Archives for November 2010

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“Index Funds” Doesn’t Mean “Stocks”

I write a lot about how index funds are great tools for constructing a portfolio. Interestingly, one of the most common objections I hear against index funds is, “I don’t want to invest in the stock market.”

I’m not sure where the idea that index funds only own stocks came from, but it’s complete nonsense. There are numerous bond index funds, and they come in a wide variety of flavors–investment-grade corporate bonds, short-term Treasury bonds, mortgage-backed bonds, and so on.

An all-index-fund portfolio could just as easily be 100% bonds as 100% stocks. And the benefits of index funds (low-costs and diversification within the asset class in question) are just as important with bonds as they are for stocks.

Diversification Is Important for Bonds

In much the same way that it’s beneficial to diversify your stock holdings across numerous companies, it’s beneficial to diversify your bond holdings across numerous borrowers. With corporate bonds, it’s best to own bonds from a variety of companies in a variety of industries. And with municipal bonds, it’s best to own bonds from a variety of states/cities from around the country.

Noteworthy exception #1: There’s no need to diversify among different Treasury bonds. It’s perfectly OK to pick the most appropriate maturity for your purposes and stick with that.

Noteworthy exception #2: If you’re a muni bond investor who lives in a state that exempts in-state muni bonds from state income taxes, it likely makes sense to sacrifice some degree of diversification by overweighting in-state bonds in your asset allocation.

Costs Matter with Bond Funds Too

As important as it is to keep costs low when investing in stocks, it’s even more important when investing in bonds. The expected return of bonds is lower than that of stocks, so every tenth of a percent that goes to pay the fund manager takes a proportionally larger bite out of your final returns.

Unsurprisingly, if you browse the history of Standard & Poors Indices vs. Active Scorecards, you can see that actively managed bond funds have an even lower chance of outperforming their benchmark than actively managed stock funds do. (And that’s saying something!)

Diversifying Your Index Fund Portfolio

When financial advisors or writers suggest owning index funds, it’s unlikely that they’re recommending an index fund portfolio consisting exclusively of stocks. While stock index funds do provide a great deal of diversification across companies, it’s still important to include other asset classes.

Fortunately, the principles of keeping costs low and diversifying apply just as well to bonds as they do to stocks.

Follow the Money: Evaluating Financial Advice

When it comes to evaluating investment advice, it pays to be a bit cynical. Asking yourself how the person giving the advice gets paid is always enlightening.

Naturally, this applies to financial advisors. For example:

  • Commission-paid advisors recommend investments that pay commissions (e.g., actively managed mutual funds and insurance products).
  • Advisors who charge based on the size of your account have an interest in convincing you not to use other financial products such as annuities.

But it applies to other sources of investment information as well.

Mainstream Media

If you’re watching a personal finance program on TV, it can be helpful to look at the program’s major sponsors/advertisers.

Is the program sponsored by actively managed fund companies or by discount brokerage firms that make money when you rapidly buy and sell individual stocks? If so, you can see why the program might want to avoid stepping on their sponsors’ toes by saying that buying and holding low-cost index funds is the best way to invest.

Or for smaller, local programs: What do the hosts do for a living? In a recent discussion at the Bogleheads forum, an investor asked why one of the hosts of a local radio program was insistent on her recommendation of actively managed mutual funds rather than index funds.

A little research turned up the fact that the host is a commission-paid financial advisor. Mystery solved. Low-cost index funds don’t pay commissions. Expensive actively managed mutual funds do.

Academic-Looking Research

Even seemingly-unbiased studies can be affected by conflicts of interest. It’s important to find out who did the research. For example, was it performed by:

  • The Chief Investment Officer of an actively managed fund company?
  • Executives at a brokerage firm?
  • The trade organization of mutual fund companies (the Investment Company Institute)?

Any of those scenarios would give you a hint as to why the research draws the conclusions it does.

And just as important: Who funded the research? Was the study performed by professors, but paid for by insurance companies? That might give you a clue about why it says such good things about variable annuities or whole life insurance.


Finally — lest you think that I’m suggesting that blogs are a source of perfectly-unbiased information — let me point out that bloggers have conflicts of interest too.

We make money recommending companies that have affiliate programs. For example, I earn a commission if you open an account at Scottrade through one of my links. I earn nothing if you open an account at Vanguard. For the same reason, it’s more profitable for me to recommend Ally Bank than Bank of America.

Follow the Money

Before making any major decisions based on financial advice, always ask: Who is this advice coming from, and how is this person paid?  You may find that it’s worth getting a second (differently biased) opinion.

Can I Retire?

Can I Retire

There are two questions that I’ve been asked over and over since I started writing this blog:

  1. How much money will I need to retire?
  2. How should I manage my retirement portfolio to minimize the risk of outliving your money?

