Archives for January 2009

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How to Choose Funds in Your 401k

Selecting funds for your 401k money isn’t always the easiest thing in the world. Often, the situation looks something like this:

  1. You’ve never heard of any of the investment options, and
  2. There’s no low-cost index fund option. (Note: If there is, it’s pretty likely that this is your best bet.)

Target retirement funds are usually a decent choice.

If your 401k offers target retirement funds as an option, they’re likely your next best bet (after a low-cost index fund, that is).

Target retirement funds (usually named something like “Retirement 2040”) hold a collection of other mutual funds. They adjust your asset allocation automatically as you approach the date you’ve selected as your goal for retirement. That is, they move your money from more volatile/higher earning investments toward less volatile/lower earning investments as you near retirement.

Two important things to check, however, are:

  1. The fund’s expense ratio, and
  2. The fund’s asset allocation.

The expense ratio is important because lower expense ratios tend to lead to better performance. And it’s important to check that the fund’s underlying allocation is appropriate for your own personal risk tolerance. (For example, sometimes the fund with a date that’s 15 or even 20 years earlier/later than the date you actually plan to retire will be the one that best fits your own needs.)

Other possible ways to choose

What if your retirement plan doesn’t offer target retirement funds? Or what if they’re offered, but they have hefty fees attached to them? At this point, there are a handful of factors you could look at:

  • Past performance
  • Expense ratio
  • Turnover ratio
  • Asset allocation in the fund as compared to your ideal asset allocation

Don’t rely on past performance.

Many people simply pick the fund that has the highest historical performance numbers. After all, that would seem to indicate that it’s the “best” fund, right? Unfortunately, basing your investments entirely upon past performance is almost a sure record for failure.

Why? Because, for most funds, periods of outperforming their peers are typically followed by periods of underperforming. It’s as simple as that. History has shown that it’s exceptionally rare for a fund manager to consistently outperform his peers. As such, betting on funds that have just had streaks of excellent performance is likely to yield poor results.

One way that past performance stats can be helpful, however, is in identifying true losers. While the top funds of last year are often below average this year (and vice versa), it’s actually fairly common for the very worst funds to hang out on the bottom of the pile year after year. Why? Because…

Expense ratios are extremely important.

Common sense tells us that–all else being equal–the less a fund manager charges the fund’s investors, the greater return the investors will earn.

For any given fund, the ratio of operating expenses to invested dollars (referred to as the fund’s “expense ratio”) stays quite consistent from year to year. Funds that had low expenses last year tend to have low expenses this year. As a result, a low expense ratio is one of the best indicators we have for predicting that a fund will show superior performance in the future.

Often, if you can find a fund that’s near the bottom of the pack in terms of 1-year, 3-year, 5-year, and 10-year performance stats, you’ll find that the fund also has a very high expense ratio. This isn’t really surprising. It’s exceedingly difficult for a fund manager to overcome the year-after-year handicap imposed by high expenses.

Look for a low turnover ratio.

A fund’s turnover ratio indicates what percentage of the assets held by the fund were sold during the course of the year. Higher turnover ratios result in higher expenses (in the form of transaction costs and unfavorable pressure on stock prices when buying or selling).

Like operating expenses, turnover-related expenses directly impact the fund’s return (in a negative direction). It’s important to note that these turnover-related expenses are not included in the expense ratio discussed above. Therefore, it’s worthwhile to take note of a fund’s historical turnover before selecting it as a suitable investment.

Be sure to check the fund’s asset allocation.

Finally, it’s essential to take a look at the asset allocation of each of the funds you’re considering. Make sure that–when considered together with the rest of your portfolio–the funds you choose in your 401(k) result in an asset allocation that’s fitting for your personal situation.

In summary:

  • If you have a low-cost index fund option, that’s probably your best bet for the stock portion of your portfolio.
  • If offered, target retirement date funds are likely to be an acceptable, low-maintenance option.
  • If neither of those is available, look for low-cost, low-turnover funds that will help you maintain an appropriate asset allocation for your entire portfolio.

Diversification with Individual Stocks

Over the last several years, I’ve read numerous articles suggesting that instead of using mutual funds, an investor can create a diversified portfolio by investing in 50 (or so) individual stocks.

