CFPs, Stock Brokers, and Investment Advisors: Weekend Reading

Hello and Happy Friday. :)

This week I want to highlight a series from Wealth Pilgrim that I particularly enjoyed. Neal breaks down the different designations/licenses that can be held by people who market themselves as “financial advisors.”

The takeaway message is that it’s important to know what licenses your advisor holds and how he/she gets paid. Otherwise, you could be dealing with a serious conflict of interests without even realizing it.

Investing

Other Personal Finance

Jobs/Careers

Thanks to everybody for reading. Talk to you Monday. :)

August 21, 2009

Tax Efficiency of Index Funds and ETFs

When discussing index funds as opposed to actively managed funds, I tend to focus primarily upon their lower expense ratios and lower turnover costs. But for those of you investing in taxable accounts, index funds (and ETFs) offer an additional advantage over actively managed funds: They’re decidedly more tax efficient.

Increased Turnover Means Increased Taxes

As compared to actively managed funds, index funds and ETFs allow you to:

  1. Pay less taxes, and
  2. Defer your taxes.

With mutual funds (as opposed to, say, shares of individual stocks), you don’t pay taxes only when you sell the fund. You pay taxes each year on your share of the capital gains realized within the fund’s portfolio.

With portfolio turnover in actively managed funds averaging roughly 100% per year, a great deal of the gains end up being short-term capital gains. Because STCGs are taxed at your ordinary income tax rate (as opposed to LTCGs which are taxed at a maximum rate of 15%), investors in actively managed funds end up paying more in taxes than they would with a fund that holds onto its investments for longer periods of time.

Also, the longer holding period for shares within an index fund’s portfolio allows you to defer taxation for a greater period of time (thereby allowing your money to grow more quickly).

ETF Tax Efficiency

In addition to the above tax benefits, Exchange Traded Funds (ETFs) have a significant tax advantage due to the way in which they’re created.

When a typical index fund needs to raise cash (due to investors liquidating their holdings), it must sell investments from within its portfolio. If these investments were sold for more than their cost basis, the transaction triggers a capital gain, which must be paid for by remaining shareholders.

In contrast, when large ETF shareholders want to redeem their shares, they’ll often simply exchange them (with the ETF sponsor) for shares of the underlying companies owned by the ETF. The ETF sponsor makes it a point to distribute the shares that have the lowest cost basis, thereby minimizing unrealized capital gains within the ETF’s holdings.

The end result is that ETFs tend to distribute smaller, less frequent capital gains to their shareholders–thereby allowing shareholders to defer the majority of taxation until they actually sell their shares.

Taxes Are Costs Too.

After considering expenses, the majority of actively managed funds underperform their respective indexes. When you factor in the impact of taxes, the results become even more dramatic. In fact, some studies have shown that the likelihood of an actively managed fund outperforming its index on an after-tax basis is less than 10%.

Why take those odds?

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August 20, 2009

Education First. Advisor Second.

Yesterday I linked to an article from William Bernstein in which he explains why he no longer thinks that most people are qualified to succeed on their own in the realm of investing. He believes that most people need to hire help.

I’m not sure (yet) whether I agree or disagree. But I do want to point out that if the two options you’re considering are:

  1. Do it yourself, or
  2. Have an advisor make the decisions for you

…then option #2 is probably at least as bad as option #1. You cannot go meet with a financial advisor and assume that everything will work itself out.

Why? Because as likely as not, you’ll get somebody who doesn’t know what he’s talking about. You absolutely must educate yourself about investment principles beforehand so that you can evaluate an advisor’s competence.

Selecting an Advisor

If I’m in a new city looking for a car mechanic, my goal is generally just to find somebody who I think I can trust. With financial advisors, however, trust is not sufficient.

Yes, trust is essential. But it’s not sufficient. You can find plenty of financial advisors who really do have your best interests at heart, who really do believe in what they’re saying, but who are still going to give you poor advice. I know this because:

  1. I used to be one of them, and
  2. It was very clear at the time that my limited knowledge about investing was significantly larger than that of most of my coworkers.

My advice is to educate yourself first. Take the time to read a few books. Then develop a list of specific criteria that you will use when evaluating a potential advisor. For example, Bill Schultheis (author of The CoffeeHouse Investor) suggests the following two requirements:

  1. Fee only (as opposed to commission-based compensation)
  2. 100% passive in entire portfolio.

To those I would add a few of my own suggestions:

  1. Ask what the advisor sees as the primary purpose of his/her service. (If he/she says anything at all about helping you earn above-market returns, it’s time to keep looking.)
  2. Make a list of the fees you’re aware of. Then ask “Is this everything?” Repeat until you’ve been explicitly told that your list includes all of their fees.
  3. Ask a few test questions simply to try and determine the advisor’s level of competence. For example, you might want to ask about his views on market efficiency or asset location.

