Saturday, December 31, 2011

Everything you need to know about investing, almost.

Almost everything you need to know is in this chart. It's worth looking at for a few minutes.

The chart above shows the last 15 years of investment returns by asset class. On the far right I have calculated the 20-year average for each asset class and pointed out the best and worst annual returns for the past 20 years for each asset class.  I love this chart - which is why I put it on the back cover of every book I have written.  Almost everything you need to know about investing can be learned from this chart:

  1. Stocks beat bonds over the long-run.  In the far right columns of the chart you will notice that all 4 of the major stock classes have a higher 20-year average return than all 4 of the major bond classes. You will notice that the various stock classes averaged 9-13% annual returns over 20 years while the various bond classes averaged just 5-8%.  
  2. Stocks don't beat bonds EVERY year, but they win about 75% of the time.  You will also notice that a stock class claimed the top spot in 11 out of the past 15 years (and 16 out of the past 20 years).
  3. Stock returns are much more variable or volatile than bond returns.  In the far right column of the chart you will notice

Monday, December 26, 2011

More on I Savings Bonds

I blogged about US Savings Bonds recently, but here is another nice article in the Wall Street Journal that sings the praises of the I Savings Bonds.  The I Savings Bonds are a great place to stash your emergency fund.  You can buy them at

A tip of the hat to: Shayne John

Saturday, December 24, 2011

10 Dumbest Things on Wall Street 2011 has published a list of the 10 Dumbest Things on Wall Street: 2011

Actually, it's a quick video - no reading required!

So much to chose from, how did they manage to cut the list to just 10?

Tuesday, December 13, 2011

'Tis the Season to Give Financial Gifts to Children

Christine Benz of Morningstar recently published an interesting article called "The Best Ways to Give a Financial Gift to Children."  The article has good information for different ways to give a financial gift, but I might not classify them as the "best" ways. The article really focuses on more sophisticated ways to give larger amounts of money without letting the child spend it - at least not right away.

The article proposes 4 ways of gifting to children:
  1. Set up a UGMA/UTMA account (Uniform Gifts/Transfers to Minors Act)
  2. Contribute to a 529 Plan (college savings account)
  3. Fund a Roth IRA (Individual Retirement Arrangement)
  4. Give a financial knowledge gift (a basic finance book)
The article explains these 4 strategies pretty well so I'll let you read it yourself.  But, I'd like to add three simpler options below:

Monday, December 12, 2011

Read my books for FREE on Kindle in December!

If you are an Amazon Prime member, you can read three of my books for FREE in December!

The Rollover IRA Cookbook: Vanguard Recipes for your old 401(k)

The ETF Cookbook: Commission-Free Investing at TD Ameritrade

The Federal TSP Cookbook: Investment Recipes for the Thrift Savings Plan

Borrow the books absolutely FREE, with no due dates via the Kindle Owners Lending Library.

Sunday, December 11, 2011

Are you putting your investment advisor's kids through college?

The next time you walk into your local bank and their hot shot salesman investment advisor asks you to pay him 1% per year to place your money in his impressive list of mutual funds he has hand picked, all with stellar track records - simply turn on your heel and walk out.

Here's why.  Over a long period of time, say 20 years, the stock market will likely average about 8% annual return (2-3% from dividends + 5-6% in capital gains).  If you pay a salesman investment advisor 1% to put your money in mutual funds with expense ratios of 1% you will only achieve a 6% annualized long-term return.  In other words, you will give up 25% of your possible investment returns!

But, with these high fees, the power of compounding is working against you.  So it is actually worse than 25%!  Let me show you how.

If you invest $100,000 at 6%, after 20 years you might have $320,000 - or a gain of $220,000.  Sounds good right?  But, if you invest $100,000 at 8%, after 20 years you might have $466,000 - or a gain of $366,000.

You could have gains of $366,000 if you bought index funds, but since you paid that salesman investment advisor 1% to put you in mutual funds with 1% expense ratios, you only earned $220,000. That is a difference of $146,000 over 20 years.  In other words, you probably put your bank's investment advisor's daughter through college - instead of your own!

To think about it another way, you could have increased your investment returns by +66% if you bought index funds rather than listening to your bank's salesman investment advisor! (146/220 = 66%).

If you are fortunate enough to have $500,000 to invest, just multiply the above numbers by 5.  After 20 years you would amass $2.3 million with an 8% return, but just $1.6 million at 6% annual return. That's right, you would be out a whopping $730,000 over 20 years (146 x 5 = 730).  You likely paid for your investment advisors house - instead of your own!

I think these numbers speak, no SHOUT - very loudly why I believe everyone should learn do it yourself investing using Vanguard index mutual funds.  Even if you think you might make a mistake or two doing it yourself, there is no question you will come out ahead.  One of the worst things you can do with your money is give it to your local bank investment advisor and pay him 1% per year to put you in mutual funds with 1% expense ratios.

Saturday, December 10, 2011

Investment Performance Persistence Improbable

Standard & Poor's released their most recent S&P Persistence Scorecard.  It clearly shows why it makes no sense to pay someone to pick "good" mutual funds for you (or for you to try to pick funds yourself).  It's easy to find plenty of mutual funds with terrific track records in the PAST, but nearly impossible to identify funds that will outperform index funds in the FUTURE.

The problem is funds with great track records rarely give a repeat performance.

The study looked at a 10 year time period. First, they identified the top 25% of mutual funds for the first 5 years. Then, they looked to see what percentage of that top 25% stayed in the top 25% over the next 5 year period.  Here is a summary of the results:

Year-End Tax Tips

Click here for a list of year-end tax planning tips provided by Bogleheads.

