Tag Archives: long term investing

How Much am I Paying in Investment Expenses?

This is the seventh installment in our series on how individual investors can assess their financial health.

Hidden CostsIn my experience, I’ve found that many people have no idea how much they’re paying for the privilege of investing. And survey data supports my observations. Ignorance is not bliss. Analysis of investment expenses suggests that many people are probably losing a substantial portion of their potential lifetime investment gains to these expenses—and a considerable portion of them are avoidable.

To understand the true scope of investment expenses, you first need to know the different forms they can take. You’re not alone if you didn’t know about some of these costs.

  • Brokerage fees – Also known as trading commissions, these are what you pay when you buy or sell securities through a broker. Typically, brokerage costs accrue every time you make a trade, though there are a variety of fee structures.
  • Mutual fund stated costs – These are the fees that mutual fund management collects for running the fund. They are expressed as a mutual fund’s expense ratio.
  • Mutual fund trading costs – The costs that funds incur through trading their underlying securities are not included in the expense ratio. They are additional expenses that are passed along to fund investors.
  • Retirement plan administrative costs – In retirement plans, the costs associated with managing the plan itself are over and above the brokerage fees and mutual fund expenses.
  • Advisory fees – If you have a financial advisor, he or she may be paid on the basis of sales commissions, a percentage of your assets, or a flat fee.
  • Cash drag – Mutual funds tend to keep a certain percentage of their assets in cash to support fund share redemptions. These assets are doing nothing, but are still part of the assets subject to the expense ratio of the fund. This is not an explicit fee but it reduces the return of your investment, so I have included it here.
  • Taxes accrued by the mutual fund – Finally, it’s necessary to account for the tax burden that a fund creates for its investors through the fund’s trading.

The Impact of Fund Expenses

A 2011 Forbes article estimates that the average all-in cost of owning a mutual fund is 3.2% per year in a non-taxable account and 4.2% in a taxable account. This estimate is likely on the high end, but it’s certainly possible that it is accurate. A more recent article estimates that the average all-in cost of investing in an actively managed mutual fund is 2.2% per year, ignoring taxes. But rather than debate these numbers, the crucial question is how much you are spending in your own accounts.

While a 1% or 2% difference in expenses may seem small when compared to variability in fund total returns of 20% or more, the long term impact of those expenses is enormous.   Let’s do a little math to show how pernicious expenses can be.

Imagine that you can earn an average of 7% per year in a 60% stock/40% bond portfolio. The long term average rate of inflation in the United States is 2.3%. That means your real return after inflation is 4.7% (7% – 2.3%).  If your expenses in a taxable account are as high as the Forbes estimate, you’ll end up with only 0.5% per year in return net of inflation. This implies that the vast majority of returns from stocks and bonds could be lost to the various forms of expenses.

If you find that implausible, consider the fact that the average mutual fund investor has not even kept up with inflation over the past 20 years, a period in which inflation has averaged 2.5% per year, stocks have averaged gains of 8.2% per year.  The extremely poor returns that individual investors have achieved over the past twenty years are not just a result of high expenses, but expenses certainly must play a role given the estimates of how much the average investor pays.

A useful rule of thumb is that every extra 1% you pay in expenses equates to 20% less wealth accumulation over a working lifetime. If you can reduce expenses by 2% per year, before considering taxes you are likely to have a 40% higher income in retirement (higher portfolio value equates directly to higher income) or to be able to leave a 40% larger bequest to your family or to your favorite charity.

How to Get a Handle on Expenses

To estimate how much you are paying in expenses, follow these steps.

  1. Obtain the expense ratio of every mutual fund and ETF that you invest in. Multiply the expense ratios by the dollar amount in each fund to calculate your total cost.
  2. Look up the turnover of each fund that you invest in. Multiply the turnover by 1.2% to estimate the incremental expenses of trading. A fund with 100% annual turnover is likely to cost an additional 1.2% of your assets beyond the started expense ratio.
  3. If you use an advisor, make sure you know the annual cost of the advisor’s services as well as any so-called wrap fees of programs that the advisor has you participating in.
  4. Ask your HR manager to provide the all-in cost of your 401k plan.
  5. Add up all of your brokerage expenses for the past twelve months.

Collecting all of this information will take some time, but given the substantial potential impact of expenses on performance, it’s worth the trouble. If, when you add up all of these costs, your total expenses are less than 1% of your assets, you are keeping costs low. If your total expenses are between 1% and 2%, you need to make sure that you are getting something for your money. You may have an advisor who is providing a lot of planning help beyond just designing your portfolio, for example. Or you may be investing with a manager who you believe is worth paying a premium for. If your all-in costs are greater than 3% per year, you are in danger of sacrificing the majority of the potential after- inflation gains from investing.

