The Amateur Financier

On the face of it, this match up shouldn’t be a Great Debate; it shouldn’t even be a minor scuffle.  After all, everyone knows that Index Funds are the one and only type of mutual fund in which you should consider investing.  And every adviser from David Bach to Suze Orman (to say nothing of plenty of accountants, financial planners, and other money experts) says that if you’re going to invest in the stock market, you should do the smart thing and own the whole market. Hundreds of experts can’t be wrong, right?

Well, now, let’s just hold on a minute; there are some contrary voices out there, who raise some good arguments in favor of actively managed funds.  So, let’s take a deep breath, and look at index funds compared to actively managed funds for a minute.  To be sure, there are several advantages to index funds that appear readily under closer examination:

1) Lower expenses: One of the key selling points for index funds are their low, low, incredibly low expense rates.  A good S&P 500 Index fund can have expenses of only 0.10% (or less) annually, while an actively managed fund in the same sector will have an expense ratio of several times that amount (typically something like 1%).  Assuming the performance of the index fund is equal to that of the active fund before expenses, the index fund will have a higher return and final value for each dollar of your invested money.

2) Less Trading: In addition to expenses ratios, you also have to worry about taxes with your funds.  Index funds trade out their contents much less frequently than active funds, thus creating fewer short terms gains within the fund.  As a result, there are fewer taxable events within index funds, and fewer tax obligations to be passed onto you.

3) More Certainty: Because index funds hold everything (or at least, a large, representative sample) within a particular index, there should never be any doubt as to exactly what your fund will be holding.  There’s no worry about style drift, closet indexing or holding the wrong stocks with an index fund; you’ll be holding a major portion of the stocks (or bonds, REITs, or other investments) within the fund’s index, and only the investments within that index.

4) Generally beat actively managed funds: Not exactly something most mutual fund managers brag about (at least, those ones who are part of actively managed funds), but most mutual funds don’t beat the appropriate comparison indexes.  At least 70% of  actively managed mutual funds have under performed the S&P 500 index (and that’s one of the more generous values cited).  You can dodge this risk with an index fund.

Obviously, index funds have quite a advantages in their corner.  But actively managed mutual funds have at least one trick up their sleeve:

Index funds cannot beat the associated index.

If you invest in an index fund, by definition, you’re not going to be able to do better than the associated index; the holdings of the index fund are designed to replicate the index, keeping you from doing any better.  In fact, in the real world, index funds can’t even perform as well as the indexes they track, because the expense ratio will always be subtracted from the fund’s performance, decreasing the fund’s performance compared to the index.  In theory at least, an actively managed and controlled mutual fund can do better than the market.  However, as point four in favor of index funds notes, the percentage that actually do so is fairly rare.

What should you do then?  Well, when considering actively managed funds consider them as somewhere in between stocks and index funds in turns of risk, and treat them in your portfolio accordingly.  To help you do that, consider the following rules:

-Limit the portion you put into actively managed funds - At least at first, until you have some experience researching and picking quality actively managed mutual funds, you should keep tight rein on the amount of your money you put into them.  Limit the actively managed mutual funds to a minimum in your account.  If you have 20% (or less) of your assets in actively managed fund(s) and the rest in a diverse group of index funds, you can essentially hedge your bet on the actively managed fund.  That way, if the actively managed fund(s) exceeds your expectations, you’ll still be a position to enjoy the profits; if it performs less well than you hope, you’ll be buoyed by the rest of your portfolio.

-Carefully watch your active funds – You have to treat active funds much more gingerly than index funds.  If you aren’t willing to closely monitor all you investments at least once a quarter (preferably, monthly or even weekly), you could find yourself losing a great deal of money there if your fund is unable to perform  Always be ready to close your account and move to another mutual fund, if the need arises; as with investing in individual stocks, you need to be alert.

-Lastly, make sure your active funds fit your portfolio - You can’t worry so much about chasing returns or hunting down a good active fund that you forget to ensure that your funds fit your your portfolio’s needs.  Instead, determine your ideal asset allocation, figure out your  contributions, and buy mutual funds (active or indexed) that fit your need.  (And if you do opt for active funds, be aware that the most successful ones tend to be in areas where there are exploitable market inefficiencies; small cap, international and emerging markets rather than large cap US funds are good places to consider.)

Keep this advice in mind, and you should be able to add active funds to your portfolio without sinking it.

One of the most common pieces of investing advice given by financial professionals, right behind using tax-advantaged accounts and dollar-cost averaging, is to diversify your holdings.  The argument is pretty simple: by holding a variety of investments, and multiple investments of each kind, you can ensure that one bad stock/bond/REIT/whatever you are holding will not do huge damage to your portfolio.

Of course, as with virtually every piece of investment advice, there are dissenting voices.  One noted one is Robert Kiyosaki, the author of Rich Dad, Poor Dad, who refers to diversification as ‘de-worse-ification’.  His main argument is that attempts to diversify cause people to simply buy blindly and pray that their holdings rise, rather than properly investing.