My new book Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less (available here on Amazon) was written to address those questions directly.

What Makes This Book Unique?

How does this book hope to be better than, for example, The Bogleheads’ Guide to Retirement Planning or Jim Otar’s Unveiling the Retirement Myth?

It doesn’t. It’s not better. It’s shorter.

As the latest addition to the “…in 100 Pages or Less” series, Can I Retire? is written for the person who might not be able to find the time to read Otar’s entire 525-page book or the 370-page Bogleheads’ Guide.

If you’re considering reading a more in-depth guide to retirement planning, I wholeheartedly encourage you to do so. (Both of the above-mentioned books are excellent!) But if there’s a good chance that, if you were to buy one of those other books, it would sit unread on your coffee table or bookshelf, then this book is written for you.

Click here to see the book on Amazon

Table of Contents

Introduction: Time to Make a Plan

Part One: How Much Money Will I Need to Retire?

1. How Much Income Will You Need?
2. Safe Withdrawal Rates: The 4% “Rule”
3. What if 4% Isn’t Enough?
4. Retirement Planning with Annuities

Part Two: Retirement Portfolio Management

5. Index funds and ETFs vs. Active Funds
6. 401(k) Rollovers
7. Asset Allocation in Retirement
8. Managing Your Long-Term “Bucket”

Part Three: Tax Planning in Retirement

9. Roth Conversions
10. Distribution Planning (which account to spend from first)
11. Asset Location
12. Other Tips for Taxable Accounts

Conclusion: Finding Help with Your Plan

Retiring Soon? Pick Up a Copy of My Book:

Can I Retire Cover

Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

Topics Covered in the Book:
  • How to calculate how much you’ll need saved before you can retire,
  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"Hands down the best overview of what it takes to truly retire that I've ever read. In jargon free English, this gem of a book nails the key issues."

Index Funds are Mediocre

A friend of mine recently told me that she was about to start using a new financial advisor, but she wanted to ask me what I thought of the advisor’s company before she wrote him a check.

The short version is that the advisor was a broker who was trying to sell her a portfolio of super-expensive, actively managed mutual funds. She explained:

“I asked him about index funds, since I know that’s what you and a lot of other people recommend. He said that index funds are mediocre because there’s no chance that they’ll outperform the market.”

The cynic in me couldn’t help but chuckle a bit. “Index funds are mediocre.” It’s a staple soundbite for brokers. Back when I was a broker, I used it all the time.

Hearing that phrase again got me thinking about all the ways that index funds are mediocre. I thought I’d share a few here.

Index Funds are Mediocre

Index funds are mediocre…if mediocrity means being able to obtain extreme diversification with as few as three holdings.

Index funds are mediocre…if mediocrity means being significantly more tax-efficient than almost every actively managed mutual fund on the market.

Index funds are mediocre…if mediocrity means outperforming 60% of U.S. equity funds over the last 5 year period, 60% over the period before that, and 66% over the period before that. (The results are even more impressive for bond funds and international stock funds.)

Index funds are mediocre…if mediocrity means never needing to check your funds to see if any of their managers retired or went to other firms.

Index funds are mediocre…if mediocrity means knowing how your money is invested because your fund company has no reason to keep the fund’s holdings a secret.

Index funds are mediocre…if mediocrity means never having to look at stock charts, watch for earnings reports, or read financial statements.

Index funds are mediocre…if mediocrity means being able to retire with 25% less money (because you’re not spending a quarter of your 4% withdrawal rate just to pay your fund manager).

Index funds are mediocre…if mediocrity means never having to worry that your (seemingly) skilled fund manager will turn out to have just been lucky…and that you won’t find out until his luck runs out.

Index funds are mediocre…if mediocrity means knowing with mathematical certainty that your money will outperform the average actively-managed dollar over every period.

Mediocre sounds pretty good to me.

International Bond ETFs and Funds: Should You Own Them?

Most discussions of asset allocation suggest that you keep a portion of your stock holdings in international funds as opposed to U.S. funds. What you don’t hear very often is the suggestion to include international bonds.

But would it be a good idea to do so?

It depends on your circumstances, but in most cases, I’d say no. International bonds aren’t worth owning due to:

  • Higher expenses, and
  • Currency risk.

Higher Expense Ratios

You can easily find U.S. bond ETFs and funds with expense ratios of 0.15% or less per year. And (depending on your brokerage firm) you won’t even have to pay a commission to buy them.

In contrast, for international bond ETFs, expense ratios in the range of 0.35-0.50% are typical. And in most cases, you’ll have to pay commissions on each transaction.

Or, if you don’t want to pay commissions for your international bond holdings, you can go with an open-end mutual fund. As far as I can tell though, there aren’t any open-end international bond funds with expense ratios of less than 0.80%. (If you know of one, please mention it in the comments.)

