Beneath the Surface

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Avoid unnecessary fees and expenses

You can’t invest without incurring some fees and expenses. When you buy and sell individual securities through a broker, you pay a transaction fee. When you invest in a mutual fund, you pay the fund’s annual management expenses. If you have a retirement plan like a 401(k), you pay a fee to the plan manager. If you buy financial advice, you pay your advisor in one way or another, whether it’s an hourly fee, a flat fee for a financial plan, a commission on financial products you buy, or an annual management fee to manage your investments for you.

The challenge here is to determine what you are actually getting for what you are paying. When something in my house needs fixing, I’m often willing to pay someone to fix it because I can tell the difference between an expert repair and one that I try to do myself. But how many investors can tell the difference between a cost-effective investment and an overpriced mediocrity, or between sound financial guidance and a bum steer? Investors may not even be aware of some of the expenses they are incurring because they’re quietly deducted without showing up explicitly on a statement. And the impact of costs on investment results is hard to assess because so many other factors affect financial performance, not the least of which are general market conditions and luck. Your financial service provider isn’t to blame if the market falls, but may be to blame for promoting products whose excessive costs aren’t justified by superior performance. Unfortunately, the complexity of financial products provides many opportunities to take advantage of unwary consumers.

Although the question won’t have an easy answer, the right question to ask is whether you are achieving any added value for your portfolio by incurring a particular expense.

No-load, low-expense funds

The post on diversification discussed mutual funds as a convenient way of investing in a wide variety of securities. Now consider how to get the benefits of mutual funds without unnecessary fees and expenses.

First, give preference to no-load funds. Loads are sales commissions on mutual funds purchased through a broker, ranging anywhere from 3% to 8% of the money invested. Frequently you have a choice of different fee structures, such as a choice between a one-time up-front commission or higher expenses in every year you own the fund. If you intend to own the fund for a long time, the up-front commission (the “A” shares) can be the better choice. But often an even better option is to contact a mutual fund company that sells its funds directly to the public, such as Vanguard or T. Rowe Price. There you can probably find an acceptable fund with neither a sales load nor high expenses. You don’t have to sacrifice performance when you go this route. The American Association of Individual Investors says, “Funds with loads, on average, consistently underperform no-load funds when the load is taken into consideration in performance calculations. For every high-performing load fund, there exists a similar no-load or low-load fund that can be purchased more cheaply.”

Every mutual fund prospectus is required to list the fund’s fees and expenses. Ideally you will see “none” in the fees part, or only some very small fees for good reasons, such as a fee for redeeming shares within one year, in order to protect the fund and its shareholders against the costs of short-term trading. What you do have to pay in any fund is annual management expenses, but you can pay very different expenses for quite similar products. This is especially true for the kinds of funds whose returns are otherwise fairly predictable, such as money market funds and bond funds holding similar types of bonds. Expense ratios may seem to vary in a narrow range (1.5% per year for one fund vs. 0.5% for another, for example), but over time, such small differences compound into large variations in investment returns. If you invest $10,000 and let it compound for 20 years, you will have $56,044 if you get a 9% return, but only $46,610 if you get an 8% return because of an extra 1% in expenses. The longer you invest in a fund, the more of your investment return you will forfeit if the fund underperforms the market because of its fees. A study by Stewart Neufeld found that underperforming the market by just 1% will cost you about 30% of your total gain over 30 years and about 40% over 50 years (Journal of Financial Planning 12/11).

When trying to hold your fund expenses down, consider exchange-traded funds (ETFs) as well as traditional mutual funds. You will pay at least a small transaction fee to purchase an ETF through a broker, but annual expenses should be as low or lower than the least expensive mutual funds. Many new kinds of ETFs are appearing, however, and not all of them are designed to provide a market return at low cost.

Index funds vs. actively managed funds

The lowest expenses are generally found in index funds because they save money by doing less research and making fewer trades. An S&P 500 index fund will hold the same 500 stocks until Standard and Poor’s changes the stocks included in the index itself. This is also known as passive investing. Its goal is to get as close to a market return as possible, unencumbered by high fees, and it can achieve that goal pretty reliably. In contrast, actively managed funds buy and sell more frequently in order to try to beat the market, so they incur additional expenses for trading and researching companies. The additional costs to shareholders can easily knock two or three percentage points off your investment return. One of the most hotly debated questions in the industry is how often active management adds enough value in skillful security selection to offset and justify the higher costs. Is active management worth paying for, or is it more cost-effective to invest primarily in low-cost index funds?

Both sides in this debate agree that an index fund can only provide a market return (minus a very small amount for expenses), while an actively managed fund has at least some potential to beat the market. The question is how often actively managed funds actually live up to that potential. Researching that question isn’t a simple matter, since there are so many kinds of funds, so many management styles, so many fluctuations in performance, so many old funds closing and new ones opening, and so forth. One of the key issues is what “benchmark” to use when comparing a particular fund to the market. The S & P 500 stock index is a good benchmark for comparing US large-cap stock funds, but appropriate benchmarks are less obvious for funds with less common specializations. The best research does appear to support these broad generalizations:

• Index funds provide a return that is close to the market average, but an actively managed fund can do either better or worse than the average
• Fewer actively managed funds beat their market benchmark than fall short of it
• The longer the time period considered, the more likely it is that an actively managed fund will underperform the market

The last point is a particularly interesting one, since it calls into question not only the ability of most active managers to beat the market, but the ability of investors to identify the ones who can be relied on to beat the market in the long run. Studies of mutual fund performance do find some tendency for performance to persist from year to year, but the finding must be carefully qualified. One of the reasons for continuity is that many of the same overpriced, low-performance funds do badly year after year. Those can be avoided. But choosing among the remaining funds is hard, since continuities in market-beating performance tend to be short-lived. Most of today’s winners probably won’t be the highest performers a few years from now. That leaves the active investor with two alternatives: either chase performance by frequently moving assets to “hot” funds (running a significant risk of losing money by buying high and selling low), or stay in one fund hoping that it’s one of the very few that can beat the market in the long run despite the burden of its management and trading costs.

