mutual funds at a lower cost. To tell you just how much lower, I was originally eyeing a Pioneer high yield offering. Imagine my surprise when I found out that I’d have to pay $49 when I bought AND AGAIN when I sold. Ouch.

As an aside, why not just round this ridiculous fee to $50? Wouldn’t anyone dumb enough to pay $49 shrug at a dollar more? If they want to play the psychological game make it $49.99. They’re leaving $10 on the table. I should work for TD Ameritrade…..

 

Screening: Expenses

 

So, armed with the list of funds that are available on my platform, I visit TD Ameritrade’s mutual fund screener site. There are many of these all over the web. The Wall Street Journal has a good one, as do Morningstar, Yahoo and MSN.

I used TD Ameritrade’s own screener for one reason. The first screen for me should be called “funds that avoid the ridiculous fee.” Because that’s too obvious, they named it, “No trading cost fund list.”

Screening: Manager

 

The second screen is for manager. If I have a manager at all, I want one who’s a little seasoned, but different than most investors, I also don’t want one who’s crusty. A fund manager nearing retirement might be milking her reputation at this point. Well-known managers such as Bill Gross at PIMCO are going to survive a couple down years with their portfolio if they decide to take a mental vacation at this point in the game. I don’t want that person.

I want them hungry.

There is no “avoid managers who have been around too long” screen, so I’m stuck using one based on minimum tenure. I don’t want one with less than three years in the saddle, personally, so I choose that screen.

Screening: Star Rating

Like I said, I’m lazy. I want Morningstar to do most of the heavy lifting for me. Although I’m smart enough to know that many lower-ranked funds could do well next year, I don’t have the time to search through them all.

In other areas, where I’m looking for more than a consistent dividend check and a fairly stable value, I might screen for more complex areas. In high yield, that’s it.

I press the “search” button.

Examining the List.

Now I feel like a kid in a candy store. Laid out in front of me is a shortened list of candidates for the title of “good enough to examine up-close.”

My attention now turns to fund evaluation company Morningstar, where I’m going to dig into each fund in detail.

I’m particularly interested in:

  • how each fund performed against it’s competitors,
  • what the dividend looks like, and
  • how the fund is managed.

I dig into these areas quickly. Simple internet searches lead me to mines of information. I’m too lazy to waste time flipping through funds, but when I’ve found my potential targets, I dig in like a rib-lover at the barbeque cook-off.

What Did I Choose?

Ultimately, the USAA High Income Fund won the day.

Why?

For an average fee of .90%, the dividend to me approaches 7% (6.93% as of this writing). The fund manager, R. Matthew Freund, has 21 years of experience (with USAA since 1994), so is mature yet not quite at retirement age. There’s been a co-manager named Julianne Bass since 2007, so there is younger blood overseeing day-to-day operations as well.

The fund has beaten the high yield sector over the past five years, but not by a ton. For the most part this fund’s performance has been slightly above or below the index. When it’s missed, it missed well above its asset category. It hasn’t had a major hiccup.

At this point, I like to guess what I’d rank the fund. I’d give it four stars out of five. It’s a winner, but not a thoroughbred. It won’t be the “hot thing” anytime soon. Perfect for this job.

Morningstar agrees, rating the fund four stars out of five. It’s an above average competitor with average fees and solid management.

Perfect. Often five star funds attract scads of assets, forcing me to look elsewhere as the management can’t invest all of the cash it’s attracted. I’m less concerned with the management of the fund over the past five years as I am over the next five. Because this fund isn’t meant to be the “go baby go” part of my portfolio, I’m fine with boring. In fact, I expect it and hope for it. Let’s get my 7% return so I can focus my energy elsewhere.

That’s how I picked the fund.

Complex? Nope.

I’d be willing to bet that this little 1000 word example is more homework than 95 percent of people complete when choosing investments. Even if a professional picks funds for you, there should be a list of screens you use to oversee picks.

It’s your portfolio. Take charge. It isn’t difficult.

(photo credit: Statue, Eusebius, Flickr;

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College Savings Simplified: The Best Places to Save Money For Education

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While I tend to do things the hard way, finding college savings isn’t one of the areas where I complicate a task. For some reason, my sixteen year old twins helps me focus on whether a 529 plan, Roth IRA, or savings bonds will treat me right.

So, even though I’ll generally remember to add softener to the washing machine just after it’s finished, I understand how college plans operate up and down.