Friday, December 9, 2011

Bye Buy US Savings Bonds :(

Starting January 1, 2012 we will no longer be able to walk into our local bank and purchase a US Savings Bond - at least not the traditional paper form.  US Savings Bonds are NOT going away - they are only going to be sold in "electronic form" via

Here is the press release from back in July.

I have always liked the I Savings Bonds that guarantee an interest rate above inflation. They accrue interest but the interest is not subject to federal tax until you redeem the bond and is completely exempt from state or local income tax.  If you use the proceeds for education expenses, you may not owe any federal tax at all.

Thursday, December 8, 2011

When and How to Use an Annuity

Here is a terrific article by Oblivious Investor on when and how to use an annuity in retirement.

I completely agree with the Oblivious Investor's opening paragraph:
 "Many annuities (maybe even most) are a raw deal for investors. They carry needlessly high expenses and surrender charges, and their contracts are so complex that very few investors can properly assess whether the annuity is a good investment.  
That said, one specific type of annuity can be an extremely useful tool for retirement planning: the single premium immediate annuity (SPIA)."

89% of 401(k) investors want help

According to a study by the Boston Consulting Group, 89% of employees want help figuring out how best to invest in their 401(k) plan.  And, 84% want help calculating how much money they need and/or will have at retirement.

Sorry for another blatant self promotion, but that is why I wrote my first book. So, I wonder why "The 401(k) Cookbook" does not sell better?  401(k) investors can figure out the answer to both questions in about a half hour using this book.

Tuesday, December 6, 2011

Does a Dead Cat Bounce?

George Putnam, editor of the Turnaround Letter advisory service thinks dead cats can bounce as outlined by Mark Hulbert at Marketwatch.  I would not condone this type of investing except for entertainment purposes as trying to time a dead cat bounce can sometimes be as tricky as catching a falling knife. Putnam produces a list of stocks that have been pummeled during the year. The idea is that these stocks can rebound (a bit) after big mutual funds dump the stocks before year end in an effort to "window dress" their year end portfolio holdings list.

This year's list of possible year-end dead cat bounces includes:

The Battle for the Soul of Capitalism

Just finished the audio-book version of, "The Battle for the Soul of Capitalism" by the great John C. Bogle (inventor of the first index fund and founder of the Vanguard Group of mutual funds).

I love Jack Bogle and recommend everything he has written, and

Friday, December 2, 2011

The Eurozone Will Survive When PIGS Fly

Below I've attempted to simply explain the European Sovereign Debt Crisis.

P = Portugal
I = Italy or Ireland (take your pick)
G = Greece
S = Spain

The above 5 countries are the weakest link in the Eurozone.  The Eurozone are the 17 countries within the 27 country European Union that use the Euro as their single common currency.  Monetary policy for the Eurozone can only be decided with a unanimous vote of the 17 member countries (nearly impossible), however

Thursday, November 24, 2011

Answer: Father of the 401(k)

Question: Who is Ted Benna?

Sorry for the answer/question format. I was watching the TV game show "Jeopardy!" before writing this post.

A good friend of mine sent me a link to an interview with Ted Benna. I had not heard of him, but apparently he was the first person to get a 401(k) retirement savings plan approved by the IRS some 30 years ago. In fact, the reason a 401(k) is called a "401(k)" is because that is the IRS tax code section that created these retirement accounts.

The interesting thing about the interview, is that Mr. Benna does not seem to like how the 401(k) has evolved over time.

Tuesday, November 22, 2011

The Warning

Have you ever heard of Brooksley Born?  Neither had I.

Neither did Alan Greenspan, Arthur Levitt, Larry Summers, or Robert Rubin, which is why they all testified to Congress to ignore Born's pleas to allow the Commodity Futures Trading Commission (CFTC) to regulate certain derivative financial instruments. Brooksley Born ran the CFTC when she attempted to regulate the multi-trillion dollar derivatives market - the same derivatives that helped trigger the 2008 financial meltdown.  Unfortunately, Alan Greenspan et. al. convinced Congress that the derivatives market would police itself just fine.

Clearly, they were wrong - and they admit as much on video.

The video on the subject made me think.  I'm a capitalist at heart, but

Monday, November 21, 2011

Finance Clippings: Luck or a brilliant value strategy?

I completely agree with this blog post from Professor Richard Warr (he's the head of the finance department at NC State). Finance Clippings: Luck or a brilliant value strategy?: Was Bill Miller's 15 year streak at the helm of the Legg Mason Value Trust luck or a skilled implementation of the value strategy (picking c...

Wednesday, November 16, 2011

What to do when your 401(k) suc(k)s

Here are a couple of good articles that point out there are times when you should NOT participate in your employers 401(k) plan.  SmartMoney article. Ask Holly article.

If your employer's 401(k) plan:

(1) offers no matching funds,


(2) charges a commission on your purchases (also called a front-end load, or sales charge),

you should opt NOT to participate in your 401(k).  Instead, fund an IRA or Roth IRA.

If your 401(k) plan charges a commission on purchases, but does offer matching funds, you should only contribute enough to obtain the maximum employer matching funds and no more.

Monday, November 14, 2011

Insider Trading Laws Don't Apply to Congress?!?

On Sunday the TV show "60 Minutes" did an excellent report about how "insider trading rules," that apply to EVERYONE, do NOT apply to members of congress.  Anyone who buys or sells investments while in possession of information not available to the public goes to jail - unless you are a member of congress.  And, no surprise, members of congress seem to have a very good stock and option trading record!  

Just think how much money you could make if you could do things like, buy stock in the initial public offering of VISA (the credit card company) knowing that highly restrictive credit card legislation was going to die in the House of Representatives? Nancy Pelosi, the Speaker of the House at the time, did just that!  