Beating the market is both very appealing and theoretically possible, but it’s harder than most people realize, contrary to the message of some financial media and some financial services sales forces. Since there are thousands of funds, some of them are on winning streaks at any given time, either because they’re lucky or because market conditions happen to favor their particular investing style. Apparent winners get a lot of play in the media, both in advertising and press coverage, creating the impression that their managers have extraordinary abilities. But the more spectacular the performance over a few years, the greater the chance of deteriorating performance over the next few years (a familiar statistical phenomenon known as “regression toward the mean”).

Why is beating the market so hard? One reason is the inherent difficulty of stock picking, since stock movements depend so heavily on earnings surprises (discussed in the risk section). The second is the fact that so much of the market consists of mutual funds, so that professional fund managers are competing against one another: If some are performing above the market average, others must be performing below it. The third problem is the higher costs associated with active management, which tend to drag even more of the funds below the market average. When Andrew Feinberg reported that only one out of every eight mutual funds beat the S&P 500 index over a twenty-year period, he titled his article “Lake Wobegon in Reverse” because so many of the funds were below average (Kiplinger’s 11/03).

A few managers probably are truly superior, but only a long and consistent track record can distinguish skill from luck. By the time the true superiority of a fund becomes apparent, it may be closed to new investors, or the manager may switch jobs or retire. Fidelity Magellan did very well while Peter Lynch was managing it, but not so well after he retired. If the fund does remain open with the same manager, it may get so large that it has to buy too many stocks in order to avoid bidding up the price of the fewer companies it would most like to buy; so it becomes less selective and more mediocre. Many big fund managers are really “closet indexers,” too unselective to have any hope of beating the market, but charging fees as if they could! If all you need is an index fund, then that’s all you should pay for.

Consider one additional point, requiring a bit of reflection. Suppose that actively managed funds had a wide range of performance (that much is true), but on the average performed as well as the general market (that part is not quite true because expenses are a drag on performance). Would you be willing to risk underperforming the market for an equal chance at outperforming the market? Suppose your employer let you choose between receiving your regular salary or randomly selecting from different envelopes with varying amounts of money, some more than your salary but some less. Would you gamble with your livelihood, knowing that in the long run you have no rational expectation of coming out ahead? Where is the added value, especially if your employer starts charging you a fee to select an envelope!? I repeat that the issue is hotly debated, but many financial planners are skeptical about the added value of actively managed funds for the ordinary investor. Dan Wheeler says, “The most rigorous studies–those with adequate sample sizes and periods, benchmarks that control for risk and survivorship bias–reveal a trend: the pros don’t add value on a consistent enough basis to warrant their fees” (Financial Planning 11/06).

That’s why many financial planners, as well as many of the most sophisticated investors like Warren Buffet, recommend that most ordinary investors make index funds the core of their investment holdings. Investors who would also like to have some potential for outperforming the market should seek actively managed funds with moderate expenses, relatively high returns for several years, and managers who have been with the fund a long time. But recognize that you will need some luck to avoid underperformance, so there is an element of gambling in this approach.

Insurance costs

Insurance companies have developed a number of products that combine insurance with investment. Part of what you pay to the insurance company is invested on your behalf, and may have a potential for a high return. Another part insures that you will receive at least some benefit, such as a death benefit or a guaranteed minimum annual payment. In general, these products are both more expensive and more complicated than direct investment in mutual funds, so consumers should tread carefully in this area. The insurance features of the product should add enough value to justify the added cost, but that is often difficult to determine.

First, consider a case in which insurance does appear to add value. You are retired with a nest egg large enough to live on for many years, but you have a reasonable probability of living long enough to run out of money someday. One solution is to take a portion of your nest egg and purchase an immediate life annuity, guaranteeing that you will have at least some income for life. Another alternative is to buy longevity insurance, which starts paying an annuity only if you live beyond a certain age. There is added value here in the form of a potential to receive something you wouldn’t otherwise have gotten, an income if you live a very long time. (If you live too short a time, you won’t recover your premium cost.) Immediate annuities and longevity insurance will be discussed further in a later post.

What you want to avoid is buying insurance you don’t really need, or that doesn’t do enough for you to justify its cost. One insurance product that companies are often accused of overselling is the variable deferred annuity. Many financial professionals earn commissions from selling them, but others neither sell them nor encourage their clients to buy them. A variable annuity is an investment through an insurance company in assets that can fluctuate in value, especially stocks. You fund the account with a lump sum or with periodic payments over time. Eventually the account will be annuitized–converted to a series of regular payments, often for life. “Deferred” means that this will happen sometime in the future rather than immediately. Investment returns are sheltered from taxation until withdrawals begin, but are taxed as ordinary income when withdrawn. (This additional tax shelter appeals to investors who are already maxing out their contributions to their retirement plans, as well as to aggressive traders who want to be able to buy and sell in the account without worrying about capital gains taxes.) Variable annuities have a death benefit that is paid if the owner dies before withdrawals begin. Many also have “living benefits” that guarantee some minimum value when the account is annuitized. In effect, you are paying the insurance company to insure you against some of the risks of investing in fluctuating markets.