What’s the truth?  As with most financial debates, there are pluses and minuses to diversification.  In an attempt to counteract some of the prevalent wisdom, let’s start with the minuses:

1) Blunts the Top Performers – One of the biggest flaws with diversification is that, by holding tens, hundreds, or even thousands of individual investments, you aren’t able to benefit from the full growth of the top performers.  If you have a single stock that doubles in price over the course of a year, you will have nearly doubled your money (after expenses); if that stock is one of a thousand held in a mutual fund, the growth of that stock will be averaged with the gains (and possible loses) of all the other stocks, greatly diminishing your returns.

2) Leads to Overconfidence – Another problem with diversification is that it can lead to thinking, ‘if I have enough different holdings, there’s no way my portfolio can decline.’  Unfortunately, if 2008 taught us nothing else, it’s that even being diversified can’t always protect you; sometimes, all the investments within an asset class decline, and occasionally many asset classes are hit simultaneously.  There are limits to what diversification can do to protect your assets.

3) It’s Boring – The last problem is purely psychological; while holding a diverse group of mutual funds makes for a good investment strategy, it’s not the most exciting topic to discuss over cocktails.  The negative effects can extend beyond simply making you less popular at parties; if you are not interested and involved with your investments, you might not give your portfolio the proper scrutiny it deserves, and could end up with a portfolio that is far from your desired allocation or investments that are completely inappropriate for you.

So, there are some drawbacks to diversification.  Still, there must be reasons why nine out of ten (or more) financial advisers recommend diversification.  So, what are they?

1) Blunts the Low Performers – The inverse of the first disadvantage of diversification, which smooths out your returns in general.  While it decreases what you could get with a proper investment in a high performing security, it will also increase your returns over the worst performing assets in the class.  It also prevents the worry and trouble caused by bankruptcies; if the company that goes bankrupt is only one of the hundreds you are holding, the damage to your portfolio is likely to be minimal.

2) Makes Investing Easier – Another big advantage of trying to invest diversely is that, thanks to products like mutual funds and ETFs, it’s easy to find diversified investments that meet your asset allocation.  Plus, it’s usually is less trouble to track the performance of a few broadly invested funds than to individually track dozens of stocks or bonds.

3) Tends to be Cheaper – Interestingly enough, thanks again to mutual funds and ETFs, it actually is cheaper (usually) to get a highly diversified investment than a more concentrated one.  The abundance of no-load mutual funds and low cost brokerages makes it inexpensive to acquire and hold many diversified investment, whereas the commissions of acquiring even a small portfolio of individual stocks will add up quickly.

Given these relative benefits, what’s the best way to approach diversification?  My advice remains the same as when I discussed how to build an investment pyramid.  First, start by creating a set of broadly diversified investments; that way, you should have a good base to build on.  Then, once you are diversely invested, you can consider putting a portion of your money into individual stocks (say twenty to thirty percent of your overall assets).  This approach allows you to gain the benefits available with individual stocks, while avoiding many of the associated problems.  You can have your cake, and eat it too!

Welcome once again to the little corner of the blog where we discuss some of the greatest arguments in the personal finance world.  Today, we’ll discuss which is better when planning for your retirement, a traditional IRA or a Roth IRA.  (There are also traditional and Roth flavors of 401(k)s, as well, but since that choice will be made by your company and its human resources department, you’ll have less control over which variety you will have.)

The big difference between the two types of IRAs is when the the money you invest in them is taxed.  In traditional IRAs, the money you invest is taken from your taxable income, allowing you pay fewer taxes now, but the withdrawals when you retire are taxed at your regular tax rate.  Roth IRAs are funded with after-tax money and the withdrawals are tax-free.  The decision then becomes when you want to be taxed, now or when you retire.

Therefore, there’s a simple way to determine which type of IRA will be better for you: hop into your time machine, travel forward to the time you retire, and see what tax rates you will be paying.  If the rates are higher in the future than they are now, you’ll do best financially with a Roth; if the rates are lower (or if the Fair Tax has been enacted), than a traditional IRA is the way to go.  Then, come back to the present and open that style of IRA; easy as pie!

What’s that?  You don’t have a time machine?  That complicates matters a bit.  You can still choose the style of IRA you open based on what you think the future will hold for tax rates.  Personally, given the rising national debt and rather low current tax rates, I would imagine that tax rates are only going to rise in the future (although, again, the Fair Tax or other non-income taxes could drastically change the tax landscape), making Roth accounts more attractive.  Some other questions to ask yourself:

Will I need more or less money in retirement? – As a consequence of our graduated tax system, the less income you have, the lower taxes you pay as a percentage of your income.  Thus, since different IRAs allow you to be taxed at different times, you can attempt to determine how much money you will need to spend in retirement.  If you intend to cut down your spending when you retire, even just to the 70-80% of your final income that many experts say that you need, traditional IRAs should be beneficial; if you intend to maintain or increase your current level of spending, a Roth IRA will help you dodge the tax burden.