At first glance, it seems to make sense. You’d be able to hold a few stocks from each of the major sectors. So it would seem reasonable to conclude that your return would (roughly) match the market return.

There’s one big problem though.

You might expect that the returns of individual stocks over a given period (if plotted on a chart) to look something like a bell curve:

bellcurve

  • Centered around the average market return,
  • Most stocks outperforming or underperforming by a couple percent, with a roughly equal amounts of stocks on either side, and
  • A small amount of outliers at either end.

But that’s not how it works.

In reality, over any period, there will be a handful of stocks that severely outperform the market and make up a disproportionate amount of the total return.

In contrast–to look at the other end of the performance chart–we know that there is a limit to how severely any stock can underperform the market. (No stock can go below zero, of course.)

In other words, we know that the severe outperformers are outperforming by a greater degree than the degree to which the most severe underperformers are underperforming. (Yikes, it’s a tongue twister almost!) From this, we can conclude that more than 50% of stocks must be performing at a “below average” rate of return in order to balance out those mega overachievers.

For instance, over the last 13 years, the market (as measured by the S&P 500) is up a total of 249%. Microsoft’s stock, on the other hand, is up a total of 18,332%. Clearly, in order to balance out Microsoft’s astonishing performance, there must have been a multitude of stocks that performed below average.

In short, over any given period, most stocks must be underperformers. The way I see it, this leads to two conclusions:

  1. Picking stocks is truly a gamble. There’s a possibility of a big payout, but the probability of any given stock even matching the performance of the market is less than 50%.
  2. A portfolio of just 50 stocks is similarly risky.

It looks to me like massive diversification is the only reliable way to make sure these overachievers are in your portfolio. Does that make sense? Or is there something I’m missing here?

Apparent Risk vs. Actual Risk

I’m currently working my way through William Bernstein’s Four Pillars of Investing. The point he hammers home in the first chapter is that the market rewards risk by providing additional return on more risky investments. This risk/reward  (or risk/return) relationship is one that’s discussed frequently in the finance field.

However, as far as I can tell, the market rewards apparent risk rather than actual risk.

What do I mean by apparent risk?

An example: One year ago, the stock market didn’t look or feel very risky to investors. Today, however, millions of people have decided that the market isn’t safe right now. It too risky.

I’d say that this is an example of apparent risk rather than real risk. The market is no riskier today than it was a year ago. When we invest, it’s the same companies we’re investing in (minus a few I suppose!). Things just feel riskier because we’ve all been reminded of the unpleasant fact that bear markets are an unavoidable part of investing in stocks.

From an economic perspective, it seems to make sense.

From Econ 101, we know that when demand for something increases, the price for it goes up (assuming supply stays constant). We also know that when the price of an investment goes up, the return offered by the investment goes down. (This is just simple math. For example, if a bond is paying $600 of interest per year, you’d earn a greater return if you paid $10,000 for the bond than you would if you paid $12,000 for the bond.)

And common sense would seem to indicate that how risky an investment looks is going to be more important than how risky it really is when it comes to influencing demand for the investment. Therefore, greater apparent risk leads to lower demand (and thus lower prices), which leads to greater return.

So how can we take advantage of this?

Ignore the noise: Just because people are saying the market is risky right now doesn’t mean it is. Stock prices have been driven down due to a decrease in demand. Might as well take advantage.

How About a Little Common Sense?

I saw this article from the LA Times last month. The point it tries to make is that many students get in a financial mess by not understanding the difference between federally subsidized student loans and private student loans.

The article uses an example of a student who–while getting her bachelor’s in photography–accumulated $140,000 of student loans. The article claims that the student was given no explanation of the fact that only $20k of it was federally subsidized. OK. Fine. That may be a legitimate point.

But let’s back up a bit. $140,000 of debt?

If we assume a 15-year repayment period, even if there was no interest being charged, that’d still be over $9,000 to pay every year! That might make sense if the degree was a medical degree or an MBA from an ivy league school–something that would provide a reasonable expectation of a rather high income. But photography?