Conclusions

It is hard to get excited about tracking expenses or cutting costs. The evidence clearly shows, however, that reducing your investment costs could make the difference between a well-funded retirement or college savings account and one that’s insufficient.

Future returns are hard to predict, but the impact of expenses is precisely known. The more you pay, the better your investments need to perform just to keep up with what you could achieve with low cost index funds. This is not an indictment of money managers but rather a reminder that investors need to be critical consumers of investment products and services.

For more analysis of the devastating impact of expenses, MarketWatch has an interesting take.

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Am I Saving Enough to Reach My Goals?

This is the second installment in our series on how individual investors can assess their financial health.

Am I saving enough to reach my goals?The starting point for any discussion of a household’s financial health is to evaluate current savings and savings rates in the context of financial goals.  The three largest expenses that most families will face are buying a home, paying for college, and providing income in retirement. Setting specific savings targets and timelines is a key step in increasing your ability to meet these goals.

To determine whether you are saving enough to pay for one or more of these goals, consider the following factors:

  • Expected total cost of goal
  • When the money is needed
  • Current amount saved for the goal
  • Expected annual rate of saving towards the goal
  • How much risk to take in investing to meet the goal

Retirement

A good first step for estimating how much you’ll need for retirement—and how you’re doing so far—is to try Morningstar’s Retirement Savings Calculator.  This tool uses a range of sensible assumptions (which you can read about in the study from which it was developed) to estimate whether you are saving enough to retire.  The study accounts for the fact that Social Security represents a different fraction of retirement income for households at different income levels and assumes that investments are consistent with those of target date mutual funds.  The calculator scales income from your current age forward, based on historical average rates of wage growth.

Are you saving enough for retirement?

The calculations assume that you will need 80% of your pre-retirement income after subtracting retirement contributions, and that you will retire at age 65.  The estimated future returns for the asset allocations are provided by Ibbotson, a well-regarded research firm (and wholly owned subsidiary of Morningstar).

The final output of this model is a projected savings rate that is required for you to meet the target amounts of income.  If this is less than you currently save, you are ahead of the game.

College

There are enormous variations in what a college education costs, depending on whether your child goes to a public or private institution and whether those who choose public schools stay in-state.  There is also a trend towards spending two years at a community college before transferring to a larger comprehensive university.    estimates that the average annual all-in cost of attending a public four-year university is $23,000 per year, while the cost of attending a private four-year university averages $45,000 per year.  This includes tuition, room, board, books and other incidentals.  It is worth noting, however, that the all-in cost of private universities are often far above $45,000 per year.  The University of Chicago has an all-in cost of $64,000 per year.  Yale comes in at $58,500.

Every college and university has information on current costs to attend, as well as a calculator that estimates how much financial aid you can expect to be given, based on your income and assets.  There are a variety of ways to reduce the out-of-pocket cost of college including work-study, cooperative education programs, and ROTC.  There are also scholarships, of course.

College tuition and fees have been rising at about 4% per year beyond inflation for the past three decades.  With inflation currently at about 2%, the expected annual increase in college costs is 6%.

To be conservative, assume that money invested today in a moderate mix of stocks and bonds will just keep up with inflation in college costs.  Vanguard’s Moderate Growth 529 plan investment option has returned an average of 6.9% per year since inception in 2002 and 6.4% per year over the past ten years.  In other words, $23,000 invested today will probably pay for a year at a public four-year university in the future.  You can invest more aggressively to achieve higher returns, but taking more risk also introduces an increased exposure to market declines.

Using the simple assumption that money invested today in a moderately risky 529 plan or other account is likely to just keep pace with cost inflation makes it easy to figure out how you are doing in terms of saving.  If you plan to pay the cost of your child’s four-year in-state education and you have $46,000 invested towards this goal, you are halfway there.

Buying a Home

A house is a major financial commitment—one of the most significant that most people make.  Unlike retirement or education, there is an alternative that provides the same key benefits: renting.

For people who decide to buy, a key issue is how much to save for a down payment.  The amount that a lender will require depends on your income, credit score, and other debts.  Zillow.com provides a nice overview, along with an interactive calculator of down payment requirements. This tool can help estimate how all of the factors associated with obtaining a mortgage can vary with the down payment.

In general, the goal is to have a down payment ranging from 5% to 20% of what you plan to spend on a home.  By experimenting with the calculator at Zillow, you can determine how much house you can afford and how much you will need to put down.  A down payment of 20% or more is the most cost-effective route because smaller down payments require that you buy mortgage insurance, which adds to the monthly payment.