In other words, international bonds come at a cost of ~0.50% more than you would pay for a decent U.S. bond index fund.

In contrast, the difference in expense ratios between U.S. stock funds and international stock funds is much smaller: often less than 0.20%.

Takeaway: International diversification for your bonds is significantly more expensive than international diversification for your stocks.

Currency Risk

International bonds (and international stocks) carry currency risk. Currency risk is the risk that the currency in which the investment is denominated will decrease in value relative to the dollar, thereby decreasing the investment’s value.

Example: Imagine that you own Russian bonds with a 5% yield. Over the life of the bonds, if the Russian ruble decreases in value relative to the dollar at a rate of 3% per year, your return will only be (roughly) 2%. Of course, the opposite could happen too: the ruble could increase in value relative to the dollar, thereby increasing your returns.

But we don’t know which will happen. That’s why we call it currency risk.

Why Do You Own Bonds?

Whether or not it makes sense to pay higher expenses and take on currency risk depends on your goals.

For many U.S. investors, the purpose of owning bonds is to earn relatively predictable returns. If that’s why you own bonds, I’d stick with U.S. bonds (TIPS, in many cases). Because international bonds come with currency risk, their returns (as measured in U.S. dollars) are less predictable.

On the other hand, if you’re an “asset class junkie” whose goal is simply to add one more (hopefully) uncorrelated asset class to your portfolio, then an international bond fund may make sense. But even then, because of their high expense ratios and relatively low long-term expected returns, international bonds aren’t exactly optimal.

For the most part, the only scenario in which it makes a lot of sense to own bonds denominated in a foreign currency is when you have expenses denominated in that currency. For example, if you’re saving for a vacation villa in Spain, you may want to do so with Euro-denominated bonds.

Shopping for Fixed Immediate Annuities

As we’ve discussed before, single premium immediate fixed annuities can be a great tool for retirement planning. They provide a high, predictable level of income for the rest of your life, no matter how long that might be. (Note: Annuities have their drawbacks, too. See the article I just linked to for more info.)

But where is the best place to look for such an annuity? And how should you choose between them?

Where to Get Annuity Quotes

The first place I’d go to look for annuity quotes is Vanguard’s site. To access their quote system, visit their “income annuities” page. Then click the “income solutions” link on the right side of the page.

You’ll have to create an account to use their service. Fortunately, however:

  • It’s free, and
  • They don’t send you any marketing materials. (At least, they haven’t sent me any, and I created my account several months ago.)

The reason Vanguard’s system is my favorite is that I have yet to find any other websites that offer quotes for annuities with inflation adjustments. If, however, you’re looking for an annuity without inflation protection, a quick Google search will turn up an abundance of websites that provide annuity quotes.

How to Choose an Annuity Provider

To get the maximum benefit from an annuity, it’s important to minimize the risk that your annuity provider goes under before you do. Rather than just choosing the insurance company that offers the highest payout, be sure to take each company’s credit rating into account.

If the website you’re using to find annuity quotes doesn’t provide information as to each provider’s credit ratings, you can look them up online at any of the following sites:

While we’re discussing credit risk, I should note that it’s worth making an effort to stay under the coverage limit of your state’s guarantee association. For example, if your state only provides annuity coverage up to $100,000 and you plan to annuitize $300,000 of your portfolio, it may be wise to buy a $100,000 annuity from each of three different insurance companies rather than buying one $300,000 annuity.

Should You Get a “Fixed Period” Rider?

Some annuities come with a rider that provides for a guaranteed minimum benefit period. For example, if you purchase an annuity that has a 10-year guaranteed benefit period, then you die 4 years after purchasing the annuity, the annuity would pay out to your named beneficiary for the remaining 6 years of that 10-year period.

For the most part, I’d suggest avoiding such riders. The unique benefit to an annuity is that it provides a higher level of income than you can safely withdraw from a non-annuitized portfolio. The more riders you add to your annuity, the lower the payout gets.

That said, the cost of a fixed period rider isn’t terribly high. In many cases, an annuity with a 10-year guaranteed period will provide a payout that’s more than 95% of what an annuity without such a rider would pay. In short, if:

  • You think you should be buying an annuity, but
  • You can’t stomach the possibility of your money being lost to your heirs in the event that you die the day after you buy the annuity

…then go ahead and get a guaranteed period rider.

Shop Around

Lastly, each company seems to have a (slightly) different mathematical model that they apply to determining the payout for a given annuity. As such, it pays to take the time to shop around and look at many insurance companies before forking over a significant amount of cash to any one of them.

Retiring Soon? Pick Up a Copy of My Book:

Can I Retire Cover

Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

Topics Covered in the Book:
  • How to calculate how much you’ll need saved before you can retire,
  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"Hands down the best overview of what it takes to truly retire that I've ever read. In jargon free English, this gem of a book nails the key issues."
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