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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?

June 21, 2010

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.

June 16, 2010

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:

Book3Cover

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"
June 9, 2010

How Much Money Do I Need to Retire? (In 2 Easy Steps)

People ask this question all the time. And, in my experience, most people assume that answering the question will involve a lengthy process of complicated calculations.

It doesn’t. It’s actually quite easy:

  • Step 1: Determine how much income you will need from your investments each year. (There’s no way around this step. If you skip it, you’re just guessing.)
  • Step 2: Find out how much it costs to buy an inflation-indexed single premium immediate fixed annuity that will guarantee you that much income for the rest of your life.

That’s it. Nothing tricky about it really.

That said, it’s worth making a few related observations.

First, you cannot safely retire on less money. Reason being that with an annuity, you get a payout that is higher than could safely be taken from a typical portfolio of stocks/bonds/mutual funds. (In exchange, you give up the possibility of leaving the money to your heirs.)

Second, if you want to leave something to your heirs, you need more. (Naturally, how much more you’ll need depends on how much you want to leave behind.)

Third, the more money you have in comparison to your necessary investment income–that is, the lower your necessary withdrawal rate–the less of your portfolio you’ll need to annuitize. If your necessary withdrawal rate is low enough, you may not need to annuitize at all, as you’ll be able to get away with a typical stock/bond portfolio.

And finally, when it comes time to actually buy that annuity, you’ll want to a) look for insurance companies with strong financial ratings, and b) do your best to stay under the limit backed by your state’s guarantee association.

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."
June 2, 2010

Social Security: A Bond in Your Asset Allocation?

One question I get from time to time is how Social Security or pension income should affect your asset allocation. Specifically, should it be counted as a large bond holding?

My answer: Not exactly.

Yes, Social Security and pension income are predictable in much the same way that income from a bond is. And yes, all else being equal, an investor with a pension can probably take more risk in his portfolio than an investor without a pension.

That said, there are some meaningful differences between Social Security and a giant bond holding. For example, you can’t sell your “Social Security bond.” Among other things, this means that you can’t rebalance back and forth between a “Social Security bond” and a stock fund in the same way that you could with real bond holdings.

How to Account for Social Security Income

Rather than counting Social Security income and pension income as part of your bond allocation, I’d suggest using this method for fitting them into your overall retirement plan:

  1. Determine how much money you’re going to be spending each year during retirement.
  2. From that, subtract any part-time job or business income you expect to earn.
  3. From that, subtract your Social Security and pension income to determine how much income you will need from your investments.
  4. Divide that number by the size of your portfolio to calculate your required withdrawal rate.
  5. Choose an asset allocation that you believe will best satisfy that withdrawal rate.

This way, rather than counting Social Security and your pension as liquid, tangible investments (which they aren’t), you’re counting them as income sources (which is what they are).

Social Security Bond Problems

In case you aren’t convinced, let’s take a look at how counting Social Security income as a bond could cause some problems.

Let’s imagine that you get $20,000 per year in Social Security income and $20,000 in pension income. If we were to count those income streams as bonds and we assume the bond has a 4.07% interest rate (that of a 30-year T-Bond at the moment), they’d be worth a total of $982,800.

And let’s assume that you need another $20,000 each year in addition to your social security and pension income. If you have a $450,000 portfolio, that’s a 4.44% withdrawal rate. If you retire at age 65 and use the “age in bonds” rule, you’d have the following allocation:

  • $0 in bonds; $450,000 in stocks (because social security and pension income would more than satisfy the entire bond allocation).

In other words, in such a scenario, if you count Social Security and pension income as if they were bonds, you’d be going into retirement with all of your investable assets in stocks, and you’d be using a 100% stock portfolio to satisfy a 4.44% withdrawal rate.

Yes, if things go your way and the stock market performs well when you need it to, your plan would work out OK. But it’s far from a sure bet.

Instead, count the income streams as an offset to your expenses, then ask yourself what allocation you should use to satisfy the necessary 4.44% withdrawal rate.

Want to Learn More about Social Security? Pick Up a Copy of My Book:

Social Security coverSocial Security Made Simple: Social Security Retirement Benefits and Related Planning Topics Explained in 100 Pages or Less
Topics Covered in the Book:
  • How retirement benefits, spousal benefits, and widow(er) benefits are calculated,
  • How to decide the best age to claim your benefit,
  • How Social Security benefits are taxed and how that affects tax planning,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"An excellent review of various facts and decision-making components associated with the Social Security benefits. The book provides a lot of very useful information within small space."
May 31, 2010

Why Buy IPO Stocks?

For the most part, people are risk averse. We prefer not to take on any additional risk unless there’s an increase in expected return.

On occasion, however, we’re not risk averse. We’re risk seeking. When we go to a casino or play the lottery, we’re taking on risk despite the fact that our bets have a negative expected return.

Why? Because in some contexts, risk is fun. It’s entertainment.

Picking Stocks for Fun

Many investors like to pick stocks for fun. For them, attempting to outsmart (and outperform) the market is an enjoyable intellectual challenge. (And for the record, I see nothing wrong with that, as long as they’re aware that the value is in the entertainment rather than in the likelihood of success.)

But what does this have to do with those of us who are buy and hold investors, who have no interest in picking stocks? In short, we may want to attempt to avoid investments that carry a high entertainment value.

The most obvious examples of such investments are penny stocks and IPOs. Because so many people use them like lottery tickets, their long-term historical returns (as a group) are rather low, despite their high risk.

Further, some experts–William Bernstein in The Investor’s Manifesto, for instance–argue that a part of the reason for value stocks having slightly higher historical long-term returns than growth stocks is that growth stocks (especially small-cap ones) carry a higher entertainment value than value stocks.

In other words, it’s fun to try to pick the next Microsoft or the next Google, so many people try to do exactly that. And in the process, they drive prices of small-cap growth stocks upward and returns downward.

The natural response, of course, is to actively seek to make your stock portfolio as boring and unglamorous as possible. The less popularity or entertainment value an investment has, the better.

May 24, 2010
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