How often should I rebalance?

I was originally going to write this post on how to maximize returns through rebalancing.  My underlying assumption was that rebalancing helps your portfolio by “buying low and selling high,” and that I only needed to figure out the best rebalancing interval (monthly, yearly, etc.) that would maximize my returns. Through my research, however, I was able to have some sense knocked into me by a couple of enlightening articles, and one fantastic quote by a Vanguard research report “Best Practices for Portfolio Rebalancing”  July, 2010:

“It is important to recognize that the goal of portfolio rebalancing is to minimize risk (tracking error) relative to a target asset allocation, rather than to maximize returns.”

This was such a great reminder for me.  The whole point of rebalancing is to make sure your portfolio reflects the level of risk that you are comfortable with.  If at the outset, you say you want 60% stocks and 40% bonds, then even a slight 0.1% shift towards stocks means your portfolio has more risk than you want it to.  Rebalancing for any other reason than to minimize tracking error is a form of active trading, which by now, it should be pretty clear I am against.

Should I rebalance every day then? Theoretically, Yes.  In reality, No.  In reality, it usually costs money to make trades.  Even if it doesn’t (like if you have a Schwab account and only buy Schwab ETFs), making these trades takes time.  So the real question is how much tracking error are you willing to accept in your portfolio, and how much time are you willing to take to maintain it.

How often should I rebalance in reality?  The industry standard is to rebalance every year, and that is a perfectly good approach.  In the Vanguard report linked above, Vanguard has a slightly more nuanced approach that I think makes the most sense.  The report suggests that you monitor your portfolio semi-annually or annually, and only rebalance when an asset drifts more than 5% from its target percentage.  They go on to say that this approach “is likely to produce a reasonable balance between risk control and cost minimization for most investors. Annual rebalancing is likely to be preferred when taxes or substantial time/costs are involved.”

I would also suggest that you rebalance every time you add money to your account. Recently I’ve been putting money into a “house downpayment” account where I buy a number of index funds.  Since this is the type of account that I don’t make automatic deposits from my paycheck every month, I usually wait a few months and make a large contribution to portfolio and use the contribution to buy more shares of the 5 different ETFs that make up the portfolio.   Since I have to place orders anyway, I might as well make sure that my portfolio will reflect my preferred asset allocation after I finish the new trades.  This is an easy way to rebalance more than just once a year without requiring extra effort.

Does rebalancing help you get higher returns?  Ok, lets say you agree to the basic premise that rebalancing is only for the purpose of minimizing tracking error.  But does rebalancing actually get higher returns?  Is there is a rebalancing time interval (or threshold) that historically offers the best returns?  If so, then you would want to know, right?  The  answer  unfortunately depends on who you ask.

In the Vanguard study (mentioned twice and linked above), the summary states that, “Our findings indicate that there is no optimal frequency or threshold when selecting a rebalancing strategy. This paper demonstrates that the risk-adjusted returns are not meaningfully different whether a portfolio is rebalanced monthly, quarterly, or annually; however, the number of rebalancing events and resulting costs (taxes, time, and labor) increase significantly.”

Another financial advisor explains it in a different way.  The author says that when rebalancing, you are just as likely to “buy high and sell low” as it is the other way around.  He says that rebalancing can increase your returns – but only if you get the timing right.  In other words, you either have to be lucky, or trying your hand at market timing, which from my perspective is a losing proposition.  Two great posts explaining this can be found here and here.

Other researchers have tried to empirically prove that a certain method of rebalancing can increase returns, like this study by a Managing Director at TD Ameritrade. This study shows that there are “significant advantages of opportunistic rebalancing (look frequently and rebalance only when you need to) over traditional annual or quarterly rebalancing.”  In this approach, there is a complex method to determine whether you should initiate a rebalancing.  The approach outlined in the study is time consuming (it requires frequent portfolio checking) and borders on being an active trading strategy, but at least makes for an interesting read.

These three different takes are by no means an exhaustive inventory of all the views on rebalancing, but I think they are representative of the types of research you will find.  While you might find a complex method of rebalancing that can add a few basis points on your annual return, don’t forget that the point of rebalancing is simply to reduce your risk.

How often do Vanguard Target Date Funds rebalance?

I’ve been doing a lot of research lately on portfolio rebalancing and it got me wondering about Vanguard’s rebalancing strategy for its own target date funds.  After reviewing the fund’s prospectus, I decided to give Vanguard a call directly using their customer service line and ended up speaking with a representative named Robert.  I asked Robert two primary questions:

How often does my target date fund (VFIFX) rebalance?  Robert first searched through the prospectus and couldn’t find anything there so he had to place me on hold and speak with another department.  When he came back he told me that Vanguard rebalances daily just by properly managing the money coming into the fund from new investors/re-investors and the money going out of the fund from withdrawals.  He also told me that if the portfolio skews more than 2 or 3 percent from its target allocation, the fund will actively buy or sell shares of its underlying holdings to rebalance.  I pressed Robert on this point by asking him if it was an automatic 2% trigger or if the fund would only make an active adjustment during set time periods.  In other words, did the manager check the fund every quarter and only rebalance if the assets were more than 2% off, or would the manager rebalance any time the the assets were 2% off – even if it meant making trades every other day (like in a volatile market)?