Or, what if you could buy a whole bunch of stock in health insurance companies the day before congress revealed legislation that would significantly help health insurance companies? John Boehner, the current Speaker of the House, did just that!  

How about buying a bunch of "put options" (betting the stock market would go down) after attending a confidential meeting where Federal Reserve Chairman Ben Bernanke first revealed the impending financial crisis?  Find out which member of congress did that by clicking the video link below.

Every voting American needs to watch the beginning of this CBS 60 Minute report.

Tuesday, November 8, 2011

Bond Market Irony and Karma: Why Evil Lehman Had it Coming

Rick Ferri recently blogged about how Total Bond Index Funds don't actually include the Total Bond Market. Ironic as it sounds, Rick is right.  Most so-called total bond market index funds try to mimic the Barclays Capital US Aggregate Bond Index (formerly the Lehman Aggregate Bond Index or in bond slang "The Lehman Agg"). Rick points out that the Barclay's Aggregate Bond Index EXCLUDES both junk bonds and TIPS.

TIPS (Treasury Inflation-Protected Securities) are an important asset class for investors since they are significantly different from traditional "fixed-income" bonds.  Thus, in my books, I utilize TIPS in many of my recommended investment recipes. TIPS are bonds issued by the US Treasury that adjust for inflation.  This is significantly different than all other bonds that pay a FIXED interest rate.

The biggest risk with investing in most US Treasury bonds is inflation risk.  If one looks at the current yield curve, you will see that 5-year US Treasury Notes currently pay less than 1% interest per year. If you own this bond, you will likely lose real value over 5 years as I expect inflation to exceed the paltry 1% yield.  TIPS also protect investors from DEFLATION as they are structured to never fall in value below their face value.  TIPS are so unique that when added to a traditional stock and bond portfolio, an investor can both reduce risk and increase returns of the overall portfolio.

Friday, November 4, 2011

Margin Call

Just saw the movie "Margin Call" with Kevin Spacey, Demi Moore, Jeremy Irons, and Stanley Tucci. The message is "If you can't be smarter, be first - otherwise cheat." I'll give the movie a 7 out of 10. You'll like it if you're a finance junkie like me. The movie is likely just a 6 for non-finance geeks.

Monday, October 24, 2011

Why I LOVE to HATE Target-Date Funds

A survey, by the Plan Sponsor Council of America, found that while equities amount to 63% of 401(k) plan assets (yea!), the most popular investment option utilized in 401(k) plans is actively-managed equity funds (boo!).

The survey also found  target-date fund popularity grew from less than 3% of 401(k) plan assets in 2006 to 13% in 2010.  In that same time frame, the percentage of plans that offer target-date funds rose from 33% to 63%.  Casey Quirk & Associates project that almost 50% of 401(k) plan assets will reside in target-date funds within 10 years.

I have a LOVE / HATE relationship with target-date funds.

I love the concept of “target-date” mutual funds.  The idea is an employee with a 401(k) only needs to know their approximate retirement date and then put all their retirement money into one fund.  Target date funds are designed to hold a mixture of stocks and bonds that systematically reduces the volatility or market risk of the fund by slowly increasing the allocation towards bonds and reducing stocks over time. 

Owning a mixture of stocks and bonds that slowly shifts towards more bonds and less stocks over time with annual rebalancing is exactly what I recommend folks do in all my books.  Target-date funds do all this for you and simplifies your life.  This is an awesome idea that makes retirement planning a no-brainer, right? So, what’s my problem?

Below are the stock / bond allocations for two target date funds managed by two very well known mutual fund firms lead by famous Chief Investment Officers. 

Question:  Which fund has a target retirement date of 2030?

Ticker Symbol
% Stocks
% Bonds
% Other

Answer: Both!

So there you have a problem – target-date retirement fund allocations vary significantly from fund family to fund family.  Two people of the same age, with different employers, could have extremely different asset allocations even if both are invested in target retirement mutual funds with an estimated retirement date of 2030.

Which fund above do you suppose is managed by a mutual fund company run by a very famous bond fund manager, and which is managed by a mutual fund company run by a very famous stock fund manger?

The fund with the biggest allocation to bonds is run by a firm with a very famous bond fund manger and the fund with the largest allocation to stocks is run by a very famous stock fund manager. 

PRLIX is the ticker symbol for the PIMCO RealRetirement 2030 Fund and PIMCO’s Chief Investment Officer is Bill Gross – perhaps the most famous bond fund manager on the planet.

LMVIX is the symbol for the Legg Mason Target Retirement 2030 Fund and the Chief Investment Officer for Legg Mason is Bill Miller – one of the most famous stock fund managers on the planet.

There is a saying, “if all you have is a hammer, everything starts to look like a nail.”  This could be the problem with these two funds, as PIMCO, the famous bond fund company clearly favors bonds while Legg Mason, the famous stock fund company clearly favors stocks.

I’d actually recommend an allocation of 60% stocks and 40% bonds for the “typical” person retiring around 2030.  Thus, my opinion is the Legg Mason fund above is too aggressive and the PIMCO fund is far too conservative for the “typical” person retiring in 2030. 

This brings us to another problem: What is “typical?”

I would argue that there are very few “typical” people and the one-size fits all target retirement date mutual funds may not be appropriate for many investors.  Two people that are both looking forward to retiring in 2030 could be VERY different people. 

First, they could be very different in age if one is planning to retire “early” at say 55 years of age, while the other may be planning to work until 75.  The older person, all other things being equal, should probably have a more conservative portfolio.

Second, even if two people are the same age and plan to retire the same year, they could have VERY different health.  Someone in perfect health might need a more aggressive portfolio than someone who is in poor health - perhaps suffering with cancer or diabetes or some other health problem.