The special features of variable annuities come at high cost, since you are paying for a layer of insurance protection in addition to the costs of managing the investments themselves. Total fees can be many times what you would pay for a mutual fund, substantially reducing your returns. For that you are getting the promise of an annual payment for life someday. (But then, you could get that by annuitizing whatever nest egg you accumulate yourself.) You are also being protected against catastrophic losses, but a properly diversified portfolio of mutual funds or ETFs can provide much of that protection at lower cost.

Variable annuities have other disadvantages: The data needed to evaluate them as investments, such as risk-adjusted performance measures, are not as readily available as they are for mutual funds. Variable annuities are not very liquid, since they often carry surrender charges or other penalties for terminating the contract before a certain number of years. And although investment returns are tax-sheltered until you begin withdrawals, this provides no benefit if the annuity is held within an account that is already tax sheltered, such as an IRA or 403(b). Annuities can even have adverse tax consequences, since dividends and capital gains will ultimately be taxed at ordinary income rates instead of at the lower rates that otherwise would apply.

The main argument for variable annuities is that they can provide a moderate income for life even if markets perform badly. Investors who have that guarantee may feel more comfortable allocating a larger portion of their portfolios to stock. The high return from stock could offset the costs of the annuity and produce a superior return for the entire portfolio. But few purchasers of variable annuities may understand that point or feel comfortable acting on it. Investors who don’t like to invest aggressively may not get much added value from a variable annuity. They might do just as well–and keep their portfolios simpler, clearer and more liquid–with a balanced portfolio of stocks and bonds. Then their portfolio may not be risky enough to require insurance.

An even more controversial version of the variable annuity is the equity indexed annuity. On the one hand it offers the security of a minimum fixed return on one’s investment. On the other hand it offers a potentially higher return based on some portion of the stock market’s gains. (For example, if the market is up 15%, your gain might be capped at 7%. Since stock investors make most of their money in the really good years, this is a significant limitation.) You get some protection from downside risk, but at the cost of high fees and a cap on upside potential. This is another complex arrangement that is hard for a buyer to evaluate. Most independent evaluations I’ve seen have concluded that it doesn’t offer enough advantage over a balanced portfolio of stocks and bonds to justify its higher cost, so that most investors will come out behind by buying it.

Paying for financial advice

The same principles apply to buying financial advice: Don’t pay for more than you need, and expect added value for any costs you incur. You may be able to manage your own investments just fine with a little occasional help. If so, you don’t have to pay someone an annual fee of 1% to 2% of your assets to manage them for you. That can easily add up to thousands of dollars a year and put a heavy drag on performance. You may find it more economical to pay a one-time fee for help in formulating a plan, and then deal directly with mutual funds in order to avoid sales commissions.

Some people pay an annual fee for a financial manager, who may also be a salesperson with products to promote; then they pay commissions to buy mutual funds or annuities; then they pay high fees and expenses for active fund management or insurance features they may not need. So they pay and pay and pay without getting much added value, and they end up with much less than they could have had with a simpler and less expensive approach. A later section will deal with options for getting financial advice.

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Allocate among asset classes sensibly

One of the most important investment decisions is how to allocate your investment dollars among the different asset classes, such as stocks and bonds. The different classes can have very different returns in any given year, resulting in large variations in earnings among investors with different asset allocations.

As discussed in the post about risk, investments such as stock offer the potential for higher returns at the cost of higher risk, while investments such as bonds offer lower average returns but lower risk. How to allocate a portfolio among assets with varying degrees of risk is probably the most basic question an investor will face. To simplify the discussion, we will speak of the choice as being between stocks and bonds, but those categories will be understood to include other assets that are either high or low on the risk/reward continuum. Optimal diversification requires investing at least a portion of the portfolio in assets besides stock and bonds, a point that will be reiterated later.

Three factors to consider in allocating between stocks and bonds are your time horizon, your personal tolerance for risk, and your income security.

Time horizon

Time horizon involves the question of what you are saving for, or more precisely, when you are saving for. If you are saving for your children’s college educations, it makes a big difference whether they are teenagers or toddlers. If they are very young, it is reasonable to invest heavily in stock, because you have time to ride out some of the ups and downs of the market. And you are generally rewarded for doing so, because stocks have usually outperformed bonds over long periods. But many parents have made the mistake of leaving the college savings in stock too long. If you’re still in stock when the child is 16, you run the risk of losing a big chunk of your savings in a down market just when you need it.

This way of thinking about asset classes has strong logical and mathematical support. The riskier asset class is more volatile, and so one can easily lose money in it in the short run. But the riskier asset class should also carry a risk premium that provides a better return in the long run. By investing for long periods, one takes advantage of the statistical tendency for results to even out in the long run. In the long run, below-average returns are offset by above-average returns, leaving investors with the average return for the asset class, which includes the risk premium. Jeremy Siegel is one of the many analysts who have popularized this theory, in his book Stocks for the Long Run.

Here is an example of the kind of evidence that is often cited in support of this theory: Over the years 1926-2005, the average annual return from large-company stocks was 10.4%. Investing for only one year would be quite a gamble, since the annual returns varied from a high of 54% to a low of minus 43%. But the average annual return for all possible 20-year periods (1926-1945, 1927-1946, etc.) varied in the narrower range from 18% per year to 3% per year. Investors who remained invested for many years were much less likely have disappointing returns.

The observant reader will have noticed that these figures do not include the market crash of 2008, which wiped out many years of stock market gains. Even a very long period of investing can have a disappointing return if it includes even one very bad year, assuming it occurs late in the period. For the 40-year period ending in 2008, stock investors received no benefit from investing in stocks rather than bonds (unless of course they were lucky enough to sell before the crash). Furthermore, In addition to the risk of having a bad year just when your nest egg is at its largest, there is the risk of entering an era in which stock returns will be poor relative to other eras. Going back all the way to 1803, Robert Arnott has identified several lengthy periods in which investors would have been better off in Treasury bonds (Journal of Indexes, May/June 2009). We won’t know what kind of an era we’re in now until we’re in a position to look back on it!

