Archives for June 2010

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Morningstar Stars: Are Mutual Fund Star Ratings Any Use?

Last week, I had the opportunity to attend the 2010 Morningstar Investment Conference.

During a panel conversation with four top Morningstar researchers, the moderator asked a question about the studies that are done from time to time, which tend to show that Morningstar’s star ratings don’t work all that well as predictors of future performance.

Don Phillips, President of Fund Research at Morningstar, had a great reply:

“The star rating is a grade on past performance. It’s an achievement test, not an aptitude test…We never claim that they predict the future.”

Pretty straightforward answer, no? The star ratings aren’t even intended to predict future performance. They’re simply a calculation based on how each fund’s risk-adjusted return has compared to that of its peers (with a very heavy emphasis on the most recent 3 years of performance).

That, combined with the fact that there are more successful predictors of performance available (i.e., expense ratios), leads to one obvious conclusion: Don’t base your fund picks on how many stars they have.

It also leaves me with a question: What good are the star ratings if they’re not useful for picking funds?

3 Good Stocks to Buy Right Now

An article titled 3 Stocks That Can Do Well in This Economy was recently submitted for my weekly roundup. I didn’t include it, as I wanted to discuss it more thoroughly.

The author, Mark Riddix, made a compelling case for the success of the three companies in question. But I wasn’t entirely satisfied as to why the stocks of those companies would be good investments.

Quick reminder: The fact that a company is growing (or is going to grow) does not by itself mean that its stock is a good investment. For a stock to be a good investment, there must be reason to think that its future growth is not already reflected in its price.

Said differently, for a stock to earn above-average returns, the company must do better than the market expects it to.

You vs. The Market

Let’s imagine that you’ve found a company that you’re confident is going to grow, and based on your calculations it looks like the market is underestimating that future growth. In other words, it looks to you like the stock is underpriced.

Whenever you think that the market has priced a stock incorrectly, there are two possible explanations:

  1. You know something the market doesn’t know, or
  2. The market knows something you don’t know.

If the current market price for a stock is below what you think is appropriate, either you know something positive about the stock that the market doesn’t know, or the market knows something negative about the stock that you don’t know.

Scenario #1 is the jackpot. But thinking you’re in scenario #1 when you’re really in scenario #2 sets you up for a nasty surprise.

How Can You Tell the Difference?

So how can you tell which scenario you’re dealing with? I’d argue that in most cases, you can’t. And if there’s no way to know, betting that you have more information than the rest of the market seems unwise to me.

The only two situations in which I’d be comfortable betting against the market would be:

  1. I’ve done enough research that I’m confident I know every single material fact about the company, or
  2. I have a specific reason to think that I have information that has not been noticed by the rest of the market.

Of course, each of those conditions is rather difficult to satisfy. And I suspect most of us have no interest in doing anywhere near the amount of research that would be necessary to do so.

I think most of us would be better off buying, holding, and rebalancing a lazy ETF portfolio.

My three stocks to buy right now? VTI, VEU, BND.

IRA Beneficiary Rules: The “Stretch” IRA

Note: This article focuses on choosing beneficiaries for your IRA. If you are the beneficiary of an inherited IRA, please see my article on inherited IRA rules.

When choosing beneficiaries for your IRA, there are really only two things you need to know:

  1. Your will is not the proper place to name an IRA beneficiary, and
  2. To the extent that it’s practical to do so, it can be advantageous to name your younger loved ones as the beneficiaries to your IRA.

Where to Name an IRA Beneficiary

When you open an IRA, the IRA custodian will ask you to fill out a beneficiary form. When you die, the person(s) listed on that form will inherit your IRA — even if somebody else is designated in your will as the recipient of your IRA.

So, when something changes in your life — new children, new grandchildren, divorce, etc. — it’s important to update your IRA beneficiaries accordingly. One of your children being left out (or an ex-spouse inheriting your IRA!) simply because you forgot to update a piece of paperwork would be a real shame.

Fortunately, updating your IRA beneficiaries is easy. With most brokerage firms, you can do it online. If you can’t, you should be able to get it done with a quick phone call.

Beneficiary Distributions: “Stretching” an IRA

When a non-spouse beneficiary inherits an IRA, she’s required to take distributions from the account over her remaining life expectancy. (More on that here.) The younger the beneficiary, the greater her remaining life expectancy and, therefore, the greater the ability for savings via tax deferral.

For example, if a 25-year-old inherits an IRA (from somebody other than his spouse), he’ll have to start taking distributions the following year (at age 26). At 26, according to the IRS life expectancy tables, his remaining life expectancy is 57.2 years. As such, he’ll be required to distribute the IRA over the next 57.2 years.