Third, two people could be of same age and health, but one has $50,000 saved and the other might have $1.5 million saved.  I would argue the wealthier person can afford to be more aggressive with their portfolio even late in life.

Fourth, consider two people the same age, health, and both have saved $500,000 for retirement.  One could be single while the other is married with 4 kids in college.  Fifth, perhaps one will receive a pension of $40,000 per year while the other has no pension.  Sixth, maybe one lives in San Francisco and pays $6,000 a month in rent while the other lives in San Antonio and lives in a house with no mortgage?

Even if you could come up with two people that are identical in EVERY economic way possible, they could be VERY different emotionally.  Smooth Sally might be very laid back and calmly reviews her 401(k) statement once per quarter, while Nervous Nick watches too much CNBC and checks the value of his 401(k) twice before lunch every day.  Nervous Nick should be in a much more conservative portfolio than Legg Mason would likely put him in, while PIMCO might put Smooth Sally into a portfolio that is far too tame.

Imagine a 21 year old man who shows up for his first day of being a waiter at Denny’s.  His boss hands him the “typical” employee uniform – a size 10 dress.
My point is there are no “typical” people.  Target date retirement funds only take into account one of dozens of potential variables that make EVERY investor different.  This is why I love the idea of a simple one-size fits all mutual fund, but in reality, one size does NOT fit all. 

This is also why I include a questionnaire at the beginning of all of my books that attempts to give each reader an investment recipe that is seasoned specifically and not typically.

Friday, October 21, 2011

End CRAPitalism!

Yes, I intentionally misspelled the title of this post.  And, no, I am not a socialist, but as a capitalist I see three horrific conflicts of interest within the current configuration of our capital markets that makes them almost un-investable.  All three conflicts of interest stem from who pays our most important watch dogs.

Bond Ratings Agencies
First, investors in bonds rely on bond ratings (i.e. AAA, AA, A, BBB, etc.) issued by "ratings agencies" such as S&P, Moody's, and Fitch.  These ratings are supposed to be based on objective, detailed analysis.  But such analysis is time consuming and thus expensive.  Who gets to choose whom to hire among S&P, Moody's, and Fitch?  You guessed it - company management hires the ratings agency.  Who pays the chosen ratings agency?   The company pays the ratings agency!

The fox does not guard the hen house, but the fox hires the watchdog!

Stock Analysts
Second, investors in stocks rely on stock ratings (Buy, Hold, Sell) issued by Wall Street analysts.  These supposedly independent stock analyses almost never result in a "Sell" rating.  Why?  A Wall Street analyst that issues a "Buy" rating is a CEO's best ally.  The CEO and other executive management have stock options and want the stock to rise. And, the CEO will pick which investment banking firm will earn fat merger and acquisition advisory fees.  Thus, a stock analyst won't want to risk issuing a "Sell" rating when it could jeopardize his firm's chances of earning fat investment banking fees.

The investment banking industry will point to SEC regulations that require a "Chinese Wall" inside investment banks that separates the stock rating division from the merger and acquisition advisory division.  The "Chinese Wall" is primarily in place to prevent the merger and acquisition advisory division from sharing non-public information with the stock rating division.  Even the most foolish stock analyst certainly realizes a "Sell" rating could hurt his firm's chances of winning fat investment banking fees even without penetrating the so-called "Chinese Wall."  After all, the stock analyst likely owns stock options in his own firm and thus wants all the divisions of his firm to do well.

Since investors cannot rely on the compromised opinions on either stocks or bonds, investors need to do their own analysis of company financial statements.  That brings us to problem number three.

Third, investors in stocks and bonds of corporations rely on "audited" annual financial statements.  The financial statements are prepared by "management," but supposedly under the watchful eye of an external auditor that assures us that the financial statements "fairly represent" the true financial status of the company.

The problem? Who do you think hires the auditor? You guessed it - company management hires the auditor.  Who pays the auditor? The company pays the auditor.  This might not quite be the fox guarding the hen house, but the fox definitely hand picks and pays the watchdog!

In the past, I've worked within the corporate finance department of a huge, Fortune 100 company with stock that traded on the New York Stock Exchange.  I personally attended meetings between management and our external auditor to discuss and debate certain assumptions affecting our financial statements.  The external auditor lost every debate.

Problem Summary
Bond rating agencies, stock analysts, and auditors are all directly or indirectly compensated by the companies they monitor. Investors beware.

Possible Solutions
Bond ratings agencies actually double-dip. Ratings agencies earn fees from the entities they rate, but also sell their ratings to investors.  The solution is simple, bond rating agencies should not be allowed to earn fees from the entities they rate. Rating agencies should only be allowed to sell their ratings to investors that rely on their opinion.  Ratings agencies surely would claim they can't survive without the fees they charge the firms they rate.  However, I believe the ratings agencies would eventually make up this difference as investors would be willing to pay more for their ratings once the ratings agencies conflict of interest is eliminated. Right now, their bond ratings are worthless.

Investment banking firms should not be allowed to both rate stocks and earn fees from the companies they rate.  Investment banks, many that are also too big to fail, should be split right down that so-called "Chinese Wall."  The stock rating divisions should be spun off into separate companies.  Like the bond ratings agencies, I believe investors would eventually be willing to pay more for the stock ratings once the stock ratings firms conflict of interest is eliminated. Right now, their stock ratings are worthless.

Solving the conflict of interest with the auditing firms is a more complicated problem.  All investors, ratings agencies, and stock analysts rely on the financial statements issued by firms.  In a perfect world, the folks that rely on the financial statements should hire, fire, and pay the auditors.

Perhaps the stock exchanges should be saddled with picking and paying the auditor for the companies whose stock trades on their exchanges?  The stock exchanges could raise their listing fees to pay for this new burden.  Or, perhaps the Securities and Exchange Commission (SEC) should levy a fee on companies and in turn hire and fire the auditor?