Do you want to lock in your tax rate? – One of the biggest advantages of a Roth is that you know what tax rate you are paying now (or at least, should be able to figure it out), and therefore know exactly what you are paying in taxes.  As we’ve already discussed, though, tax rates in the future are a big unknown.  If you prefer to pay your current tax rate and not have to worry about tax increases in the future, a Roth provides you with that opportunity.  On the other hand, if you are currently in a high tax bracket, taking a tax break now for your traditional IRA may make the most sense.

(If your taxable income is high enough, you may not even have the option of using a Roth.  For single filers, you can put in the  maximum ($5000)  if you earn less than $105,000 in 2009, with partial contributions allowed up to an income of $120,000; married couples filing jointly can donate up the max if they earn less than $166,000, and partial donations up to $176,000.  A complete matrix comparing income limits and other factors affecting traditional versus Roth IRAs and 401(k)s can be found here.)

Am I diversified? – Diversification isn’t just about holding a variety of investments, it also involves ensuring that your portfolio is prepared for whatever the tax rates do in the future.  If you have a traditional 401(k) at your work place, having a Roth IRA to help in case of rising taxes is a good way to diversify.  Similarly, if you are one of the lucky ones who has a Roth 401(k), having a traditional IRA can help to lower you current tax burden and help to minimize the taxes you will pay overall.

These questions, as well as your thoughts about how taxes will change in the future, will help you to decide which type of IRA will be best for you.  As is frequently the case, there is no easy answer to which type of account is better that applies to everyone equally, but hopefully, asking yourself questions about your tax rate, future spending, and the types of other accounts you hold will help you to make some good decisions.  Happy retirement planning!

Here’s another persistent and oft-debated question: when you manage to control your expenses and actually have money left over at the end of the month, what do you do with it?  Do you pay down any debt that you happen to hold, or do you put the money away into an emergency fund?  As with most serious debates, both sides raise some good and interesting points.

For many people, paying down debt makes the most financial sense.  If you have credit card debt with an interest rate of 25% (sadly, a standard rate for many card issuers), then for every one hundred dollars you put towards paying down the debt will save you twenty-five dollars a year.  Even if you were able to find a completely safe account that yields 5% a year (which isn’t too likely, given the current state of most savings account yields), you’d still be losing twenty dollars per year for every hundred dollars you keep in your emergency fund.  There’s also the psychological factor to consider.  Being able to look in the mirror and say, ‘Yes, I’m debt free’, or at least, ‘I’m free of high interest credit card debt’ is a wonderful feeling.

As always with these great debates, the other side makes a strong case, as well.  Having an emergency fund has its own psychological benefits: if you find yourself facing a large, sudden expense (in other words, an emergency), being able to pay for it out-of-pocket without adding onto your debt.  Furthermore, there are some emergencies where you are unable to use credit cards, and having the necessary funds available for such cases will be a huge morale salve.  (For example, my fiance has a little dog named Toby, and his vet doesn’t accept credit cards.  If we don’t have cash on hand to pay for Toby’s treatment, Toby will end up suffering.)

So, what’s someone who faces both a sizable amount of debt and no emergency fund supposed to do?  The best option is to split the difference; work to build an emergency fund and pay down your debt at the same time.  A short list of actions to take:

1) Build up a small emergency fund.  Not a full emergency fund, which would cover six to twelve months of expenses, but enough that you can cover the more common ‘emergencies’ that arise in life; things like car maintenance, doctor’s trips, or fixing a leaky toilet.  We’re not trying to prepare for a financial disaster at this point, but simply to smooth out our monthly spending.  One month worth of expenses, put into a high yielding, online savings account (SmartyPig would be ideal for an emergency fund) should suffice in most cases; but if you have reason to believe you could end up needing more in the near future (if there’s someone in your household with health issues, for example), then by all means, build a larger emergency fund.

2) Start paying down the highest interest debt.  Ideally, you should make the minimum payments to all your debts, and devote any extra money (now that you’ve got a small emergency fund cushion) to the debt with the highest interest rate.  Once you have paid off that debt, you can put all that money into paying off the next highest interest rate debt, and the process will continue from there.

3) Increase the size of your emergency fund.  Once you have the highest interest rate debt out of the way (any debt with an annual interest rate of more than 8%, let’s say), you should start increasing your emergency fund with some of the money you are paying each month.  The last thing you want is to add more high interest debt now that you have eliminated your previous debt.  You can start splitting the money you had been putting into debt repayment between paying off the rest of your debts and building up your emergency fund.  How much you put towards each goal will depend on how comfortable you feel with your emergency fund and how much you want to be completely debt free.

4) Decide on your next course of action.  By this point, you have paid down your highest interest debt, are only paying low interest rates on your other debt (if you have any debt remaining at all, that is), and have built up a sizable emergency fund.  Where you go from here depends on your goals and current situation.  You could start investing for the future, agressively pay down the rest of your debt, or start saving for a specific purchase.  Each choice is equally valid, and any one of them could be a good option for you, depending on your goals and other factors.