Now, I know that a person’s judgement capacities aren’t fully formed by the time they’re aged 18. (Mine sure weren’t!) But still. I know several people younger than 18 who wouldn’t have any trouble recognizing that $140,000 is a lot of money to borrow and that they might have trouble paying it back.

And as to the question of being duped into a high-interest loan? If an 18-year-old is mature enough to be sent off into the world to live on her own (or rather, to live in a small area with several thousand similarly-aged people), then surely she’s mature enough to recognize the wisdom of reading the terms to an agreement that puts her on the hook for one hundred and forty grand.

But this is just one example. Apparently more than half of our country has been doing something similar for the last decade. Yikes!

How many of our current problems could have been avoided with a little common sense?

Review: The Power of Less by Leo Babauta

I just finished reading Leo Babauta’s The Power of Less. I can’t help but share a few thoughts, as the book really clicked with me. (Granted, this should be no surprise given how much I enjoy Leo’s blog.)

The major premise of the book is that if we can identify the 4-5 most essential things in our lives–and do our best to eliminate everything else–we’ll be able to:

  • Enjoy life more fully.
  • Be more productive.

In the introduction to the book, Leo puts it this way:

Simplicity boils down to two steps:

  1. Identify the essential.
  2. Ignore the rest.

I had to do a double-take when I read this. I can’t get past how analogous this to what I’m always saying about investing. In fact, just a couple weeks ago–while working on the introduction to my next book–I had written this:

Oblivious Investing consists of a simple, two-part strategy:

  1. Invest in diversified portfolios of stocks via low-cost funds.
  2. Stick with the plan, ignoring all the short-term market fluctuations.

Jeez. It’s practically the same thing. (With, of course, the exceptions that Leo’s thesis applies to life in general, and that he’s much more concise.)

As you can imagine, I like Leo’s way of thinking.

A practical, usable approach to productivity

Leo’s book is the antithesis of other productivity/self-help books that recommend dramatic restructurings of our entire lives. Leo repeatedly urges taking things slowly. Like he does on his blog, Leo advises us to work on creating new habits.

For instance, rather than attempting to achieve a weight loss goal by deciding to run for 30 minutes everyday, Leo suggests that we start with 5 minutes each day. Do that consistently until it becomes a habit. Then try 7 minutes. He suggests always starting with a small goal. Small enough, in fact, that it seems almost too easy.

I love this approach. It increases the likelihood of sticking with the plan, because it prevents burnout. Similarly–as we all know–small, repeated actions can have a big impact over extended periods. (Dollar-cost-averaging, anyone?)

I have to say, for as much as I enjoy his blog, I enjoyed the book even more.

[Side note: Leo also recently put out a free ebook entitled Thriving on Less: Simplifying in a Tough Economy. Definitely worth the time to read, imo.]

Funds of Funds: Higher Expenses Means Trouble

Given that there are currently more mutual funds than there are stocks of actual companies, it’s no surprise that some ivestment managers have decided to make a living by creating portfolios of funds rather than stocks.

Funds like this have historically shown to have an even lower chance of beating the market than other actively-managed funds. Why? Two layers of expenses. (To pay for both the underlying funds as well as the fund whose job it is to choose among them.)

Grand total costs of these actively-managed portfolios of other actively-managed funds often approach 3%. That’s a big portion of return that they’re eating.

Passively-managed funds of funds

Other funds of funds are simply passively-managed portfolios of funds run by the same company. They own shares of their own company’s funds, and buy/sell them at predetermined times (to maintain a given asset allocation, for instance.) The most common funds in this category are the “target retirement” funds.

Many of these funds are acceptable choices, because the only expenses being charged are the expenses for the underlying funds. (And this makes sense given that these funds only invest in funds run by their own company, so there should already be a built-in profit margin.)

Unfortunately, however, several target retirement funds do actually charge an extra level of expenses. In this scenario, you’re essentially getting the same funds that would be available to you anyway, but you’re paying more money for them than you need to.

Overall lesson: Before investing in a fund, be sure to take the time to actually read its prospectus (or, at least, the part of it that describes the investment costs). It’s important to at least know what you’re paying.

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