These dangers have led some analysts to question the entire logic of relying on stocks for retirement investing. However, one reason for doing so is simply mathematical, the tendency of returns to even out in the long run. We can still say with some confidence that:

• On the average over a very long time, stocks have outperformed bonds by several percentage points a year, which can compound into a very large advantage over time
• Investments that are held for many years are more likely to realize this risk premium, because of the evening out of returns in the long run
• But even holding stock for decades cannot completely guarantee receiving that risk premium

Consider stock a long-term investment, and reserve it for time horizons of at least five (and preferably at least ten) years. Let stock investing play a fairly large role in saving for distant goals, especially retirement. Not only is the pre-retirement period long enough to ride out many periods of market decline, but retirements themselves have been getting longer because of increasing longevity. Most people should leave at least some of their retirement savings in stock even after they retire, so that they can generate a high enough return to sustain a long retirement.

Long-term bonds should also be considered a long-term commitment, because of the risk of having to sell them at a discount if you sell them long before maturity. (And even then the risk premium, in the form of a higher interest rate compared to shorter-term bonds, may not be big enough to justify the commitment.) Intermediate-term bonds are a safer way of saving for needs that are a few years off. Money for very short-term needs (within a year) is best kept in short-term bonds or cash accounts, for the sake of greater liquidity and stability of principle.

Risk tolerance

Before allocating a large portion of your portfolio to riskier asset classes, you also have to consider your personal tolerance for risk. It is one thing to grasp intellectually the benefits of riding out a bear market. It is another thing to handle it emotionally when it happens. When the downturn comes, no one knows for sure whether it is a “ten-year storm,” a “twenty-year storm,” or the “storm of the century” from which stocks won’t recover for many years. If you are likely to lose your nerve and sell during a severe bear market, then you can’t expect to gain much from stock investing, because you’re likely to lose money by selling at the worst time.

Risk tolerance is largely a psychological matter, and you probably can’t change it very easily. But you may benefit from becoming more conscious of it. At least consider the possibility that you are too far toward one extreme or the other on the risk tolerance scale. The two extremes have been described, somewhat pejoratively, as fear and greed. You are dominated by fear if you are so afraid of losses that you avoid even reasonable risks. Then you may be saving a lot of money, but sacrificing high returns by keeping too much of it in cash. You are dominated by greed if you are so eager for big gains that you accept even unreasonable risks. Then you may be gambling too much of your money on the hope that some volatile investment will go up in the short run. The wise course for most investors probably lies somewhere in between.

Many financial publications and investment companies have questionnaires that you can use to assess your own risk tolerance.

Income security

A third factor to consider is the security of your non-investment income. A person with solid job qualifications, steady employment, or a good pension can afford to allocate more capital to riskier, but potentially more rewarding, investments. If some of that capital is lost, it can more easily be replaced with current income. A person whose future income is uncertain and who may have to rely on savings just to pay basic expenses needs to be more cautious.

Allocation as diversification

The previous post discussed diversification within asset classes as a way of reducing risk. Allocating among asset classes also reduces risk, since it reduces the likelihood that all your investments will lose money at the same time. When stocks are down, bonds may be holding their value or even appreciating, as Treasury bonds did during the Great Recession. The technical way of saying this is that the returns from different asset classes are less than perfectly correlated. The lower the correlation between two assets, the more you can reduce the volatility of your portfolio by investing in both of them.

Let’s assume that your time horizon is long enough to justify a large investment in stock, say at least half of your portfolio. Holding some other assets besides stock can dampen volatility and reduce the risk of spectacular losses in any one year. Bonds are very good for risk management, since their returns are less volatile than those of stock and fluctuate at least somewhat independently of them. A portfolio of stocks and bonds is much less volatile than an all-stock portfolio, and it’s even less volatile than an all-bond portfolio.

However, bonds don’t give you ideal diversification because of their relatively low return. If stocks go down, you won’t usually get a high bond return to compensate. That has led financial planners to recommend some diversification toward the higher end of the risk/reward continuum, toward assets with potentially higher returns than bonds, such as real estate, precious metals, commodities or commodity futures, and direct investments in business startups. Including such assets improves the odds of maintaining a high return in fluctuating markets. Some of these, such as commodity futures, can be especially volatile, so ordinary investors should limit their exposure to a small portion of their portfolios.

A note on computerized asset allocation

Financial planners use sophisticated computer models to help clients allocate their portfolios. These models project the probable results of various allocations, based on historical experience. Remember, however, that any such model is only as accurate as the assumptions on which it is based, assumptions that can be invalidated by unforeseen events. The model may assume that annual market returns will vary within a certain familiar range, but future returns could fall outside that range. An asset allocation that appears “optimal” from the standpoint of the model could turn out to be the wrong allocation under future market conditions.

Then why bother with such tools? Because without them, the typical investor could easily make even more simplistic assumptions than the computer models make. An investor might assume that a particular stock, or the market as a whole, will continue to go up at a constant rate, while the financial planners at least know how to build some volatility into their models. A model can also implement a disciplined approach to investing, one less prone to emotional overreactions to recent market swings. The optimal allocation will always be an elusive goal in an uncertain world, and you should take any claims to have achieved it with a grain of salt. But rational analysis can at least protect you from making the most obvious financial blunders, such as putting money you need in the near future into highly volatile investments.

Limitations of diversification

The ideally diversified portfolio would contain a variety of investments with such high but uncorrelated returns that losing investments would be offset by winners every year. Unfortunately, experience has shown that even the most diversified portfolios are limited in their ability to maintain high returns and manage risk. On the average, diversifying beyond stocks and bonds only adds a point or two to investment returns. And the correlations among different asset classes remain high enough to allow many different investments to lose money at the same time.