If you’re saving for college, it’s important to categorically work through the details of each plan to determine which best fits your needs.

…because there IS A right way to save for college, and a wrong way to save.

The bad news? The BEST way to plan college savings differs depending on who you are and what your circumstances may be.

I know that sounds generic and evasive, but it’s true: the best way to save for college will depend on your own income, current savings and college goal, so the best course of action will be this:

Know what plans exist and how they’ll affect your ability for financial aid before investing a dime.

If you haven’t yet, you should read the pieces on:

– 5 Steps to a Successful College Plan – This will guide your plan of attack when creating a college plan.

– Narrow Your College Search – This will focus your college search to those schools which are the best fit, both financially and for your particular interests.

After reading these two thorough primers, you’ll be armed with an idea of the cost and feasibility of your favorite school.

 

Let’s now save for the goal: education.

 

Complicated Ways to Save For College

 

Some methods of saving for college are so fraught with risk that I’m reticent to ever recommend them to people. That doesn’t mean that these college savings plans are bad; on the contrary, they all have some huge upside potential, provided that all the right conditions exist. Here are a few:

 

In-State Tuition Reimbursement Plans – Many states offer plans which reimburse the cost of college credits at a later date. This can be a fantastic way to lock in the price of a college, provided that everything goes according to plan.

Upside: Paying today’s rates for in-state public institutions. Don’t have to worry about market conditions or returns on investment.

Downside: Have to worry about state plan solvency. More than one state has already notified participants that they might not be able to meet their obligation. In fact, some plans no longer guarantee that your dollars will lock in present rates. Instead, these plans invest your money with state funds. Who wants their state government as a money manager?

 

 

Life Insurance – Some life insurance plans, such as whole life and universal life are presented as attractive options for education savings vehicles.

Upside: These plans are financial-aid friendly. When completing a FAFSA application, money inside of life insurance policies doesn’t count against your savings, acting as a nice shelter. Also, if for some reason the insured passes away, money is available for education.

Downside: You may have to cancel your life insurance policy to withdraw education funds. What if you still need the policy? Also, do you really need life insurance? If the answer is yes, and you’re sure that you will no longer need coverage after this incident, then this might be a good option.

Watch out for fees, too. Not only will you pay for insurance, but often a policy which offers stocks and bonds are filled to the brim with fees to manager and (maybe more importantly) to withdraw funds.

Still want life insurance in your account? Read this good article at FinAid.org for a more in-depth argument: Variable Life Insurance Policies.

 

Annuities – Tax deferred savings may seem like a good option for education planning. Why save into an account that’ll be taxed every year when you can shelter your money?

Upside: These accounts are FAFSA friendly, meaning that they are not usually counted in the equation for financial aid. Many annuities offer some flexible savings options.

Downside: Too many to mention here, but mostly: fees and penalties. Make sure you’re going to be over age 59 1/2 before you remove money, because if not, there’ll be IRA penalties on top of whatever the annuity company may charge.

Taxes can be a bear. Here’s why: when you withdraw cash, dollars in the account are removed in a LIFO (last in-first out) accounting manner. This means that all interest on the account must be taken before principal is removed. Why is this a big deal? Taxes. You’ll pay taxes as if you earned the money in the year you remove the money. This income may also make your chances of receiving financial aid worse in the following year.

 

Less Complicated But FAFSA or Tax Return Unfriendly

 

Stocks or Stock Based Mutual Funds – These accounts can be used whenever you wish, assuming the dollars aren’t inside of a tax shelter. In some years there’s a chance of nice returns, too.

Upside: Returns. While there are no guarantees, over long periods of time the instability of a stock or stock-based exchange-traded fund or mutual fund can be countered with a high average annual return.

Downside: Risk. There is a chance you could lose a substantial amount of principal if you don’t monitor or manage your money. Also, this type of investing isn’t FAFSA-friendly. Dollars that aren’t sheltered count directly against your chances of financial aid.

 

 

 

Bonds or Bond-Based Mutual Funds – More stable than stocks, these types of funds have performed attractively over the last ten years.

Upside: Returns with generally less risk than stocks above. Because bonds throw off dividends as one of the main methods of creating returns, these investments often perform more consistently than stocks.