Capitalism has become cRapitalism since investors have no where to go for reliable information.  None of my proposed solutions are perfect, but I think they are better than the current systems we have now.  I believe my solutions above, combined with the outlawing of executive stock options, can save and improve capitalism.

New 401(k) Limit is $17,000 in 2012

The IRS announced several inflation adjustments for retirement plans in 2012. Here are some highlights:

  • The elective deferral (contribution) limit for employees who participate in 401(k), 403(b), most 457 plans, and the federal government’s Thrift Savings Plan is increased from $16,500 to $17,000.
  • The catch-up contribution limit for those aged 50 and over remains unchanged at $5,500.
  • The AGI phase-out range for taxpayers making contributions to a Roth IRA is $173,000 to $183,000 for married couples filing jointly, up from $169,000 to $179,000 in 2011.  For singles and heads of household, the income phase-out range is $110,000 to $125,000, up from $107,000 to $122,000. 

Wednesday, October 12, 2011


The Financial Times article, “Fund mergers obscure performance” highlights a real problem in the investment industry. Many mutual fund companies close poor performing funds or merge them into better performing funds.  This may not sound like a huge problem, but it enables fund companies to appear more successful than they really are. 

A quick search shows that one large fund family has 204 mutual funds.  Even if only 5% of these funds outperform their relevant benchmark index, they would still have over 10 funds they could tout in investment magazines.  The strategy of having many, many, many funds, allows large fund families to always have plenty of funds with good track records.  When you open Money magazine, or SmartMoney, or Kiplinger’s you will see dozens of ads for mutual funds with fantastic track records.  The problem is the outperforming funds were probably only lucky and quite likely won’t be as lucky in the future.

As I pointed out in previous posts, the majority of mutual funds underperform index funds.  A quick search on Morningstar’s mutual fund database shows only 25% of large cap blend mutual funds that have a 10-year return higher than their benchmark index and only 13% of mid cap blend funds beat their benchmarks.  However, your odds for picking one of those outperforming funds 10 years ago was much smaller than 25% for large cap funds and much smaller than 13% for mid cap funds.  Why?

Many, many funds that were around 10 years ago have disappeared by now.  Hundreds of funds are closed each year and hundreds more are opened.  This is how the mutual fund industry dupes folks into believing they can beat passive index funds.  Just think about it, if you personally could run 10 different stock portfolios, you could probably produce 4 or 5 that would beat passive index funds even if you just randomly picked your stocks.  After a few years, you would just close the funds with poor performance and open new funds with no track record.  Again, after a few years close the funds with poor performance and start new funds.  Do this over and over until you have a dozen funds with great track records.  This is exactly what many fund families do!

So, instead of having a 25% chance of picking a Large Cap fund that will outperform an index fund, your odds are probably more like 10% or even less.  In the Mid Cap space your odds are likely less than 5% of picking a fund that will outperform a good low cost Mid Cap index fund.  And, if you own any of these funds in a taxable account, your odds of outperforming simple index funds on an after-tax basis is very close to ZERO due to the increased capital gains active funds pass on to their investors who have to pay taxes on those gains.  

Rick Ferri has written a great article on this topic titled: Fund Investors Should Lead "Occupy Boston". Every mutual fund investor should read it.


But wait, it actually is worse than that!  First, I need to give you a little primer on equity mutual fund “style boxes.”

Mutual fund databases like Morningstar and Lipper segregate domestic stock mutual funds into 9 categories based on the type of stocks the funds focus on.  Funds are segregated by the size of the firms whose stocks they buy: Large Capitalization companies (referred to as Large Caps), Mid Caps, and Small Caps.  Then, each of these three tiers are further segregated into funds that focus on high growth companies (Growth Funds) or on stocks that are “cheap” referred to as Value Funds.  The third category is for funds that buy both “Growth” stocks and “Value” stocks.  This category is usually called “Core” or “Blend.”  So, we end up with 9 investment “style” boxes.


Value fund managers want to be measured against Value indexes and Growth fund managers want to be measured against Growth indexes.  We’ve seen 25-year periods where Value and Growth was a dead heat tie.  (This is why I don’t recommend messing with Value or Growth and just buy Core or Blend funds, preferably index funds).  But, sometimes Value stocks perform better than Growth stocks over shorter periods of time like 5 years. Sometimes Growth beats Value.  One really never knows when or why one will outperform the other.  But, it is important for investors to know which index should be used to measure their funds performance.


The 5 years leading up to 2006 was a period where Large Value stocks had dramatically outperformed Large Growth stocks.  One particular fund family had two Large Cap funds – one was a Large Cap Value Fund (ticker: BBTGX) and the other a Large Cap Growth Fund (ticker: BLGAX) as follows:

                                                            Value               Core                Growth
5-year Large Cap Index Returns        5.3%               0.5%                -3.6%
BB&T Large Cap Funds                     4.0                                          -4.9
Underperformance                -1.3%                                       -1.3%

Both the Large Cap Value Fund and the Large Cap Growth Fund had performed poorly during the 5-year period. Each fund had failed to beat their passive index by approximately -1.3% per year for 5 years.

If a fund family had no morals, they might think to merge the two funds, bury the track record of the worst of the two bad funds, keep the “least bad” track record, and move the “new” fund to a category where the poor track record “appears” to be better.  So, BB&T did just that!

Despite the change in the name and the focus, the fund actually kept its performance track record!  Really, I’m not kidding!  The 4.0% 5-year return looked bad in the Large Cap Value category where the benchmark index was 5.3%, but suddenly looked great in the Large Cap Core category where the benchmark index return was just 0.5%!