The 2008 financial crisis was so severe that even investors with reasonable diversification within and among asset classes were not protected against serious losses. Stock prices fell so much that even portfolios with modest allocations to stock were hit hard. Losses were not confined to US stocks, but also occurred in foreign stocks, high-yield bonds, real estate and commodities. The number of different asset classes that all fell at the same time was very upsetting, especially to those who had regarded diversification as a magic bullet that could kill off risk. (Even then some assets performed well, especially long-term Treasury bonds.) The financial crisis has dramatized the limitations of asset allocation models, warning us against assuming that an allocation that would have worked under most historical conditions will necessarily work today.

Perhaps the most serious problem with standard allocation models is that they may overlook the issue of valuation. Including real estate in your portfolio isn’t a great idea when housing is overvalued and the bubble is about to burst. Some analysts recommend a different approach to allocation, one that bases the allocation to a particular asset class more on current market conditions. Although no such method has been perfected, some planners do believe in allocating less to assets that appear currently over-valued and more to assets that appear currently under-valued. This opportunistic, tactical approach is discussed in the section on Opportunity.

Asset allocation in brief

In summary, here are a few guidelines for allocating investments among asset classes:

• Include a range of assets in your portfolio to reduce risk without sacrificing good returns
• Diversify into conservative investments like short-to-medium-term bonds to reduce volatility
• Diversify (cautiously) into more aggressive investments like commodities to maintain high returns
• Tilt toward more conservative investments if your time horizon is short, your risk tolerance is low, and/or your income is insecure
• Tilt toward more aggressive investments if your time horizon is long, your risk tolerance is high, and/or your income is secure
• Allocate less to asset classes that appear currently overvalued, and more to classes that appear currently undervalued

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Diversify within asset classes

Asset classes are the major categories of investments, such as stocks, bonds, and real estate. When you invest in a particular asset class, making a variety of specific investments within that class gives you the best tradeoff of risk and reward. You maximize your chances of getting the rewards of investing in that class and minimize the risk of underperforming the class as a whole. You accept only the reasonable risk of investing in that class, for which you are rewarded by the class’s risk premium, but avoid the unreasonable risk of putting all your eggs in one basket.

Diversification in stock, bonds and real estate

If you invest in stock, you should normally invest in a variety of companies, since different kinds of companies do well under different market conditions. Avoid investing in only one sector of the economy (such as technology companies), or only in large companies (which are outperformed by small companies some of the time), or only in growth stocks (stocks whose prices relative to recent earnings are boosted by future earnings expectations).

If you invest in corporate bonds, also invest in a variety of companies, to limit the damage in case any one company should default on its obligations. Diversification is less of an issue for treasury bonds, since there is only one United States Treasury, and it has never defaulted on a bond obligation. There is another kind of diversification that applies to bonds, however, and that is diversification with regard to maturity, also known as “bond laddering.” You get the best protection against fluctuations in interest rates if you own bonds with a range of maturities, some much closer to maturity than others. If interest rates go down, your longer-term bonds will be more valuable, since they will continue to earn interest at the old higher rates. But if interest rates go up, your shorter-term bonds will be an advantage, because they will mature sooner, freeing up money for investment at the new higher rates. You get some protection either way.

You can get diversification in real estate by investing in a REIT (real estate investment trust). It owns a number of properties and/or mortgages on properties. REITs trade on stock exchanges, and you can buy shares in them through a broker. You can get even more diversification by investing in a mutual fund that holds shares in a number of different REITs. This can be helpful, since a particular REIT may be specialized in a fairly narrow real estate market, such as office buildings.

Diversifying through mutual funds

Whether one is investing in stocks, bonds, or real estate, mutual funds can provide excellent diversification, since they can make a much larger number of different investments than one individual could make conveniently. In general, this diversification reduces the risk that a portfolio will underperform the asset class as a whole. However, mutual funds themselves vary greatly in diversification. Some deliberately maximize diversity by buying some of everything in an asset class (a “total stock fund” or “total bond fund,” for example). Others diversify only within narrower categories, such as small companies, or certain sectors of the economy, or certain parts of the world. Some stock funds focus on “growth stocks,” stocks that are priced relatively high in relation to recent company earnings because of high confidence that their earnings will grow. Other funds focus on “value stocks,” stocks that are priced relatively low in relation to company assets or earnings because future earnings are more in doubt.

The particular focus of a mutual fund is often fairly obvious from its title, and funds are also classified by research organizations such as Morningstar. The definitive guide to a fund’s investment objectives and policies is the fund prospectus. Sophisticated investors may select a narrowly-focused fund because they believe that market conditions favor its particular approach. Less experienced investors are probably better off with very broad funds, or a combination of funds covering much of the market: growth as well as value, large-cap as well as small-cap, and so forth.

In today’s global economy, investors are probably wise to include one or more global or international funds. (“Global” funds usually include the United States, while “international” funds usually don’t.) The basic argument for going beyond one’s own country is the same as for any diversification: Don’t put all your eggs in one basket. No one knows what part of the world might experience the greatest economic success going forward. On the other hand, international investing does entail special risks, such as the risk that currency fluctuations may reduce the value of money that you make in euros, or yen, or some other currency. (Of course, foreign investments can also be a hedge against a declining dollar.) Investments in countries lacking stable democratic institutions or well developed economic markets (“emerging markets”) carry additional risks, but also have enormous potential for growth. Some analysts doubt that international investing offers a sufficient risk premium to justify the risks, since they see little likelihood that other parts of the world will surpass the United States in economic success by any significant margin. Others think that while the 20th century was the “American century,” the 21st could easily be the “Asian century,” and those who don’t invest abroad may miss out on the biggest investment opportunity of our time. I believe in investing at least a portion of your portfolio abroad.