Robert’s response to this was interesting – although in retrospect unsurprising.  He said that Vanguard does not release that information because of the potential for abuse.  If it was public knowledge that Vanguard rebalanced its funds on certain dates, then traders could take advantage of that fact by manipulating the price of the underlying funds that the VFIFX would have to buy in order to rebalance (In this case, VFIFX has 3 underlying funds: the Vanguard total stock market index, the Vanguard total international stock market index, and the Vanguard total bond index).  I’m not entirely sure how someone could benefit from this knowledge, but I’m guessing it is related to the ways in which a hedge fund manager can manipulate stock prices.

Does my target date fund shift its asset allocation on a continuous basis?  Robert pointed me to the graphic on the Vanguard Target Retirement fund site (which I’ve also linked to in previous posts).  When you click on a fund under the heading  “Decide which fund is right for you,” you will see a graphic similar to the one below.  This particular graphic corresponds to the 2050 fund (VFIFX).

As you move the slider left or right, it will tell you the asset mix that the fund will have at that time.  My question to Robert was whether the asset allocation changed continuously as the graph indicates (meaning a smooth line), or if it changed at stepped intervals – like every five years that corresponds to the Target fund offerings (there is no target date fund for 2051).  Robert said that the graphic essentially represented how the allocations would change, but didn’t go into much further detail.

I took a screenshot below showing the allocation change that occurred by moving the slider slightly to the right.  From what the graph tells me (by playing with the slider for a few minutes) the asset allocation changes every year. Presumably that is the answer – Vanguard Target Date Funds adjust their allocation every year.  Although, conceivably Vanguard could adjust the allocation daily by hundredths of a percent to create an even more continuous risk reduction instead of adjusting just once a year.

What is the best way to invest money for 5 years?

Like many people around this time of year, I received a nice little check from the IRS for my 2011 tax return.  I started thinking of all the things I could do with the extra money – a 47″ plasma TV, maybe an iPad, or  some new ice hockey goalie equipment.  You know, the important things in life.  Also on the list of things I want, however, is a luxury condominium with a sweet view of downtown.  Except that costs more than any tax return that I will ever see.   I figure I’ll be ready to buy a home in about 5 years (because 5 year plans never go wrong) and as a result, it is probably about time that I start saving for it.  So I decided to put my big screen TV hopes on hold and put the tax return money towards my future home.  But that was as far as I got before I realized I didn’t know where to put it.

Where should I put money that I need in 5 years?  The 5 year investment is tricky, because it is short enough that you can’t afford the stock market risk like you can with a 20 year investment horizon, but long enough that it would be silly to let it sit in a non-interest bearing account.  There are a couple of basic options out there.  There are your standard savings and rewards checking accounts, Certificates of Deposit (CDs), and finally, investment accounts.  These days savings accounts won’t get you much more than 0.75% APY, and even the best 5 year CD will only get you 1.80% APY – all according to bankrate.com.  (Also check out Smartmoney.com’s take on the best short term investments).  These options don’t even keep up with inflation, so 5 years from now your spending power will actually be reduced as a result of putting your money in these low yield accounts.  If you want the chance of earning interest greater than inflation, you are stuck with investment accounts – which is kind of scary.

At least with the savings accounts or CDs you know that in 5 years your money will actually be there.  But if you invest in stocks and the market goes bad… that luxury condo you’ve been dreaming of quickly turns into a suburban town home.  Just because you open an investment account, however, doesn’t mean that you have to invest in all stocks.  In fact, you probably shouldn’t.  As described in the my asset allocation post, a sound retirement portfolio will include bonds and treasury notes in addition to stocks.  Those who are 40 years from retirement can afford to take on much higher risk (because they have a long time to make up potential losses) and are recommended (according to Vanguard’s target date funds) to invest in 90% stocks and 10% bonds.  Those who are only 10 years from retirement are recommended to invest 66% stocks, 32% in bonds and 2% in cash. You can see the increase in bonds (in blue) as you get closer to the retirement goal in the graphic below from Vanguard’s website.

What asset allocation is best for a 5 year investment?  When I started thinking of the Target Date Fund’s progression to less risky assets, it suddenly hit me.  The 5 year investment is an awful lot like your target date fund investments when you are in retirement.  And think about it: When you are in retirement you certainly can’t afford for your nest egg to take a big hit in the market, but you need continued appreciation to try and live off the nest egg’s interest.  So what exactly does an in-retirement asset allocation look like?  I went straight to Vanguard’s website and copied down the asset percentages for the 4 funds shown below.  On the chart, the risk and expected rate of return decreases from left to right.  I’ve included two target date funds that have a target retirement date close to 2012 just as a comparison, but it is the allocation percentages from the Vanguard In-retirement fund (VTINX) that you will want to use.  While I was looking on the website I came across Vanguard’s “Life Strategy” funds, which believe it or not, have a fund specifically designed for 3-5 year investment horizon (VASIX).  This would also be an reasonable asset allocation, though it is more conservative than VTINX;   likely due to to the fact that that it is meant to be used to save for something as soon as 3 years away.