But they didn’t stop there.  Once BB&T had successfully “moved” the Large Cap Value performance track record into the Large Cap Core category, on January 29, 2007 BB&T merged the lousy Large Cap Growth Fund into the new fund named Large Cap Fund

This is how the owners of the Large Cap Growth Fund came to own a Large Cap Core Fund with a Large Cap Value track record!  Seriously, I’m not making this up!  This should be illegal, but if it is, they got away with it. 

Just to obscure the issue as much as possible, in 2010 BB&T renamed “The BB&T Large Cap Fund” to “The Select Equity Fund.”  Lastly, just in case someone was still able to connect the dots, recently they changed the name yet again to the “Sterling Capital Select Equity Fund” but kept the original ticker symbol of BBTGX

However, with all this changing of the name, and the focus of the fund, and jumping of style boxes, what was not changed is the poor performance.  Five years later, the Sterling Capital Select Equity Fund now ranks in the bottom 5% of all Large Cap Blend Funds in the Morningstar mutual fund database.  With a 5-year annualized return (loss) of -6.4%, the Sterling Capital Select Equity Fund once again trails its benchmark – underperforming the S&P 500 Index by a whopping -5.2%.

In my opinion it should be illegal for a mutual fund to officially change its investment strategy and performance benchmark and keep its old performance track record.  I believe, in a situation like this, the old fund with the old strategy should be deemed to have been closed and a new fund with NO PERFORMANCE track record has been created.  

In short, STYLE BOX JUMPING SHOULD BE OUTLAWED.  Mutual funds without morals need to be eradicated from the investment industry.  The investment managers and the mutual fund boards of directors that allow this to happen should be banned from the industry.

The lesson here: Actively managed mutual fund performance is even worse than you think. So, just buy low cost index funds.

Tuesday, October 11, 2011

Getting Out of a Bad Annuity: 1035 Exchange

The Oblivious Investor blog has a good post about how to get out of a bad annuity.  If you own any annuity, it is worth a look.

Not all annuities are bad - just 95% or more.  For this reason, I typically tell folks to completely avoid all annuities. The odds are the annuity your salesman is pushing is one of the bad ones.  He/she would not be pushing it if it didn't provide big fees for him/her.  While it might not make tax sense to sell out of an annuity, it might make sense to "exchange" a bad annuity for a less bad annuity.  I would hazard a guess that if you have an annuity, and it is NOT a Vanguard annuity, you should look into exchanging into a low cost Vanguard annuity.

Most annuities will charge a "surrender fee" when you leave, but this fee gets smaller over time and quite often goes to zero after 7 years. You've got to do the exchange right to avoid a tax headache - so read the blog at the link above, and call Vanguard at 1-800-357-4720 if you are not comfortable doing this yourself online.

As I always say, I don't work for Vanguard, but they are the lowest cost investment manager in the world and most of my money is invested in their mutual funds and ETFs. That is why I always recommend them to family and friends and use their funds and their ETFs in my investment recipes in my books.

Monday, October 10, 2011

Capitalism Without Capital: Why Executive Stock Options Should Be Outlawed

Lehman Brothers and Bear Sterns survived World War I, World War II, and The Great Depression. Why then did the mortgage crisis of 2008 cause these firms to fail? What was different with this economic crisis?  The answer: employee stock options.

In the past 20-30 years, income disparity from the CEO and other executives down to the rank and file employees has dramatically diverged with C-level executives (CEO, CFO, COO) now making 300-400 times the average worker up from 30-40 times just 20-30 years ago.  What changed?  The answer: the invention of employee stock options.

Actually, I am talking about “executive” stock options. Rank and file employees rarely receive stock options as compensation, and when they do, it is a trifling amount.  Typically stock options are awarded from the very top CEO level down to mid-level managers.  But, the allocation of stock options is greatly skewed with the largest grants made to the highest level executives.

In the past, investment banks were partnerships.  Every decision within these firms was a really big deal since the vast majority of every partner’s net worth was at risk.  Becoming a partner was a huge decision and NOT a no-brainer.  Becoming a partner meant the individual would share in the profits of the firm – generally a lucrative option.  However, becoming a partner quite often required the employee to buy into the partnership.  Thus, the employee actually had to save their own money and then put it all into the firm.  While the new partner shared in the profits of the firm, those profits largely stayed in the firm until retirement.  Most of these partners became quite wealthy on paper, but the vast majority of their wealth was tied up in the working capital of the firm until they retired.  Having everyone’s wealth at risk made these folks fairly balanced in their decision making.  Sure, they knew if they bet big they could win big.  But, since their personal wealth was at stake, they also were somewhat cautious.  In addition, every partner was VERY interested in what was going on in EVERY division of the firm.  Just because a partner worked in the equity division, he was not immune to a blunder in the fixed income division of the firm.  Thus, everyone monitored everyone, and that form of checks and balances worked pretty well for more than 100 years through thick and thin.

Then, over the last 20 years or so, investment banks “went public” by issuing stock to the public.  Suddenly, anyone could own a piece of Wall Street and share in their profits.  However, more importantly, investment bankers could now gamble with other people’s money instead of just their own. 

This switch from partnership to a stock form of company structure resulted in two significant changes in compensation.  Investment bankers have always had a large portion of their compensation tied to profits of the firm.  Wall Street bonuses have always made up the majority of employee compensation.  However, in the partnership form, a large portion of this bonus would stay within the capital account of the firm.  With the new stock form, cash bonuses were taken home free and clear by the employee. 