Diversifying through exchange-traded funds (ETFs)

An exchange-traded fund is a basket of stocks or other securities that trades like a single stock. Like a mutual fund, it’s a fairly easy way of assembling a diversified portfolio. As the name indicates, ETFs trade differently than mutual funds. You can buy shares in a mutual fund directly from a mutual fund company, such as Vanguard or Fidelity. (You can also buy mutual fund shares through a broker, but the funds that are marketed that way charge sales commissions known as “loads”.) ETFs trade on an exchange and must be bought or sold through a brokerage account, usually with a commission.

Both mutual funds and ETFs have a net asset value which reflects the value at a given time of the securities they contain. The value of a mutual fund is set once a day after the markets close. The value of an ETF fluctuates all day long like an individual stock. In a very volatile market, the ability to fill an order right now rather than at the end of the day gives ETF buyers and sellers a little more control over the price of a transaction.

Owners of both mutual funds and ETFs have to pay operating expenses to cover the costs of managing the funds. On the average, ETF expenses are a little lower. However, ETF owners incur transaction costs when they buy and sell shares, due to brokerage commissions and bid-ask spreads. While the price of a mutual fund share is just the net asset value of the fund, the price of an ETF depends on what buyers are bidding, what sellers are asking, and the relative numbers of buyers and sellers. You may pay more than the net asset value when you buy and get less when you sell.

All things considered, both mutual funds and exchange-traded funds are acceptable ways of diversifying. Investors who are making frequent small investments may prefer no-load mutual funds to avoid transaction costs. Mutual funds are especially convenient for those who wish to make regular investments through payroll deductions or automatic bank transfers. Investors who are making fewer trades but holding shares for a long time may prefer ETFs because of their low annual expenses.

Diversifying on your own

You can avoid the annual expenses charged by both mutual funds and ETFs by choosing individual securities on your own. In that case, one should be aware of the different kinds of securities in each class, and be sure not to buy too much of any one thing. Many investors loaded up on computer and telecommunications stocks during the “dot-com” boom of the 1990s and suffered especially heavy losses in the bear market that followed.

The selection of particular securities is definitely a challenge, since there is no single well-established method that reliably produces favorable returns (see the previous post on risk). What we have is many different methods, each with its own advocates, but each working only some of the time. One way to learn about them is to join the American Association of Individual Investors. You can also subscribe to many expensive investment newsletters that recommend stocks. However, careful analysis of these newsletters has found that only about one out of five of them outperforms the market over the long run, and then only by a small margin. To find out which newsletters have the best track records, look into the research by Mark Hulbert. Many investors just rely on their broker to recommend stocks for them. The brokers make money on the trades whether the resulting portfolio performs well or not.

Most research suggests that small investors must be either extremely diligent or extremely lucky to achieve an above-average, “market-beating” return by selecting their own securities. But that doesn’t have to be your goal. Your success as an investor may not depend on individual security selection at all, since even an average return may be sufficient to achieve your financial objectives in the long run. The easiest way to get that average return is by investing in well-diversified mutual funds with low fees and expenses. Then you will have little risk of underperforming the market by very much. Just be sure to save and invest enough for that average return to produce the results you want.

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Accept reasonable, but not unreasonable risk

All investment entails risk because we can’t know the future with certainty. We try to anticipate the future, based on our experience of the past, but any expectation could be invalidated by unforeseen events. Any dollar you invest could conceivably disappear, but that’s a risk that any investor must accept. What we can do is distinguish more reasonable risks from less reasonable ones.

Being alert to risk

The first step is to be aware of what kinds of risks exist. Some risks are very obvious, such as the risk that a stock will go down, or that a company might default on its bond obligations. Other risks are more subtle. You can invest in something that’s extremely safe, such as US treasury bills, but earn such a low return that you can’t keep up with inflation, so the real value of your account is actually declining.

One type of risk that can be especially confusing is the risk of fluctuating bond prices due to changes in interest rates. Suppose you buy a 20-year bond paying 7% interest. You have the security of collecting that 7% interest every year. But suppose interest rates rise and new bond issues of the same type are now paying 9%. If for some reason you would want to sell your bond before it matures, you would have to sell it at a discount to its face value. Otherwise, who wants to buy your 7% bond, when they could buy one paying 9%? The farther your bond is from maturity, the more you will have to discount it to make it attractive. Longer-term bonds are inherently riskier than shorter-term bonds because they lock in an interest rate for a longer time. They fluctuate more in market value when interest rates change.

The volatility of an investment–how much it varies in value under different market conditions–indicates its risk. In general, stocks are even riskier than bonds, because they fluctuate even more in market value. Stock indexes such as the Dow Jones Industrials or the S&P 500 can easily lose a third of their value in a bear market. (They lost 33.8% and 38.5% respectively in 2008, their worst showing since the 1930s.) Individual stocks can lose even more when individual companies have a bad year.

Risks and rewards

Some investors find the risks of investing intimidating. They are what we call “risk averse.” They are so afraid of losing money that they confine themselves to only the safest of investments. As a result they miss out on many of the rewards of investing. Successful investing requires us to take calculated risks, risks that are justified by a reasonable expectation of reward. The extra reward that you should get from accepting more risk is what we call a risk premium.