Downside: Taxes. Bonds often throw off an attractive dividend that savers often reinvest. This money, unless it comes from a special type of bond such as a municipal bond fund, is taxable every year, slowing down your return. While there has been tax reduction with capital gains taxes, these are taxed as income, which is a much higher tax bite. These are also FAFSA unfriendly investments, unless you use government savings bonds. These can be good to you tax-wise, as long as they’re titled correctly and cashed in the same year as you’re paying qualified education expenses.

 

The Easy Way To Save For College

 

Roth IRA Plans – A Roth IRA is generally a retirement savings vehicle. Money invested gives you no tax benefit today, but can be taken tax free during your retirement years. You’ll have to follow a few rules, but you are allowed to withdraw funds for college. You may also use nearly any time of investment you choose inside of a Roth IRA.

Upside: Tax shelter. This money can grow tax deferred for education, and if you end up not using it can be used later for retirement, tax free.

Downside: Retirement savings. The best use of a Roth IRA is clearly as a retirement savings vehicle. While money can be used for college, why miss out on the main Roth opportunities around retirement?

 

Coverdell Education Savings Accounts (ESAs) – These plans allow you to save not only for college, but also for earlier years of private school expenses.

Upside: Flexibility. This tax shelter allows you to use money for many types of education options, so it’s great if you’ll have elementary, high school and college savings needs.Classroom

Downside: Funding. Man, these accounts are small. Because you can only place $2,000 per year into this type of account, they often don’t make sense. I’d also meet people with very limited funds in a few different Coverdell IRAs. Who can manage all these little accounts effectively?

The IRS page on Coverdell ESAs is very helpful. Find more details here.

 

529 Plans – State sponsored education plans offer a good tax shelter, are somewhat FAFSA friendly, and eliminate taxation of dollars as long as funds are used for qualified education expenses.

Upside: Amounts of savings. You can pack tons of money into these plans. Most allow as much as $300,000 to be invested into a 529 account. These accounts can either be in self-directed fund options or can be in age-based options. If you don’t use the money for the primary beneficiary, funds may be used by siblings, parents, children or other close relatives. In these plans your choice of education institutions isn’t limited to a single state. You may use these dollars in any state and still receive the tax benefit.

Downside: Money earned in a 529 plan must be used for education expenses or you’re slammed with penalties. If you aren’t sure about saving for college, funding your Roth IRA first might be a better idea, because while these funds are flexible for college funds, money will be trapped here.

 

Of these, the savings option I like best is a 529 plan, because of its flexibility, range of schools that accept funds, and tax treatment. While it isn’t best for everyone, for the vast majority it’s where you should save for college.

 

Here’s How To Evaluation 529 Plans

 

Just like we’ve told you previously that Morningstar is the best way to evaluate mutual funds, I like savingforcollege.com to evaluate 529 plan options.

Here’s a link to savingforcollege.com. Have a look around to see how thorough this site is on investing for education.

The Good – Lots of information on FAFSA and college savings options. Great reviews on the fees associated with 529 plan savings accounts.

The Bad – While fees are certainly important, I’m about returns. Savingforcollege.com does a poor job of comparing how money managers work unless you’re willing to fork over some money for a premium membership. When compared to more robust money management sites such as Morningstar.com, there’s no reason to pay for this information.

 

Can I recommend a single-best 529 plan?

 

Absolutely not.

Check your state’s plan options at savingforcollege.com to see how they stack up. Always evaluate a few national plans to see how they compare against your own state’s options.

My favorite national plan is UPromise, though I also like the T. Rowe Price option.

Why Upromise?

I’ll attack this next week, but here’s a preview: not only is the plan managed better than most options available, but if you sign up your credit and debit cards, but using the Upromise Rewards program (which you can sign up for whether you use a Upromise 529 plan or not) you’ll receive points which can translate into extra money into the 529 plan later. Combine the benefits of low cost investing, good management and extra money, and you’ve found a plan that’s hard to beat.

If you want to compare Upromise with your state’s plans, here’s a link for more information: Upromise is the smart way to save for college!

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Stop Reading About Last Year’s Top Ten Mutual Funds

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Okay, play before work: when theOtherGuy and I were designing the new site last Friday, it was a total nightmare. I wanted to get the Blog Post of the Week! up before midnight (so that Andrea from SoOverDebt.com could get both of our reader’s attention). Running out of time, I just grabbed a pic of my blog-writing friend Cooper. My cat.

Yesterday, my friend Doug—who has a lifetime of tech work behind him–was commenting on the new site layout:

(finally) Doug: …and one more thing, get rid of the cat picture.

me: Ha!