In contrast, if a 78-year-old inherits an IRA (from somebody other than his spouse), he’ll have to distribute the account over the next 10.8 years — a much shorter period due to his shorter remaining life expectancy.

In short, the longer a beneficiary’s remaining life expectancy, the smaller percentage of the IRA he has to withdraw each year, and the more he can take advantage of the power of tax deferral. As a result, to the extent practical, it often makes sense to choose your younger loved ones as the beneficiaries for your IRA.

Easy, Right?

As complicated as IRAs can be, choosing the beneficiary (or beneficiaries) for your IRA is fairly straightforward. Just remember to keep your beneficiary form up to date with your IRA custodian. And, if it’s reasonable to do so, consider leaving your IRA to your younger loved ones in order to maximize its value for your family.

Are ETFs Bad for Investors?

From time to time I see financial writers lamenting the explosion in ETF popularity over the last few years. They complain that the original idea of index investing (i.e., buying and holding a low-cost, diversified portfolio) has been perverted in favor of a focus on trading ETFs for short-term profits.

Frankly, I disagree. I think the proliferation of ETFs has, on the whole, been great for investors.

(Quick note: I’m not arguing that ETFs are better than the index funds that already existed. Nor am I saying that most investors should be buying ETFs on margin, day trading them, or buying sector-specific ETFs.)

More Access to Low-Cost Investments

A couple decades ago, pretty much the only way to build an indexed portfolio was to have an account at Vanguard. Today, anybody with a discount brokerage account has access to the tools with which to put together a low-cost, diversified portfolio.

Is that bad for investors?

Price Competition

Over the last year or so:

  • Schwab created their own commission-free ETFs,
  • Fidelity responded by working out a deal with iShares to offer commission free trades on iShares ETFs, and
  • Vanguard eventually replied by allowing for commission-free trades of Vanguard ETFs.

It’s price competition in action, and I doubt it would have happened if it weren’t for the massive demand for ETFs.

Is that bad for investors?

Cost Awareness

We’re naturally cost-conscious in most areas of their lives. We do our best to save money on groceries, utility bills, back to school supplies — everything. Everything, that is, except for investments.

For decades, investors have been paying through the nose for mutual fund portfolios. And we’ve been doing it without even realizing it.

That’s finally changing. More and more investors are becoming cost-conscious about their portfolios. And ETFs are (at least in part) to thank for that.

For example, when Fidelity and Schwab each promoted their commission-free ETFs, they promoted the low-cost aspect of it. There were full-page adds in financial magazines encouraging investors to pay attention to expense ratios and commissions per trade.

Is that really so bad?

How Do You Pay Your Financial Advisor?

The question of how to pay a financial advisor comes up frequently in personal finance literature. Typically, the discussion focuses on conflicts of interest and goes something like this:

  • Commission-paid advisors have very large (perhaps insurmountable) conflicts of interest with their clients,
  • Advisors who charge a percentage of assets under management have smaller, though still meaningful, conflicts of interest with their clients, and
  • Advisors who charge hourly fees or who use a fee-for-service system have few conflicts of interest with their clients.

That’s all well and good, and I’d agree with such analysis. But I think there’s also something to be said for a simple common sense approach:

Is your advisor’s fee-structure a good match for the type of service he/she provides you?

Financial Advisors as Doctors

By way of analogy: You probably don’t pay your doctor an annual retainer. Nor do you pay an annual fee that’s a function of how much you weigh or how tall you are.

Most likely, you pay per visit. Why is that?

I suspect it has something to do with the nature of the service your doctor provides: an annual checkup, plus consultations when a specific need arises. In other words, most days, you don’t need your doctor to do anything for you.

The same goes for investing. From day-to-day, managing a portfolio requires very little work. And for many of us, that work can be almost completely automated.

That said, an unbiased advisor who can answer the more complicated questions and point out possibilities for planning is surely valuable. For example:

But the nuts and bolts of investing and portfolio management is simple:

  1. Select an appropriate asset allocation.
  2. Minimize costs.
  3. Rebalance according to an explicit plan in order to keep your risk level where you want it to be.

Call me crazy, but I don’t see much need for ongoing help with that.

Tax Site Migration Roundup

Last weekend, I decided (for an assortment of reasons) to move all the content over from my tax site to this site. In the process, it occurred to me that many readers here may not even be aware I had another site.

So in the interest of a) pointing out articles that may be helpful to you, and b) giving Google a nudge toward finding the articles’ new locations, here’s a roundup of a handful of the more popular pieces. We’ll be back to our regular, investing-related discussion on Monday. 🙂

Taxation Basics

Investing and Taxes

Sole Proprietorships/Self-Employment

Accounting

Tax Forms

Business Entities

Other Miscellaneous Articles

For More Information, See My Related Book:

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