The reason why people are willing to accept the risks of stock investing is that stocks have outperformed bonds on the average over the very long run. The reason why people are willing to accept the risks of intermediate or longer-term bonds is that they usually offer higher interest rates than short-term bonds. Companies with lower credit ratings also have to offer higher interest rates as a risk premium on their bonds. So bonds are rated according to credit-worthiness. In the Standard and Poor’s ratings, for example, the most secure bonds are AAA, followed by AA, A and BBB. Those are the ratings considered “investment grade.” Bonds with ratings below BBB are often called “high-yield” bonds because of their higher interest rates, and they are also known as “junk bonds” because they are issued by financially shakier companies. Some investments are so risky that even the possibility of high rewards shouldn’t convince you to bet very much of your money on them.

Different kinds of investments fall along a continuum, with low-risk/low-reward investments at one end and high-risk/high-reward investments at the other end. At the low end are the least volatile of investments, such as insured bank deposits, treasury bills and money market funds. They are very safe, but earn very low returns. At the high end are very speculative investments such as precious metals, collectibles, commodity futures and stock options. They can earn spectacular returns, but they are so volatile that ordinary investors should approach them with great caution. In the middle are the investments from which most investors make most of their money: stocks, bonds and real estate. Bonds lie more toward the conservative end of the continuum, with shorter-term bonds more conservative than longer-term bonds. Stocks and real estate tend to be higher than bonds on both risk and reward. Small-company stocks are riskier than large-company stocks, but on the average have generated higher returns. That is especially true for small-company stocks that are priced low relative to the book value of the company’s assets (so-called “value stocks”), probably because the low price implies uncertainty about future earnings, but also provides potential for price appreciation.

Distinguishing reasonable and unreasonable risks

Much of investing consists of taking reasonable risks and being rewarded for doing so. On the other hand, you should avoid unreasonable risks, risks that are not justified by a risk premium. You can think of unreasonable risk as basically gambling. On the average, you get no reward from playing the slot machines, since the total amount paid out in winnings is less than the total amount gamblers put into the slots, after the casino takes its cut. You could come out ahead if you are unusually lucky, but a rational calculation indicates that in the long run you will come out behind. Playing the slots is what’s called a loser’s game.

Betting on horse races is also a loser’s game for most bettors, although strictly speaking it doesn’t have to be. In theory, a bettor with extraordinary knowledge of horses might be able to beat the odds. But most bettors have to rely on what is commonly known about the horses, especially their track records. Everybody knows who the favorites are, and they’re bet so heavily that it’s hard to make much money on them. If you bet the “dark horses,” you’ll win big when you win, but you won’t win very often. The average bettor has to lose money, because the track pays out less in winnings than it takes in in bets. So for most bettors in the long run, it’s a loser’s game. Some people get a kick out of playing loser’s games. They are willing to accept the risk of losing in order to have the possibility (as opposed to the rationally calculated likelihood) of winning. But they are gamblers, not investors.

Stock investors vs. stock gamblers

What kind of game is stock investing? Investing in the stock market in general is not a loser’s game, because the companies whose stock is publicly traded usually make money (at least in the aggregate, with the gains of some more than offsetting the losses of others). Their shareholders get the benefits either in the form of dividends or share appreciation, or both. Nevertheless, many market observers have come to the conclusion that betting one’s money on particular stocks is a loser’s game for most investors, especially if the number of stocks selected is very small. To understand the reasoning behind that conclusion, we have to make a distinction between the risk premium that investors usually get from investing in stock in general, and the risk premium they may or may not get from investing in a particular stock.

Consider two groups of investors. Group A consists of all the investors who own shares in the Vanguard Total Stock Market Index Fund, a mutual fund that owns stock in virtually every publicly traded company. Group B consists of all the investors who own shares in any one publicly traded company, but only one company. Let’s assume that stocks have a reasonably good year, and the index fund generates a 10% return. Every investor in Group A took on the same risk (that the market as a whole might go down) and got the same reward for doing so. But every investor in Group B took on the additional risk that their particular company would underperform the market as a whole. They could easily lose money by betting on the wrong company. Were they rewarded for their additional risk? On the average they couldn’t be, since their average return remains around 10%. (Group B does have the advantage of not having to pay the mutual fund’s annual expenses, but we will ignore that since the expense ratio of this index fund is well under 1%.) For every investor who was smart enough–or just lucky enough–to pick a stock that returned more than 10%, there must be another whose stock returned less than 10%. Wall Street is not Lake Wobegon, where “all the children are above average.”

The fact that the average investor gets no risk premium for trying to pick individual stocks does not prove that no investor gets a risk premium for doing so. In theory, a stock-picking expert should be able to beat the market, just as a horse expert should be able to beat the odds in horse racing. But both logic and evidence suggest that this is much harder than most people think. It’s not enough to “bet the favorites,” that is, just invest in companies that are well known for their strong financial track records. Those companies may have the best earnings prospects, but they also carry high price tags. Back in the 1960s, most people thought that IBM was a good bet, since it was the leading computer company. And over the next four decades, its earnings did grow at an above-average rate. But investors who bought the stock in the 1960s paid so much for it that their percentage return on their investment actually turned out to be below average.

What a stock-picking expert needs is an extraordinary ability to spot bargains, to identify companies that will perform surprisingly well and turn out to be worth more than the masses of investors think. What really moves stock prices are earnings surprises. But surprises are by definition hard to anticipate, and unpleasant surprises are just as common as pleasant ones. Anticipating results that are surprising to everyone else cannot be a very common ability. The evidence bears this out. Not only do most ordinary investors fail to beat the market in the long run by trying to pick individual stocks, but so do most professional stock pickers, including most mutual fund managers and publishers of newsletters giving advice on which stocks to buy! (A later post on investment fees and expenses will discuss this finding further.)