What kind of return can I expect from these funds? Keep in mind that because this is an investment in the stock market and bond market, there is no way to predict your annual yield over 5 years.  BUT, based on the asset types in each fund we can make an educated guess about what kind of returns to expect over the long run – like 20 plus years.  I know in some ways that is not helpful because we are looking at a 5 year window, but that is the best we can do; it is impossible to predict an investment’s 5 year return with any accuracy.  With that said, over the long run, I figure that these funds will average a 4% return annually.   Why is that? The goal of most in-retirement funds (at least Vanguard’s) is to get a 4% return.  The idea is that while in retirement, you can spend 4% of your nest egg every year, but by earning 4% through investments, your nest egg never loses value.  Since Vanguard advocates for using the 4% rule in retirement planning calculations, I have assumed that their retirement investments (such as VTINX) are structured to provide roughly the same return.  As it turns out (see graph below) VTINX has actually averaged a 5.30% average annual return since its inception (which was only 8 years ago so the numbers don’t mean that much).

Morningstar.com provides the actual (not average) annual return in each year since 2003.  This look shows how volatile the annual yield can be, ranging from  negative 10.93% in 2008 to a positive 14.28% return in 2009. What I’m trying to say is this:  if you invest in VTINX and keep it for 30 years, your average annual return would probably be around 4%.  However, it is entirely possible that for the 5 year window between 2012-2017 (when you own the fund) the fund would have an average annual return of 10%, or even 1%.  It is riskier than a CD, for sure,  but it is certainly well managed risk.  And besides, 4% return on my investment sounds pretty good to me, especially when I can only get 1.8% with a CD.

OK. You’ve convinced me.  But I don’t have an investment account, so what do I do? It is pretty easy:

  1. Open a Vanguard or Schwab investment account.  Make sure that you are opening an investment account and not a retirement account like an IRA, Roth IRA or 401(k).  Why those two firms? Both Vanguard and Schwab allow you to buy their brand of ETF index funds (which have the lowest expense ratios) for free.  FOR FREE!  There are no other investment firms out there with this kind of access to index funds, and as explained in my Target Date Fund Series, I think buying index funds (not individual stocks) is the smartest thing you can do.  In addition I’m consistently impressed with the advice and service that I get from both these firms (yes, I have accounts at both).
  2. If you open a Vanguard account and are going to invest more than $1,000, then you can simply buy the VTINX ($1,000 minimum) or VASIX ($3,000 minimum) fund mentioned above.  If you are starting out with less money you will have to buy 3 or 4 index fund ETFs to mimic the asset allocation of either VTINX or VASIX.  But don’t worry, I’ve made it easy for you – take a look at the chart at the bottom of the post.  It gives you the symbol of the ETF you should buy (right hand side) along with the percentage of your investment that you should spend on each ETF.   Two quick notes if you want to mimic the VTINX asset allocation: First, To put 5% in cash, you won’t have to buy a particular fund, just leave 5% of your savings unspent in the account.  Second, if you have a Vanguard account they don’t have an ETF for inflation protected securities, so just put that extra 20% in the BND fund.
  3. Keep adding to your investment account (use the same percentages detailed in step 2).
  4. Rebalance every year.
  5. Buy a home! (or whatever else you have been saving for)

How long does a mutual fund transaction take?

Last week was a crazy week for the stock market (it feels like they all are recently). And since you might be reading this a few weeks or months after the fact here is a nice little summary from Forbes.com.  On Monday August 8th, 2011 – the first trading day after S&P’s downgrade of the United States’ credit rating – the S&P 500 index lost a whopping 6.7%.  On Monday night, after catching up on the day’s stock market news I had two thoughts:  1. SELL EVERYTHING NOW! and 2.  BUY MORE STUFF NOW!

This, I think, is probably pretty representative of how most people reacted to the news.  Ultimately, levelheadedness prevailed and I decided to put more money into my retirement fund – aka. Option 2.  But by the time I came to that decision the trading day had long been over and I was faced with the unpleasant realization that mutual fund transactions do not get completed instantaneously.  I clicked the “buy” button anyway – even though I had no idea when my transaction would be processed. And after a few days of nervously checking my mutual fund account, then the stock market, and then the mutual fund account again… I can finally answer the post’s initial question:

How long does a mutual fund transaction take?   Mutual funds differ from regular stocks in that you can’t buy and sell mutual fund shares instantaneously during the day.  Mutual fund share prices do not fluctuate throughout the day.  Instead, their share price is calculated once at the end of every trading day.  This is due to the fact that mutual fund prices do not reflect investor perceptions, but rather a simple accounting of the fund’s actual Net Asset Value (NAV).  As a result if you click the “Buy” button at 10:00AM on Monday morning, your transaction will not be processed until the market closes at 4:00 PM Monday afternoon.  In addition, the price that the mutual fund is listed at when you start the transaction will probably be different than the price you will eventually pay at the end of the day (because the NAV will be recalculated at 4:00PM).  The bottom line is, no mater when your mutual fund transaction is initiated, it will be processed the next time your clock reads 4:00:00 PM.

