Beware of Mutual Fund Hype

Posted on April 26th, 2011 in Investments, Newsletter Articles, Retirement Planning by wayne

Whenever I see advertisements for a mutual fund family, I am reminded of the famous saying by Garrison Keillor “Welcome to Lake Wobegon, where all the women are strong, all the men are good-looking, and all the children are above average.” Similar to the children of Lake Wobegon, mutual fund families want you to believe that they all provide above average returns.

John Bogle is the founder of Vanguard funds and arguably the world’s most famous proponent of low cost investing.  In a recent Financial Times article, Bogle does an excellent job of deconstructing the misleading numbers that are often provided by purveyors of financial products.  Let’s examine his logic:

Bogle first reminds us that a stock’s value is NOT its current price.  As Benjamin Graham first recognized in the 1920s, the value of a stock is represented by the discounted value of the company’s future cash flow.  He called this the “intrinsic value” of a company.  At any particular time, the price of a share of stock may greatly exceed or be significantly less than its intrinsic value.  However, in the long term, a stock’s price will center around its intrinsic value.

Bogle next states that, due to the reduction of the stock dividends from the historic average annual rate of nearly 4.5% to the current rate of approximately 2%, nominal annual stock returns for the next decade will likely center around 7% instead of the historical 9.5% rate.  Thus, if a 9.5% rate of return for future stock appreciation is used in financial projections, these projections will likely be significantly overstated.

As an example, if you invest $50,000 for 20 years, with a 9.5% nominal rate of return, $50,000 would become $307,080.  However, if the nominal rate of return is 7%, in twenty years the nominal value of $50,000 would be $193,484.

A second “mistake” that Bogle notes is when projections show investment returns in nominal terms instead of their “real rate of return.”  The real rate of return is the nominal return return less the rate of inflation.  If the expected nominal rate of return is 7% and inflation over the next 20 years is expected to match the historic long term annual rate of 3%, the real rate of return is 4%.  Thus, using the same $50,000 investment over a 20 year period, the “spendable dollars” returned is only $109,556, a $200,000 reduction from the originally projected amount.

The third “mistake” is not including investment costs when considering total investment returns.  Investment costs include fund operating expenses, trading costs, loads (including 12b-1 fees) and asset management expenses.  These combined annual expenses can easily be 1.5% or more of your invested assets.  If these fees are included, your annual real rate of return can be reduced to 2.5% or less.  Including the reduction from investment fees, the $50,000 equity investment may only grows to a “spendable” $81,931 in 20 years.

All of the above calculations assume that the invested funds are held in a retirement account.  If not, tax consequences could further reduce the investment returns.

After considering these dramatic reductions in projected investment returns, it may seem prudent to forgo investing in stocks.  However, keeping money in a “safe” CD or money market fund will likely provide the historic long term real rate of return of -1% for these types of investments.  With this real rate of return, these “safe” investments will provide a “spendable” $40,895 on the original $50,000 investment in twenty years.  The “safe return” is approximately ½ of the return from the equity investment.

The message behind Bogle’s article is to be wary of future performance projections portrayed by many mutual fund companies and other financial service organizations.  By avoiding these three common mistakes, often ignored by investors and pension fund plans as well, you can identify more appropriate investment rates of return.

Should You DIY?

Posted on April 26th, 2011 in Financial Abundance, Investments, Newsletter Articles by wayne

The April issue of Money magazine included an article addressing when it is appropriate to DIY (do it yourself) certain financial tasks.  Two of the tasks included were “Managing a Portfolio” and “Creating a Retirement Income Plan.”  Money did not distinguish between the types of personal financial support available, implying that two different professionals may be required to perform these two services.

If you are interested in personal finances and are willing to invest the time required in learning how to manage personal finances, DIY may be appropriate.   Financial Abundance Guide was written as an aid for these individuals, helping them identify strategies to effectively manage their financial resources.  Unfortunately, I have found that most people have the same amount of interest in learning how to manage their finances as I have in learning how to re-tile my roof.  None!

If you are not interested in learning to DIY personal finances, here are some ways to identify the financial advisors that can meet your requirements.

The first area to consider is the type of advisor who fits your needs. There are basically three types of financial advisors:

1.    Commissioned based financial advisers typically present their services as “free.”  These advisors sell commissioned financial products such as mutual funds and deferred annuities. Sometimes, it is difficult to identify the commissions being paid to the advisor, such as mutual funds with12b-1 fees or products which must be held for several years to avoid a reduction in payout.

2.    Fee based advisors usually work for a broker/dealer.  These advisors charge a fee that is often based on a percentage of the assets in your brokerage account(s).  When an advisor is “fee based,” part of their compensation also comes from commissions for selling mutual funds and proprietary products.

3.    Fee only advisors receive compensation either on an hourly basis or based on a percentage of the assets they are managing.  These advisors receive no commissions.  They are only compensated by fees paid by their clients.

The second area to consider when choosing a financial advisor is the scope of personal financial services they offer.  These services also fall into three categories:

1.    Investment management firms provide services related to managing your investments.  While they may be compensated in any of the three methods described above, their financial services are often limited to helping clients manage their assets.

2.    Wealth management firms primarily focus on helping their clients effectively manage their assets.  However, a wealth management company typically provides other personal financial services such as creating retirement income plans, retirement planning and risk management (insurance) assessments.

3.    Financial Planning firms provide asset management services as a component of a comprehensive financial planning process.  While most financial planning firms provide an a la carte selection of services, they will have at least one CFP® who is capable of providing comprehensive financial planning for their clients.

If the only financial support you require is investment management, virtually all financial advisory firms can provide these services.  If investment management is your only financial concern, you need only to decide whether you wish to pay for this service through commissions, fees or a combination of the two.

If more than investment management support is required, you must determine if the advisory firm is capable of providing the required services.  A Certified Financial Planner (CFP®), offering comprehensive financial planning services, will typically be capable of supporting your planning requirements.  A CFP® will also have completed extensive financial planning educational training and will have met both the experience and ethics requirements of the CFP® Board of Standards.

Whether you need only investment advice or require a complete financial analysis and plan, be certain that your adviser listens to and understands your tolerance for risk.  If you find an investment adviser or financial planner who treats your financial future as well as they treat their own, you should be well on your way to a prosperous financial future.