In addition to the new portability in bonus payments, executives were given stock options in what has been falsely sold as an effort to “align employees’ incentives with stockholder interests.”  But, this is not a perfect alignment.  For example, imagine you own one share of stock in XYZ Corporation that is currently worth $60.  Also imagine a company executive has been given one stock option.  Typically, an executive stock option has a life of 10 years and gives the executive the “option” to buy the stock at some point in the next 10 years at the current price of $60.  Thus, the executive wants the stock to increase in value.  If, in 7 years the stock trades at $100, the employee has the ability to convert the stock option into stock.  The executive pays just $60 and receives a share of stock now worth $100.  However, the executive rarely keeps the stock.  Most executives don’t have to put up any money at all.  Usually, an executive in this circumstance will exercise the option and immediately sell the stock.  So, the executive buys the stock for $60 and immediately sells the stock for $100 and pockets the $40 difference.  In fact, companies facilitate this process and the executive usually does not have to put any money up at all – they just pocket the $40 gain.

We have been sold a false bill of goods in the thought that this executive’s incentives have been perfectly aligned with actual owners of the stock.  Let me now point out another scenario that shows how wrong this thought is.  Let’s take the same example as above.  Let’s say you own a $60 stock and the executive has a stock option with a $60 exercise or strike price.  But now imagine the employee makes a very bad bet with the firm’s capital.  Perhaps the executive buys a complicated collateralized debt obligation that falls dramatically in value.  Further assume that this large loss causes the stock to fall to $20.  As a shareholder, you just lost $40.  However, the company executive has lost nothing.  The executive still collects his salary and probably a much smaller bonus, but the executive never actually owned the stock.  The stock option expires worthless.  So, the executive did not get the added kicker of cashing in his stock option, but he also did not incur any loss whatsoever.  I suggest that executive stock options do not align company executives’ incentives with shareholder’s best interest.  Sure, stock investors and stock option holders both want the stock to go up, but actual shareholders are much more concerned about the possibility of the stock going down than someone who merely has the “option” to buy the stock in the future.

In addition, stock options encourage company management to stop paying dividends. Stocks with large dividends tend to be much less volatile than stocks that pay no dividends.  This lowers the value of executive stock options.  Plus, the value of the stock goes down by the exact amount of the dividend every time.  Thus, an executive who owns a stock option has two reasons to not want the firm to ever pay a dividend.  Executive stock options encourage company managers to take undue risks as there is no downside for the employee. 

Executive stock options also encourage managers to over leverage the firms that they run. Imagine an employee conceives of a project that costs $100 and believes it will result in earning either $15 or a loss of $5. The owner of a stock option will likely make that bet while a stock holder might not be thrilled with those odds.  In addition, the executive knows that this project could increase the stock price by 15%.  This same executive knows that if he can borrow another $100 in the bond market that he can magnify the impact of this project and its impact on the stock price by a factor of two.  With no downside, the owner of an option to buy a stock would likely make this gamble.  Why not really roll the dice and borrow $1,000 or $10,000 or $10 billion?  The executive might hit it big and be able to retire early.  And, if it blows up, so what?  It’s not like he had anything personally at risk.  He’ll still get his salary and bonus, but just won’t cash in on the stock option.

The incentive to over leverage the firm is further encouraged by the U.S. tax code since interest on debt payments is tax deductible while dividend payments are not tax deductible. 

So here is a recipe to take advantage of the current state of capitalism without capital.  Start a company with other people’s money by selling stock in your firm.  Use that money to borrow 20 times the amount from the bond market.  Invite all your friends to sit on your board of directors and issue yourself a whole slew of stock options.  Then take all the money everyone has given you and go make a huge bet on something.  Repeat as necessary until you win and cash in.  (This recipe works anywhere, not just Wall Street).

Directors at US corporations have no idea what they are paying their executives.  Let me repeat that. Boards of directors at companies that issue executive stock options won’t know what they really paid their executives until the options are cashed in or expired.  That means many firms won’t know the true compensation of their executives for another 10 years!  How is an investor supposed to forecast the financial statements of a firm for the next 10 years when we don’t really know the true profitability of any firm for the last 10 years? 

Executive stock options have led capitalism down a path where capital is misallocated.  Boards of directors have no idea if they are over paying their executives, and investors have no idea if companies are profitable or not.  Thus, managers within companies are possibly misallocating company funds and investors may be allocating funds to companies whose financial statements are not known with any certainty.  With executive stock options, company executives actually have no capital at risk.  A stock option allows the executive to win or break even, but there is no risk of loss.  Isn’t the reason capitalism succeeded for as long as it has is that it properly allocates capital to those people and those projects and those firms that deserve it?  Capitalism does not work without proper allocation based on specific measurable profits. 

Executive stock options should be against the law as there is no downside for the company executive. Instead, executives should be compensated with actual shares of stock – not options on stock. And, executives awarded stock should not be allowed to sell until they leave the firm.

Capitalism without capital is just gambling, with other people's money, and destined to fail.  We need to outlaw executive stock options, now.

Thursday, October 6, 2011

Vanguard Finds Picking Active Managers is Hard – Duh?!

Vanguard fired Mellon Capital Management.  Vanguard had previously hired Mellon to manage the Vanguard Growth and Income Fund(VQNPX).  VQNPX is a large cap blend mutual fund whose stated goal is to beat the S&P 500 Index.  Mellon didn’t get the job done so Vanguard has hired two new managers to try to beat the S&P 500 Index. 

The fact that Vanguard even attempts to have actively managed funds perplexes me since the Vanguard Group was built on the theory that active managers won’t beat index funds over the long-term.  The performance of VQNPX below once again proves this:

VQNPX                      S&P 500
3-year             -0.6%                          +1.2%
5-year             -2.6%                          -1.2%
10-year           +2.2%                         +2.8%

I love Vanguard, but this makes no sense to me. Personally, I think the VQNPX investors would have been better served if Vanguard had merged the fund into the Vanguard 500 Index Fund (VFINX) – but time will tell.