[Quick note: If you're looking for somebody who will help you with your entire financial picture rather than just your investment portfolio, there's a whole slew of additional considerations. For the moment, I'm speaking only to the question of finding somebody qualified to advise you on your investments.]

Great guy, or great advisor? You need to know the difference.

It’s not enough for an advisor to show the he cares about you and your goals, and it’s not enough for you to use an advisor rather than bothering to learn about investing. You must have a decent amount of background knowledge so that you can determine whether or not an advisor is demonstrating an acceptable level of professional competency.

August 19, 2009

Avoiding Investing Mistakes

The average college graduate finishes school with $23,186 in student loans.

Quite likely, he spends a few years after school building on that debt.

At some point, he figures things out, and begins to work toward paying it off.

Finally, he begins to look for information about getting started with investing. More likely than not, he ends up buying some nonsense about picking stocks or hot funds.

He tries that for a few years (or more). Perhaps he gets lucky and it works. Perhaps not.

Eventually, something turns sour and he decides to try a different method.

Perhaps that one works for a while. Perhaps it doesn’t.

Hopefully, before it’s too late, the investor figures out that the problem is not with his method of picking stocks, his method of picking hot funds, or his method of predicting market movements. Rather the problem lies in the fact that he’s attempting it in the first place.

Skipping Steps

The investment industry is in an eternal September. There’s an endless supply of beginner investors for the financial industry to prey upon. As William Bernstein (of Four Pillars fame) recently put it, “[Increasing aggregate investor competence] is a process so glacially slow that the grim reaper easily outruns it.”

But that doesn’t mean that you have to be as slow as everybody else. You can skip steps in the above process. You don’t have to make all the same mistakes that other investors have.

The solution–while perhaps rather boring–is simple:

  • Read books about investing.
  • Then read some more (preferably from sources that offer viewpoints contrary to those of books you’ve already read).
  • Ask your friends and family about what financial mistakes they’ve made in the past.

With financial decisions, it often takes several years before you learn whether or not you made a good choice. Why not accelerate the process by learning from others?

August 18, 2009

Average Stock Market Returns are Dangerous

photo courtesy of Alex E. Proimos on flickrAs they say, you can drown in a river that has an average depth of 6 inches (should you attempt to cross and find that, at this particular point, the river is 8 feet deep).

Similarly, investors must be cautious about data regarding average returns offered by investments.

For example, if an investor were to look look at calendar years from 1928-2008, he would see that the stock market has earned an (arithmetic) average after-inflation return of 7.9%. Not bad! But to count on earning an 8% real return is to set oneself up for failure. For example:

  • In 28 of those 81 years, the stock market actually lost money.
  • In 8 different years, the market lost more than 20% of its value.
  • In 4 different years, the market lost more than 1/3 of its value (with the worst year being 2008, with a loss of 36.6%).*

And, as investors were reminded in the last year, even lengthier periods can be subject to wildly variable rates of return. Again, looking at calendar years from 1928-2008, we can see that:

  • In 10 of the 72 ten-year periods, the market lost money.
  • Over the 10-year period ending in 1974, a stock market investor would have lost more than 37% of his money, with a compounded real rate of return of -4.6%.

Takeaway Lesson: When making an investment plan, be sure to take into account not only average returns, but the variability of returns as well.

*I only noticed while writing this that on an after-inflation basis, 2008 (real return of -36.6%) was in fact worse than 1931 (real return of -33.8% due to annual deflation of approximately 10%).

August 17, 2009

REITs and Stable Value Funds: Weekend Reading

Hello, and Happy Friday. :)

I’ve gone on record many times saying that I really like target retirement funds, as long as they’re low-cost. I think I have to officially revise my standpoint to be that “I really like Vanguard’s Target Retirement Funds.”

According to a Morningstar study, after Vanguard’s target funds (with expense ratios averaging 0.19%), the next cheapest fund family’s target funds carry an expense ratio of 0.65%. Over time, that’s a big difference.

Investing

Other Noteworthy Articles

Carnivals

Thanks for reading, and I hope you enjoy your respective weekends. :)

August 14, 2009
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