I’ll use the actual scenario that occurred last week as an explanatory aid.  As you may already know, I am the proud owner of a Vanguard Target Date Fund. I’ve included a screenshot  of the chart for my fund (VFIFX) spanning the last 20 or so days, including the crazy last week.

On Monday, August 8th, around 10pm (after the trading day closed) I initiated a transaction to buy more shares of VFIFX – when it was listed at about $19.25 a share.  At 4:00 PM on August 9th – when my transaction should have been completed – the price was about $20.00 a share.  This means that because of the mutual fund transaction delay, I would be getting less for my money than I would have if I managed to buy the shares before the close on Monday.  Fortunately for me, my transaction took a day longer.  Because I don’t keep any money in my vanguard account (besides what is in the VFIFX fund), when I clicked “Buy” I was actually initiating a transaction to transfer money from my checking account to the vanguard account and then to buy mutual fund shares.  As it turns out it took a day for the money transfer to occur (this may take longer/shorter with your specific accounts), which meant I bought shares at the close of Wednesday August 10th.

Why do I care how long it takes me to buy a mutual fund?   The answer is that you shouldn’t.  If nothing else, last week’s experience was a good reminder to me that investing in mutual funds (and retirement investing in general) is not about timing the market.  It is about putting money in your account consistently, trusting the market’s historical performance, and not worrying about market fluctuations.  But, just in case you find yourself trying to get an edge by buying mutual funds on a downswing, it is important to know beforehand how long your transactions take.  This way you can properly assess the risks associated with the transaction time delay.  I know that this is not a post with ground breaking investment strategy, but it took me long enough to find this information on my own that I thought it was worth sharing (and writing down for my own future reference).

1. Individual Stocks and Retirement Portfolios

This is part one of seven in my attempt to explain how you should invest in your retirement portfolio.  Click here for the introduction.

Should I own individual stocks in my retirement account?  In the Fall of 2007, I had just come off a bitterly disappointing fantasy baseball season.  It was a season where I spent about 30 minutes a day researching stats and adjusting my roster.  Every day I would look at each player to see what his batting average was against the opposing pitcher, if he was on a hot streak and or even if he was playing a day game or night game (some players hit better in the day).  So when I came in third place, I felt like I had nothing to show for all the time and research that I had spent that season.

Coincidentally, that semester in school I was introduced to the stock market for the first time and became fascinated with the idea of making money in stocks.  I thought to myself, “If I spend as much time as I do on fantasy baseball on researching stocks, I might be able to actually make money instead of wasting my time looking at baseball stats.”  And so I began investing in a discretionary (non-retirement) portfolio.

As of today, my portfolio’s value has declined about 4 percent from its original value in 2008.  This is not terrible considering many portfolios lost 1/3 of their value during the mortgage crisis that happened to occur at the same time, but it is also nothing to brag about.  I still keep some money in this discretionary portfolio, but when I asked myself the question “Where should I put my retirement money?” I vowed to never own any individual stocks in my retirement portfolio.  Here are the three questions I asked myself that got me to that conclusion.

How much time do I want to spend on my retirement account every week?  Believe it or not one of the best books I read on individual stock investing was Real Money by Jim Cramer.  It was great at teaching the basics of how to analyze stocks and time the market by explaining things like price to earnings ratios and sector rotation.  One of the most important lessons I learned from Cramer was that owning stocks was not about “buy and hold” but “buy and homework” – as he is famous for saying.  He recommends that you do one hour of research per week for every stock you own, and that you need to own at least 5 stocks to have a diversified portfolio.  That is five hours more than I want to spend thinking about my retirement account every week.

If I spend the time, will it be enjoyable or stressful?  All right, let’s say I did have the time and inclination to spend at least 5 hours a week doing research.  That means that I’d be checking my stocks’ value once a day on the internet.  I would be straining my ear if I heard something on the radio about the stock market and thinking of what it might mean for my retirement.  Instead of flipping channels right past CNN I might actually want to hear what the talking heads are saying about the Federal Reserve and interest rates – and still have no idea if I should buy or sell some of my shares.  I know for a fact that there will be surges of joy when my portfolio goes up 2% in value one day, and then instant depression if the portfolio’s value drops. To me it just sounds like stress.  Especially when my ability to retire is on the line.

How likely am I to get better returns than everyone else?  Just for fun, I asked myself, what if I did have the time, and I didn’t mind the stress.  What makes me think – as an individual investor researching 5 hours a week – that I am going to see greater returns than a MBA that does this for a living?   Sure, there are always going to be a few people that made the right call and hit it big.  And I will always have some friends telling me how good the market’s been to them (though I know they are probably lying).  The fact of the matter is that the market is a zero sum game.  The winners and losers must balance out.  How can I be so sure that I’ll be on the winning side?  As I later learned (and present in part 2), all the research indicates that underperformance is a much more likely scenario.