Vanguard Discovers Market Timing is Hard - Duh!?

Vanguard Mutual Funds is merging its Vanguard Asset Allocation Fund (VAAPX) with its Vanguard Balanced Index Fund (VBINX).  The Asset Allocation Fund (VAAPX) utilized "tactical" asset allocation moves which is Wall Street code for "trying to time the market." The Vanguard Asset Allocation fund tried to increase its allocation to stocks when the manager thought stocks would go up, and increase its allocation to bonds when it thought stocks would do poorly.  The VAAPX fund is currently allocated 90% stocks and just 10% bonds.
Conversely, the Vanguard Balanced Index Fund (VBINX) simply uses a static allocation of 60% stocks and 40% bonds and periodically re-balances the portfolio to keep this static 60/40 mix.  Below are the performance results of the two funds at the end of last month.  You can easily see why Vanguard is merging the Asset Allocation Fund into the Balanced Index Fund.  Simply put, Vanguard has discovered that they are no good at getting in and out of the stock market in an attempt to "time the market." Duh!  No one can do this.  Not even Vanguard.
VAAPX                      VBINX
3-year             -1.6%                          +4.1%
5-year             -0.4%                          +3.9%
10-year           +2.9%                         +4.8%

I think the VAAPX investors ($8 billion) will be better served in the VBINX fund going forward. Here is the link to the Vanguard announcement

Thursday, September 29, 2011

Avoid Hell's Kitchen and Beat 90% of All Investors

There ought to be a new entry in Wikipedia’s definition of “mean reversion” – See Bill Miller. 

I hate to kick a guy while he is down, but the Bill Miller example is just too good an opportunity for a teaching moment.  Princeton professor Burton Malkiel is famous for his book, “A Random Walk Down WallStreet.”  One of my favorite Malkiel quotes:

“if picking stocks is a random walk down Wall Street, picking funds is an obstacle course through Hell’s Kitchen.”

There is no better example of how difficult it is to not only pick stocks, but also to pick mutual funds than the Legg Mason CapitalManagement Value Fund (Ticker: LMVTX)  managed by famed investment manager Bill Miller.  Bill Miller’s face once graced the cover of virtually every investment magazine after producing one of the greatest streaks in investment history.  Miller became famous after managing to beat the S&P 500 Index 10 years in a row with his LMVTX mutual fund.

Unfortunately, as is usually the case, terrific investment returns are typically followed by dreadful investment performance.  This phenomenon has been seen time and time again, and makes picking mutual funds at least as difficult as picking winning stocks – maybe harder.  Bill Miller’s Legg Mason Capital Management Value Fund is unfortunately the poster child for this phenomenon.  After beating the S&P 500 Index 10 years in a row, the LMVTX has failed to beat the S&P 500 Index in 4 of the last 5 years, and is on pace to lose again in 2011.  What’s worse is the margin of failure. Consider the following performance figures in percentages:

2006    2007    2008    2009    2010    2011 YTD
LMVTX             5.9       -6.7     -55.1    40.6      6.7      -7.6
S&P 500         15.8       5.5     -37.0    26.5     15.1     -1.8
Difference       -9.9     -12.2    -18.1    14.2     -8.4      -5.8

Despite its name, the Legg Mason Capital Management Value Fund competes in the Large Cap Blend Morningstar category where its 5-year and 10-year performance track record is now so poor it is ranked in the bottom 1% of all mutual funds competing in that category. Don't get me wrong, Bill Miller is a very smart guy. He has done nothing "wrong."  He's just a guy who was very lucky for 10 years and he has been very unlucky more recently.  The fact is, most mutual funds fail to beat simple broad market index funds.  In that case, Bill Miller is in good company.

If this one example of how difficult it is to identify mutual funds that will outperform broad market indexes, consider the following information I gathered while perusing the Morningstar database of mutual fund returns.  Morningstar shows 1,890 mutual funds in the Domestic Large Cap Blend category (the same category in which the fund above competes).  Of these 1,890 funds only 823 have been in existence for 10 years.  Of those 823 funds with 10-year track records, only 209 or 25% have produced a 10-year return higher than their benchmark index.  So, there you go. It’s easy to find mutual funds that have beaten their index IN THE PAST.  I just found 209 of them.  But, the Bill Miller example shows you that while it is easy to find PAST WINNERS, it is impossible to predict future performance.

If that isn’t enough, consider the Morningstar database of 426 Mid Cap Blend mutual funds. 193 of these funds have a 10-year track record, but only 25 of these beat the relevant mid cap index over the 10-year period.  That’s right, only 13% of all mid cap blend mutual funds beat their benchmark index. Another way to look at it is 87% of the mid cap blend mutual funds failed to beat their benchmark index. 

And, the data on the funds above OVERSTATE the performance of mutual fund managers due to something called survivorship bias.  The Morningstar database only shows the funds in existence right now, and does not include the hundreds of funds that went out of business over the past 10 years due to poor performance. Thus, your odds of picking a fund that will outperform index mutual funds IN THE FUTURE is likely less than 10%.  (This will be the topic of another post, soon).


The lesson here is that it is extremely tough to pick winning mutual funds since their historical track records provide no guide for the future whatsoever.  The funds with great track records rarely give a repeat performance.  So, how is an investor supposed to pick mutual funds that will beat stock market indexes IN THE FUTURE? You can’t, so just buy index funds and you will likely beat 90% of all investors. 

So, when your over-paid investment advisor shows you a list of 8-10 mutual funds with fantastic performance records that he/she recommends you buy, don’t be impressed.  Turn and walk away.  There are many good index funds out there, but I have always recommended Vanguard mutual funds to my friends, family, and in my books.