There are several alternatives for investing a down payment fund.  The primary consideration, however, is whether you are willing to adjust your timeframe based on how the market performs.  If you are committed to buying a house within one to three years, you really cannot afford to take on much risk.  If you are looking at a timeframe of five years or more—or if you hope to buy in one to three years but you are comfortable delaying if market returns are poor—you can afford to take more risk.  There is no single answer for everyone.

If you are investing only in low-risk assets, however, estimating how much you need to save each month for a required down payment is straightforward enough, because the current expected rate of return on safe assets is close to zero.

 

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How Am I Doing? An 8-Point Financial Checklist

How am I doing?A question that nags at many people is whether they are on track financially.  Even an average financial life can seem remarkably complex.  How does anyone know whether he or she is doing the right things?  A range of studies on how people manage their money suggests that many, if not the majority, are making choices that look decidedly sub-optimal.  Americans don’t save enough money and when they do save and invest, they often make basic mistakes that substantially reduce their returns.  More than 60% of self-directed investors have portfolios with inappropriate risk levels.  Almost three quarters of Americans have little or no emergency savings.  The solution to these problems starts with an assessment of where you are and where you need to be.

The key, as Einstein once said, is to make things as simple as possible but no simpler.  In an attempt to provide a checklist that’s in line with this edict, I offer the following questions that each person or family needs to be able to answer.

The first three questions focus on consumption and saving:

  1. Am I saving enough for to meet personal goals such as retirement, college education, and home ownership?
  2. Am I saving enough for contingencies such as a job loss or an emergency?
  3. Am I investing when I should be paying down debt instead, or vice-versa?

The next five questions deal with how you invest the money that you save:

  1. Is my portfolio at the right risk level?
  2. Am I effectively diversified?
  3. Am I aware of how much am I paying in expenses?
  4. Are my financial decisions tax efficient?
  5. Should I hire an investment advisor?

Anyone who can answer all eight of these questions satisfactorily has a strong basis for assessing whether he or she is on track. Odds are there are more than a few questions here that most of us either don’t have the answer to or know that we are not addressing very well.

Part of what makes answering these questions challenging is that the experiences of previous generations are often of limited relevance, especially when it comes to life’s three biggest expenditures: retirement, college, and housing.

For example, older people who have traditional pensions that guarantee a lifetime of income in retirement simply didn’t need to worry about choosing how much they had to save to support themselves during retirement.

The cost of educating children has also changed, increasing much faster than inflation or, more crucially, household income.  For many in the older generation, college was simply not a consideration. It has become the norm, however, and borrowing to pay for college is now the second largest form of debt in America, surpassed only by home mortgages.  Children and, more often their parents, must grapple with the question of how much they can or should pay for a college education, along with the related question of whether a higher-ranked college is worth the premium cost.

The third of the big three expenses that most families face is housing costs. Following the Second World War, home buyers benefitted from an historic housing boom.  Their children, the Baby Boomers, have also seen home prices increase substantially over most of their working careers.  Even with the huge decline in the housing crash, many Boomer home owners have done quite well with real estate.    Younger generations (X, Y, and Millenials), by contrast, have experienced enormous volatility in housing prices and must also plan for more uncertainty in their earnings.  And of course, what you decide you can afford to spend on a home has implications for every other aspect of your financial life.

In addition to facing major expenses without a roadmap provided by previous generations, we also need to plan for the major known expenses of everyday life. It’s critically important to determine how much to keep in liquid emergency savings and how to choose whether to use any additional available funds to pay down debts or to invest.  There are general guidelines to answering these questions and we will explore these in a number of future posts.

The second set of questions is easier to answer than the first.  These are all questions about how to effectively invest savings to meet future needs.  Risk, diversification, expenses, and tax exposure can be benchmarked against professional standards of practice.

What can become troubling, however, is that experts disagree about the best approach to addressing a number of these factors.  When in doubt, simplicity and low cost are typically the best choices.  Investors could do far worse than investing in a small number of low-cost index funds and choosing the percentages to stocks and bonds based on their age using something like the ‘age in bonds’ rule.  There are many ways to try for better returns at a given risk level, and some make far more sense than others.  Even Warren Buffett, arguably the most successful investor in the world, endorses a simple low-cost index fund strategy.  Upcoming posts will provide a number of straightforward standards for addressing these questions.

Investors who find these questions  too burdensome or time consuming to deal with may wish to spend some time on the eighth and final question: whether they should hire an investment advisor to guide them.  Investors may ultimately choose to manage their own finances, search out a human advisor, or use an online computer-driven advisory service.