I’m not trying to say that investing in individual stocks is always a bad idea.  I am saying it’s a bad idea for a retirement portfolio.  Its one thing if you make the wrong call in your discretionary portfolio and have to buy a 40 inch TV instead of the 60 inch 3D HDTV you’ve been saving for.   But what if you make the wrong call in your retirement portfolio?  The fact is, because the retirement nest egg is so important to your future security, buying and selling decisions have extra stress and extra importance.   Having that extra stress for returns that aren’t even likely to beat the market hardly seemed worth it.  Especially when I have to spend at least 5 hours a week.  So If I don’t want to invest in individual stocks myself, where should I put my money?

To continue reading, follow the link to Part 2 – The Case for Index Investing.

2. The Case Against Mutual Funds

This is part two of seven in my attempt to explain how you should invest in your retirement portfolio.  Click here for part one.

I knew I did not want to invest in individual stocks myself, but I still thought that  picking the right stocks at the right time was the only way my retirement portfolio was going to grow.   Personally, I was not confident that I would find an edge over other investors or even that I would be able to overcome the human tendency to want to sell low and buy high – the opposite of good trading.  But I figured some savvy broker with a Harvard MBA would be able to.  As a result I started looking into actively managed mutual funds.  Mutual funds are an investment vehicle that pools money from individual investors and leaves it in the hands of the fund manager (the savvy MBA type).  This fund manager’s only job is to make money for the investors in this fund.  Usually he or she (most likely a he) will have a team of research assistants and all day they research stocks, bonds, commodities… you name it.  If he has 3 assistants, that means the fund spends an average of 160 hours a week researching the market (compared to the 5 that I would devote to it).  And that’s if they only work 8 hour days.  In other words, mutual funds have the time and experience to make better investing decisions – and get better returns.  Or so I thought.

It turns out that buying mutual funds – a retirement solution that so many people rely on, is one of the worst investment vehicles for your retirement money.  That is in part due to the fees and commissions that are associated with buying some funds (such as loads), but most importantly it is due to mutual funds under-performance relative to the market.  The biggest fallacy in the finance industry today is notion that actively managed funds will outperform the market.

What is “the Market?” When I say that most mutual funds fail to beat the market, what do I mean by “the market?”  The market is an elusive term, but most often refers to the return you would get if you literally bought every stock listed on the S&P 500.  The  S&P 500 is an index made up of 500 stocks selected by Standard and Poors (S&P) to be an indicator of total US Stock performance.  There are many other indexes designed to track the market performance – you’ve probably heard “The Dow” (Dow Jones Industrial) or “The Nasdaq”  or even the Rusell 3000 quoted on news stations. They all represent different ways of measuring the market’s overall performance. The Russell 3000, for instance, is an index composed of the 3,000 largest US traded stocks.  While all of the indexes mentioned above track essentially the same thing, the S&P 500 is often used as the standard benchmark for the performance of US stocks.

There is a lot of debate over what exactly is the average return you can expect from the market over a long period.  But for this post, the exact return that you can expect is irrelevant since the market, over the long term, has proven to be the best type investment that you can make.  The market consistently outperforms other investments such as bonds and treasury bills.  If you interested in the types of annual returns you could expect for each investment type or are skeptical about my claim tat the market is the best investment, see the post on “Average Annual Market Returns.”

Nowadays buying the market is possible because of index funds.  An index fund is a type of mutual fund or ETF (Exchange Traded Funds – more on that in Part 3) that has a portfolio meant to exactly track a market index.  For example, there is a S&P 500 index fund.  That means when you buy this fund, its performance will exactly match the performance of the S&P 500, which will come pretty close to matching the entire performance of the US stock market.  Index funds are considered a form of passive investing (as opposed to active investing) because the managers of index funds make no attempt to make money.  The managers (probably just a computer program) simply aim to make sure the fund’s portfolio matches whatever index it is tracking.

Because of the existence of index funds, achieving the same return as the market takes absolutely no skill whatsoever – since everyone can do it.  As a result, the market returns have become the standard by which all active investing strategies and managers are measured.  In other words, if you are a mutual fund manager and you buy and sell individual stocks all year, yet at the end you have under performed the market, you will look silly.  You could have bought an index fund and sat back in your big comfy leather chair, done absolutely nothing, and would have generated better returns.

Are Mutual Funds really that bad? If you are like me, you would expect that mutual funds would consistently beat the market, but it turns out that they don’t.  One of the best books I read exposing this truth was The Power of Passive Investing, by Richard Ferri. A main point that the book constantly drums into your head is that 2/3 of mutual funds fail to beat the market. Further more, the average underperformance from losing funds was more than double the outperformance of winning funds.  I’ve stated it as simply as I can here. But let me assure you, there is an entire book full of independent studies to back this up. The image below is one of the most straightforward pieces of evidence in the book.  It shows the performance of the 136 actively managed funds (that invested primarily in domestic equity and have been around for the past 25 years) compared to the S&P 500 index fund.  There is no secret to the numbers, you can find the annual returns for each of these funds online.