What about a legendary stock picker like Warren Buffet? He does place heavy bets on individual companies, and he has been richly rewarded. Does he think that most ordinary investors should try to do what he does? Absolutely not. Most of us lack the time and the ability to pick companies as astutely as he does. If we try, we will be taking on additional risk by gambling too much on too few securities, without a reasonable expectation of an additional return. Buffet himself thinks we would be much better off managing risk by investing in highly diversified funds and settling for an average market return. Diversification is the topic of the next section.

Get time on your side

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The time value of money (TVM)

Why do you expect to receive interest on money you lend (and to pay interest on money you borrow)? Partly it’s to compensate you for the risk that money you lend might not be repaid, or that inflation might have eroded its value before it’s repaid. But there’s an even more fundamental reason that applies even to risk-free investments. A dollar that is yours to use today is more valuable than a dollar you won’t get until some time in the future. Interest payments compensate you for giving up the use of your money today.

The future value of money is the value to which it would grow over time at a particular rate of interest. The future value of a dollar next year at 5% is $1.05. The present value of money is the value today of an amount to be received in the future. If the ratio of future value to present value is 1.05, then the present value of a future dollar is 95.2 cents (1 / 1.05 = .952).

The time value of money becomes much more obvious over longer time periods. Then the growth over time is based on compound interest. At 5% interest compounded, the future value of a dollar after 20 years is $2.65, while the present value of a dollar you won’t receive for 20 years is only 38 cents. Future value is calculated by compounding present value, and present value is calculated by discounting future value. The calculations can be done easily on a business calculator or a spreadsheet using mathematical functions.

The financial significance of time depends on whether you are in a vicious circle of debt or a virtuous circle of saving, as described in the previous post. When you borrow, time works against you because of the accumulation of finance charges. When you save and invest, time works for you because of the compounding of earnings. The future value you receive is your reward for sacrificing present value. Appreciate the power of compounding, and get it working for you instead of against you.

Doubling time

An easy way to demonstrate the power of compounding is to calculate the “doubling time,” how long it takes an investment to double at a given rate of return. Suppose you invest in the stock market and earn 10% a year (which is close to the historical norm). On the average, about 3% of that will represent inflation, so let’s say that the real return is about 7%. Anything that grows at 7% doubles in about 10 years. (You can calculate an approximate doubling time for anything by dividing the annual rate of growth into 72.) And that means it quadruples in 20 years and grows by a factor of about eight in 30 years. That’s the benefit of long-term investing, which you miss out on by not getting started as early as you can. Procrastinate for 10 years, and you can miss one whole doubling.

At 7% per year, $1000 invested at age 35 will grow to $7,612 by age 65, but the same amount invested at age 25 will grow to $14,974 by age 65. And $1000 invested every year from 35 to 65 will grow to $94,461, but the same amount invested every year from 25 to 65 will grow to $199,635.

Long-term implications of savings rates

Let’s use TVM to tackle a more difficult problem, the relationship between a household’s savings rate during the working years and its income during the retirement years.

The Census Bureau classifies households by age, based on the age of the “householder,” the adult who is listed first on the reporting form. For this simplified example, let’s assume that households with householders 25-64 are in the working years, and those with householders 65-94 are in the retirement years. So forty years of working and saving might have to support thirty years of retirement. Let’s also assume that within each five-year age group from 25-29 to 60-64, a household receives the median household income for its age group, and invests a portion of it in a diversified portfolio earning a 5% real return after inflation.

Let’s compare the average income before retirement to the average income after retirement, for households with various savings rates. For the average income before retirement, we’ll use the same figure for all households, the average income over all the age groups 25-64. To get a post-retirement income, we can calculate the nest egg a household would accumulate by age 65 with a given rate of savings. We will then make the conservative assumption that they could withdraw at least 4% of that nest egg in each year of retirement. (Withdrawal rates will be discussed in a later post.)

Now we can calculate a “replacement percentage,” the percentage of the average pre-retirement income that would be replaced by the post-retirement income. With these assumptions, the replacement rate comes out about five times the savings rate. If the household saved 5% of its income consistently during its working years, it could have a post-retirement income equal to 25% of its average pre-retirement income. If it saved 10%, it could replace 50%; and if it saved 15%, it could replace 75%. Most households needn’t plan on trying to replace all of their income with earnings on savings, because they should have additional sources of retirement income, such as Social Security, part-time earnings, or a pension. They may also have reduced expenditures, as a result of downsizing or paying off the mortgage.

More sophisticated projections

Projections like this are useful for appreciating the importance of the savings rate, but they are too general to predict the future incomes of particular households. With today’s computers, financial advisors can do far more sophisticated projections, which take into account more factors. They can take into account variations in asset allocation, such as how much of the household’s investments are in the stock market. They can take into account different rates of taxation for different investments, as well as differences in tax brackets for different taxpayers. They can take into account the ups and downs of markets and the timing of the ups and downs. You could have a very bad bear market just when your savings are at their peak. Sophisticated financial planning software can do “Monte Carlo” projections, which summarize the results of thousands of scenarios and calculate the probability of achieving a financial goal. No projection, no matter how sophisticated, can guarantee any one future, but we can identify futures that are more likely than others, based on historical experience.

Time and uncertainty

The idea of getting time on our side is not without its limitations. Once we start considering long time frames, such as the life of a human being, historical change becomes a factor. Fundamental assumptions of our financial models, such as average rate of return and normal variations in return, may turn out to have been features of a particular historical era. If you plan to live in your house for fifty years, it better be able to withstand a fifty-year storm. But what if storms that used to occur only once in a hundred years start occurring about every ten years, as a result of global climate change? Or on the financial front, what if economic globalization makes markets more volatile and economic depressions more frequent? No set of investing principles can guarantee economic security in an uncertain world. But principles that have “stood the test of time” at least up until now are better than no principles at all.