While financial planning can seem complex and intimidating, our series of blog posts on the key issues, as outlined in the eight questions above, will provide a framework by which individuals can effectively take control and manage their financial affairs.

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Goldman Sachs Predicts 4.5% 10-year Treasury Yields

Treasury BondGoldman Sachs just came out with a prediction that 10-year Treasury bond yields will rise to 4.5% by 2018 and the S&P 500 will provide 6% annualized returns over that same period.  The driver for this prediction is simply that the Fed is expected to raise the federal funds rate.

Because rising yields correspond to falling prices for bonds, Goldman’s forecast is that equities will substantially outperform bonds over the next several years.  If you are holding a bond yielding 2.5% (the current 10-year Treasury yield) and the Fed raises rates, investors will sell off their holdings of lower-yielding bonds in order to purchase newly-issued higher-yielding bonds.  If Goldman’s forecast plays out, bondholders will suffer over the next several years, while equity investors will enjoy modest gains.

Historical Perspective

This very long-term history of bond yield vs. the dividend yield on the S&P 500 is worth considering in parsing Goldman’s predictions.

Bond Yield vs. Dividend Yield

Source: The Big Picture blog

Prior to the mid 1950’s, the conventional wisdom (according to market guru Peter Bernstein) was that equities should have a dividend yield higher than the yield from bonds because equities were riskier.  From 1958 to 2008, however, the 10-year bond yield was higher than the S&P 500 dividend yield by an average of 3.7%.

Then in 2008, the 10-year Treasury bond yield fell below the S&P 500 dividend yield for the first time in 50 years.  Today, the yield from the S&P 500 is 1.8% and the 10-year Treasury bond yields 2.5%, so we have returned to the conditions that have prevailed for the last half a century. But the spread between bond yield and dividend yields remains very low by historical standards.  If the 10-year Treasury yield increases to 4.5% (as Goldman predicts), we will have a spread that is more consistent with recent decades.

Investors are likely to compare bond yields and dividend yields, with the understanding that bond prices are extremely negatively impacted by inflation (with the result that yields rise with inflation because yield increases as bond prices fall), while dividends can increase with inflation.  During the 1970’s, Treasury bond yields shot up in response to inflation. Companies can increase the prices that they charge for their products in response to inflation, which allows the dividends to increase in response to higher prices across the economy.  The huge spread between dividend yield and bond yield in the late 70’s and early 80’s reflects investors’ rational preference for dividends in a high-inflation environment.

What Has to Happen for Goldman’s Outlook to Play Out?

To end up with a 4.5% 10-year Treasury yield with something like a 2% S&P 500 dividend yield, the U.S. will need to see a sustained economic recovery and evidence of higher prices (inflation) driven by higher employment and wage growth.  In such an environment, investors will be willing to accept the lower dividend yield from equities because dividends grow over time and tend to rise with inflation.  This has been the prevailing state of the U.S. economy over the last fifty years.  Most recently, we had 10-year Treasury yields in the 4%-5% range in the mid 2000’s.  If, however, we continue to see low inflation and stagnant wages in the U.S. economy, bond yields are likely to remain low for longer.

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Hedge Funds: The Emperor’s New Clothes?

Brett Arends recently wrote a piece for MarketWatch in which he expressed the opinion that hedge funds are a sucker’s bet.  He bases his argument on a fascinating  study called Higher Risk, Lower Returns: What Hedge Fund Investors Really Earn that was published in 2009.  The authors of the study, professors from Emory University and Harvard, came to the conclusion that hedge fund investors would have (on average) been better off buying an S&P500 Index fund. So, if hedge funds have performed as badly as this academic study suggests, why have assets invested in hedge funds skyrocketed over the past 20 years?  Continue reading

What you need to know before you invest in IPO’s

I have not seen this type of brand name IPO trading volume for quite some time. From Groupon (GRPN) and Pandora (P) to Zynga (ZAGG) and now Avaya, the media would have you believe that investing in a brand name IPO is a quick fix for your portfolio.

Take the recent public stock offering in LinkedIn (LNKD) for example. The IPO price was set at $45 and jumped to $90 after one day of trading. As of this writing, the price is just below $73. At its current valuation, Morningstar estimates the Price-to-Earnings (P/E) ratio at 466. By comparison, the tech-heavy NASDAQ has a P/E of less than 20 (as of this writing).

Clearly, many people are very excited about the LinkedIn IPO and it shouldn’t surprise you that investors have had a long history of enthusiasm for IPO stocks. But has this enthusiasm ever paid off over the long-term? Continue reading