Providing evidence of mutual funds underperformance is more than just one man’s crusade.  Even the popular investing site, The Motley Fool agrees, stating that “more than 80% of  mutual funds underperform the stock market’s average returns.”

Why haven’t I heard this before? I know what you are thinking – “If this is true, then why haven’t I heard this before and why don’t more people know about it?”  I thought the same thing.  According to Ferri, the primary reason we flock to mutual funds is because of the massive amount of advertising that is done on their behalf.  You see commercials for financial advisors and mutual funds, but you don’t see commercials for index funds. Most investment companies earn revenue by selling investment products and charging commissions or fees – two things you can’t charge an investor who simply buys index funds. Simply put, its hard to make money off of index funds, so the investment companies wont promote them.  Mutual funds on the other hand, are a cash cow for many companies.

But if the numbers are so terrible, how do they make mutual funds look so good in advertisments?  First, they only tell you the mutual fund return independent of the fees and commissions you will have to pay (Average mutual fund fees can reduce your annual return by 2%!)  What’s more is that advertisements only talk about the winning funds (which as shown above, actually represent the minority of funds).  How many times have you heard about Fidelity’s Magellan fund?  When I think of mutual funds, that’s what I think of, and it was one of the best performing funds of our time – consistently outperforming the market.  Is it really that surprising that you’ve never heard marketing for a fund that underperforms?

There are also a bunch of other tricks that advertisers use. They might compare their mutual fund’s performance to inappropriate benchmarks.  An example might be a mutual fund that had a majority of its holdings in domestic stocks, but had 40% in emerging market funds.  If emerging markets generated great returns and you compared that fund to the S&P 500 (a domestic stock index) it might look like you “beat the market,” when perhaps your emerging market stocks didn’t even beat the emerging market fund index.  Another strategy for advertisers is to give you the line, “why would you want to subject your self to merely average returns when you could have better than average returns?”  And they have a point.  Investing in an index fund guarantees you will get average returns, and investing in a mutual fund could get you better returns.  What they leave out is that getting better returns is not that likely.

Though I was initially skeptical that mutual funds could be that bad, I ultimately couldn’t ignore the data from multiple sources that said the same thing.  Two thirds of mutual funds fail to beat the market.  So if you can’t beat the market with a mutual fund, then why not just buy the market?

To continue reading, follow the link to Part 3 – Asset Allocation.

3. Asset Allocation

This is part three of seven in my attempt to explain how you should invest in your retirement portfolio.  Click here for part two.

At this point I was feeling pretty good.  I had just discovered an irrefutable truth about investing that not many people knew –  and it was actually going to make me money.  I was going to buy an index fund instead of a mutual fund and ride the market’s performance all the way until retirement.    Except its not quite that easy, because you can’t just buy one index fund.  One of the main points that was pounded in my head through all my research was that you can’t have have all of your retirement money in stocks.  In order to have a safe retirement portfolio, you must have your money in more than just one asset class.  An asset class is a group of securities (things you can buy on an exchange) with similar risk and rate of return characteristics.  For example, investors often refer to stocks, bonds and cash equivalents as the three main asset classes (some might also include Real Estate and Commodities).   Stocks have the highest risk and the highest return, cash equivalents are the lowest risk, but also have the lowest returns.  Bonds are somewhere in the middle.   The main reason to have different assets is to reduce the risk of your portfolio.  If you have a portfolio of all stocks, and the market crashes, you are out of luck.  But if the market crashes and you own bonds as well, your portfolio won’t lose as much value.  That is the very basic explanation of asset allocation.  Another benefit to having different asset classes (also known as diversifying your portfolio) is that when you rebalance your portfolio, you are guaranteeing that you are selling high and buying low.  More on that in Part 6.

How should I divide up my retirement money? As a young investor, the conventional wisdom says that you want 80-90% of your retirement money in stocks and the rest in bonds.  As you get closer to retirement you will want more money in bonds and in cash (the safer investments) so that you can preserve the money you saved.  There is a whole science out there about the best way to allocate your assets which I am only skimming the surface of.  In fact, most of the experts have a much more nuanced view of asset allocation.  It is not just about stocks and bonds, but about certain categories of stocks and certain kinds of bonds.   Richard Ferri’s book, The ETF Book, recommends the following asset allocation for “early savers.”