Doug: I know you think I’m joking. I’m not. It’s a deal breaker. Take down the cat.

me: (suddenly miffed for no reason whatsoever): Ha!

So now, completely out of spite, Cooper’s pic is going to stay on the site for the next seven days. Our Alexa site rank will probably plummet. No advertisers will touch us (nothing new there). But because Doug said “deal breaker”, Cooper gets his seven days of near-fame.

Now, on with the show……

SmartMoney.com yesterday published a list of the top 100 funds of the past 5 years. We’re inundated with these types of lists in January. I had a rare opportunity to read USA Today on my way home from Disney last week, and long-time finance writer John Waggoner penned a piece titled Fund Investors Ran in Place in ‘11. The story discussed what we already know: 2011 was a roller coaster year, with the average stock fund, according to Lipper, losing 2.9 percent. Investors are scrambling to find better results.

That wasn’t shocking.

What I found annoying was the story’s partner: “More on Funds, Quarterly, Yearly Results Tables….”. It was pretty much the same story I saw yesterday at SmartMoney. The obvious (unstated) connection I believe readers will make is that they’ll find better fund by reviewing the best ones from last quarter or last year.

USA Today and SmartMoney wouldn’t run stories featuring the top ten mutual funds (or 100….or whatever) if people didn’t search for this information. I don’t fault them at all. It sells. Turning to the USA Today piece, here’s a listing of the 4th quarter’s best and worst, as well as the 12 months’ best and worst funds. One page over I find the list of the top funds over 5 and 10 years.

Yuck.

Stop reading about the Top Ten Mutual Funds.

In his seminal investing book The Truth About Money 4th Edition’ target=_blank>The Truth About Money, financial advisor Ric Edelman discusses this thirst people have to throw money at last year’s winners. We want to own winning funds. Many of us have heard grandpa tell stories about the legendary returns of Fidelity Magellan back in the day, or of that high-flying Janus Twenty fund in the months leading up to the tech wreck. We want those days back. We’d love nothing more than to be invested with some manager who always makes us money. But as Edelman describes, history works against you if you’re trying to find great results this year by reviewing last year’s winners.

Looking at the top ten mutual funds rarely produces winning result.

WHY SHOULDN’T I INVEST IN LAST YEAR’S WINNERS?

  • When everyone clamors to enter a fund, investing millions of new dollars, the fund is doomed to failure. According to this study: Star Power: The Effect of Morningstar Ratings on Mutual Fund Flow, funds with high returns one year and Morningstar rating upgrades nearly immediately experience an unnaturally high gain in assets. These assets must be invested by the manager, who finds it more difficult to spread the investment among quality names. You’ll rarely find a manager can keep up with these huge asset spikes.
  • Often, the top ten mutual funds and ETFs are in specific categories which spiked during that calendar year. In 2010, commodity names like silver and cotton performed handsomely. In other years, real estate, large company stocks, or internet stocks have been big winners. If you invested in silver or cotton in January, 2011 based on 2010 results, you stepped in it. To mis-quote Sarah Palin, “how’s that workin’ for ya’ now?”
  • You may pay handsomely for a top fund. Funds with high expenses which spike may be especially dangerous. One top fund of 2010, Morgan Stanley Focus Growth B (AMOBX) carries an expense ratio of 1.77 percent. This fund competes against the S&P 500. If you’d purchased iShares S&P 500 index exchange traded fund, your expense would have been 0.09 percent, plus any trading costs. Big difference.

Here are some top funds, ETFs and ETNs listed in “best of” 2010 publications and their 2011 results:

Fund Name2010 Result2010 S&P2011 Result2011 S&PWho Listed
M.S. Focus Growth B AMOBX25.8715.06-6.432.11The Street
Fidelity Growth Co. FDGRX20.55 0.67 The
Street
Fidelity Contrafund FCNTX16.93 -0.12 The
Street
Proshares Ultra Silver AGQ182.44 -47.47 USA Today
iPath DJ-UBS Cotton Index96.22 -22.71 USA Today

In November of 2010, TheStreet.com listed the top performing funds competing with the S&P 500 here.

In January 2011, USA Today published a chart of the top performing funds of the year, which included ETFs and ETNs.

HOW SHOULD I PICK FUNDS?

(Photo credit: Crosa: Wikimedia Commons)

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