  • 25% – Total US Stock Market
  • 15% – Small Cap Value Stocks
  • 5% – Micro-Cap Stocks
  • 10% – Real Estate
  • 10% – Pacific Rim Stocks
  • 10% – European Stocks
  • 5% – Emerging Market Stocks
  • 10% – Total US Bond Market
  • 5% – Inflation Protected Bonds
  • 5% – High-Yield Corporate Bonds

That is 10 different asset categories!  More generally, however, it is 80% stocks (55% US, 25% International) and 20% Bonds.  Compare that allocation to Ferri’s suggestions for those who are about to retire.  The generalized allocation is 50% stocks (35% US, 15% International), 45% Bonds and 5% Cash:

  • 23% – Total US Stock Market
  • 7% – Small Cap Value Stocks
  • 0% – Micro-Cap Stocks
  • 5% – Real Estate
  • 6% – Pacific Rim Stocks
  • 6% – European Stocks
  • 3% – Emerging Market Stocks
  • 30% – Total US Bond Market
  • 10% – Inflation Protected Bonds
  • 5% – High-Yield Corporate Bonds
  • 5% – Cash

Can I find a fund for each of these asset categories? When I first looked at this list, I thought it would be impossible to find funds for some of the more interesting categories like “Inflation Protected Bonds.”  Fortunately for us, you can buy an index fund for every one of these asset classes.  It didn’t always used to be this way.  In fact, it wasn’t until 1975 that the first index fund was created by Vanguard as a mutual fund.  And it wasn’t until 1993 and the creation of ETF’s that enabled  you to buy an index just like you would buy a stock. Check out the link for more information of how ETFs work.  Personally, I like to think of ETFs as mutual funds but with ticker symbols.

You’ll notice that index funds can be both mutual funds and ETFs.  There is a great article by the Motley Fool explaining the differences in detail.  While they perform the same function and will generate the same returns (not accounting for any fees), there are differences in their underlying mechanics and the ways in which you can buy mutual funds and ETFs.  With mutual funds, you buy your shares at the end of every day.  There also may be a minimum amount you must invest to enter the fund.  With ETFs you buy a share of the index fund just like you would buy a stock.  For example, to buy the Ishares (a brand) S&P 500 index fund, you would search for ticker symbol “IVV” and place an order, which would be subject to any commissions that you get charged for trading stocks.  Most of the index funds out there today are ETFs and because they have ticker symbols they are often more easily bought and sold than mutual funds that you may only be able to buy if you have a certain company’s brokerage account.

It is important to note that not all index funds are benchmark indexes – or indexes that are meant to track the performance of a market.  Generally, when speaking about index funds – as I have in previous sections – investors are referring to benchmark indexes.  Strategy indexes are index funds that use analysis or strategy to pick stocks in their index and are not meant to track the market.  For example, there could be a strategy index ETF that uses a screen so that only stocks of socially responsible companies are in the index.  Another strategy index may use a complex mathematical formula to constantly buy stocks that exhibit certain price trend characteristics.

Strategy index ETFs like these outnumber benchmark indexes by 2 to 1 in ETF market (according to Ferri’s The ETF Book), but from my point of view they are not something that you want in your retirement portfolio.  Because strategy indexes are attempts to beat the market, they should be treated the same way as actively managed mutual funds and should have their performance compared to the market’s performance.  While there have been no studies (that I have seen) measuring performance of strategy indexes against the market, I am willing to bet that their performance is about the same as mutual fund performances – which as you will recall from part 2, is not very good. Furthermore, if you agree that having proper asset allocation in your retirement portfolio is important, then strategy index funds will not work for you.  It will be impossible to tell if your strategy index (that is based on some computer model with stocks that change every day) will have the proper ratio of micro cap to small cap to emerging market stocks.

How do I actually buy these different asset categories? At this point, I knew I didn’t have all the specifics, but I had a general plan for how I was going to actually fund my retirement account.  As I saw it, the first step was to find an ETF benchmark index that matches the asset categories I was looking for.  Once I found an ETF for each of the 10 categories listed above (for a young investor), I would buy each of the 10 ETFs every time I put money into my retirement portfolio.  I would make sure that the amount of money I had in each ETF was equal to the percent that recommended in the preffered asset allocation.  Lets say each ETF cost $1 a share (in reality the Bond Index ETF might cost $21.63 a share and the Emerging market Stock Index might cost $84.16 a share) and I had $100 to put in my retirement portfolio.  I would buy 25 shares of the Total Stock Market ETF, 15 Shares of the Small Cap Stock ETF, 5 shares of the Micro Cap stock index and so on…  In a case where all the shares were $1, except for the Total Stock Market ETF which was $25, I would buy just 1 share of the Total Stock Market ETF.  Its not the number of shares that count, but the amount of money in each category.

My retirement plan was finally starting to come together – that was until I realized that there was more than 1 ETF for every index I was looking for.

To continue reading, follow the link to Part 4 – Expense Ratios.

4. Expense Ratios

This is part four of seven in my attempt to explain how you should invest in your retirement portfolio.  Click here for part three.

As I began google searching for the first ETF I would buy, I quickly realized that there was more than one ETF for each type of index fund that I was looking for. In fact, for most of the index funds, there were at least three ETFs I could choose from. From my research, it appears that there are three main players in the ETF benchmark index world: Vanguard, Schwab, and iShares. These are three companies that actually “make” their own ETFs. Take the Total Stock Market Index, for example. I saw at the very least that I could buy Vanguard’s ETF (VTI), Schwab’s ETF (SCHB), or iShares’ ETF (IWV). Each of the ETFs were created for the same purpose – to track the performance of the broad (as in not just large companies) US stock market. Each ETF used a slightly different benchmark to track the broad market. IWV uses the Russel 3000 index, SCHB uses the 2,500 stock Dow Jones US Broad Stock Market Index, and VTI uses the MSCI US Broad Market index.  Despite the small differences, each index would be acceptable to use for the 25% of my portfolio that was to track the “Total US Market.” Knowing that each of the three ETFs were essentially the same, I was left with one question:

How do I know which ETF to choose? Since I had at least 3 options in front of me, I had to find a reason to choose one over the other. and I didn’t want that to be based on something silly – like which fund had the coolest ticker symbol. This is where expense ratios come in. Expense ratios are the amount by which your annual return will be decreased as a result of fees from the company that makes your index fund. So for example, IWV, the S&P 500 index fund from iShares has an expense ratio of 0.21%. That means if IWV’s annual return is 10%, the actual return reflected in your bank account would be 9.79%.  As of March 2011, these were the expense ratios for each of the three funds mentioned above:

  • Vanguard’s VTI 0.07%
  • Schwab’s SCHB 0.06%
  • iShares’ IWV 0.21%

The expense ratios are not even one whole percent!  The good news is that this is typical for funds that track the major indexes.  ETFs that track more nuanced indexes, like the emerging markets index, have slightly higher expense ratios.  Here are three examples of Emerging Market ETFs:

  • Vanguard’s VWO  0.27%
  • Schwab’s SCHE  0.25%
  • iShares’ EEM  0.69%

Clearly in the two examples above Schwab and Vanguard funds have the lowest expense ratios.  They are in fact almost identical, leading me to question whether the small percentage differences is a valid reason for choosing one fund over the other.

Is one tenth of one percent really that important?  I found a great website that had an article on how expense ratios affect long term performance.  Using the author’s work as a template, I made a spreadsheet of my own so that I could look at the specific examples I started above.  Lets take the first example – the three ETFs measuring the Total US Stock market:

This is a screenshot from the excel file I was using.  Here I am assuming that each fund will return 8% each year after an initial $10,000 investment.  After 10 years, if you put your money into SCHB which has an an effective annual return of 7.96% (8.0% – .06% expense ratio) you would have $120 less than you would have if you did not have to pay an expense ratio.  After 30 years, you would have $1,664 less in your retirement account because of SCHB’s expense ratio.    Lets say you chose to go with VTI over SCHB.  Over 10 years that choice would have cost you $20 ($140 – $120), and over 30 years that choice would have cost you $274 ($1,938-$1,664).  Now in the grand scheme of things, this is not a whole lot of money, especially over 30 years.  Now if you chose  the iShares IWV fund, I really can’t defend that decision.  After just 10 years you would be giving up $296, and after 30 years you would be giving up $4,043!  This is all money that you could have saved if you chose the SCHB fund.

With such low expense ratios – less than .1% –  the difference between competing ETFs is not as noticeable.  If we take a look at the Emerging Market ETFs, however, the differences become even more real:

In this case, choosing the Vanguard fund over the Schwab fund will cost you $39 in 10 years and $522 in 30 years.  Don’t even get me started on what you would loose if you chose the iShares fund.  That decision would cost you over $10,000 ($17,602 – $6,758) in 30 years!  If you are like me, you might be thinking “Expense Ratios really suck” and might ask yourself why you are buying funds that have them in the first place.

Do other assets have expense ratios? Any type of investment that requires a pooling together of different individual stocks or commodities is likely to have an expense ratio.  Consider it the price you have to pay to organize a number of different assets into one fund.  So while individual stocks don’t have an expense ratio, they are assets that are not relevant in this discussion since we are interested in index funds for our retirement portfolio.  If the lack of expense ratios in stocks make you want to buy them for your retirement, just think of the percent of your (likely) underperformance relative to the market as your expense ratio for buying individual stocks.

As far as mutual funds go, they have expense ratios and much more.  Typical expense ratios for actively managed mutual funds are around 1.5% according to Fool.com.  Not only do mutual funds have expense ratios, but many of them also have sales charges called loads.  A front-end load, for example, is a fee that takes a percentage of your money (around 5%) the moment you buy the mutual fund.  So if you wanted to put $10,000 into a mutual fund with a 5% front end load, you transfer $10,000 into the fund, but only  $9,500 makes it into your portfolio.  Then, after they are done stealing your money up front, the fund will still have an expense ratio further reducing your return that wouldn’t have beat the market anyway.  Now just in case I haven’t proved my point on how important expense ratios are, I want to include some examples of higher expense ratios, like those you might find in a mutual fund.  I haven’t bothered to calculate what loads do to your real return, but i didn’t see the point. Hopefully this spreadsheet scares you enough to never want to buy a mutual fund with a high expense ratio, much less one that charges load fees.

Armed with a new understanding of how to chose each ETF that I would buy, I quickly selected the 10 ETFs with the lowest expense ratios.  I logged onto to my Scottrade Account (my online broker at the time) to make my first trade when it hit me:  At $7 a trade, I would be spending $70 every time I put money into my retirement account.

To continue reading, follow the link to Part 5 – Account Fees and Commissions.