TERADIME MONTHLY NEWSLETTER - APRIL 2004
Topic: Investing 101 � Asset Allocation.
If the only thing you ever learn
about successful investing is how to properly allocate funds, you will be 97%
ahead of all of the investing community out there. People who know me well, have heard me preach that asset
allocation is the most important component of investing. Even though we run a
service that tries to time the market, you should know that less than 5% of my
personal wealth (or lack thereof) is being actively managed. The rest is being
allocated in the index tracking mutual funds or funds of funds. Actively managed does not only mean buying
and selling stocks or bonds. Investing
in an actively managed non-index mutual fund is also considered to be a form of
active management. For example, if your
money is being invested in mutual funds via sponsored 401K plans, the chances
are some of those mutual funds are actively managed by financial professionals
(Financial Professionals � people who
lose your money for you and charge you between 1.2 � 2.5% of your assets for
the service). At least when you lose money by following our advice you do
not pay me 2% of your assets for it. J
Investment management firms will
never tell you the truth about actively managed mutual funds. If you knew the
truth, they would never get your business. They want you to believe that you
need to invest in an actively managed �5 star� mutual fund to beat the
market. They would never tell you that
today�s 5 star funds are tomorrow�s 1 star funds. They will tell you that you need to buy and sell their �focus�
list stock, so that you can pay them fat commissions. Well, you don�t have to do it.
Repeat after me: �I will never invest in an actively managed fund�. Your best option for the long term (20 +
years) is to be properly diversified among multiple index funds that invest in:
1
Domestic and international securities;
2
Large, medium, and small cap stocks;
3
Government bonds with long term and short term maturities;
4
Corporate investment grade and junk bonds;
5
International bonds;
6
REITs (Real Estate Investment Trust);
7
Commodities;
8
Dollars, Euros, Yen, etc�
These types of securities have
different risks and rewards. Depending on your age and when you plan to retire
the mix of all of the above classes of securities will be different, and will
have to constantly change as you get older to gradually move your portfolio
from high risk/growth oriented securities to moderate and low risk/income
producing securities. The best way to
invest in the above asset classes is via ETFs (exchange traded funds) that
provide low fee structure (total fees are around 0.25% of assets). In comparison, your average actively managed
mutual fund has fees around 1.5% of assets.
You must never invest in any mutual fund (no matter how many stars it
has) that charges you over 1% of assets unless these are the only funds that
are provided to you by your 401K plan. In that case you are stuck and you will
be forced to diversify among the funds that are provided to you by your
company.
Why is the fee structure so
important? What is the real difference
between .25% and 1.5% (besides the obvious 1.25 delta)? Before I provide you
with the example below, you must be informed of the following statistics that
you will not find at Charles Schwab, Fidelity, Merrill Lynch, TD Waterhouse, etc�
- Any performance statistics taken for less than
a 20-year period are invalid and can be attributed to pure luck vs. skill.
(Unfortunately the same is true for
my market timing signals)
- Less than 1% of mutual fund managers stay with
the mutual fund for 20 years or longer as stock pickers. Just look at your
jobs and your friends. Even if you worked for the same company for the
past 20 years, how many of you actually did exactly the same thing at your
job? So, do not �buy into� the hot mutual fund or manager, please.
- Take a look at the table below that provides
the comparison of the performance of the top 30 mutual funds vs. S&P
500. It painfully proves that �previous performance is no guarantee
of future results�.
Did you find any 20+ year period
that beat the index? OK, you can stop looking now.
The only question is: how can these guys (active managers)
still get so much business and manage so much money and get so much in
compensation, like they know something? Part of the answer is marketing and a great sales force. Another one is: �Uneducated investors are their best customers�.
Now my example:
Assume that you are a super-lucky
investor that can, every year, successfully pick an actively managed fund that
averages 1% above the index and charges 1.5% of assets as fees. The fund is very tax inefficient, but you do
not care, since in our example you are investing your 401K, IRA, or even better
Roth IRA money where taxes do not matter.
You have $100,000 to invest. The fund does NOT charge any front or
back-end load fees; just plain 1.5% of assets and it beats the index.
At the end of the year the index
fund returns 7%, and since your fund has beaten the index by 1% it will return
8%. This is 8% before the asset
management fee, which is conveniently being deducted on your behalf in such a
way that you do not even realize that the NAV (net asset value) was reduced to
account for the deduction of that fee.
So, $100,000 * 1.08 = $108,000. Applying 1.5% of assets
will leave us with 108,000 � (108,000 * 1.5/100) =
$106,380. Not bad for a year worth of
work.
Now, let look at our index ETF that only returned 7%, but only charged you .25% as an expense ratio.
So, $100,000 * 1.07 = $107,000.
Applying .25% of assets will leave us with 107,000 � (107,000 *.25/100) = $106,732.50.
So, under performing by 1% will
still leave us $352.50 ahead of the actively managed mutual fund.
Now, the real magic of 4th grade Algebra (4th
grade is my favorite grade):
$352.50 / $6,380 * 100% = 5.5%
So, after taking into account asset fees, your index fund has beaten
your outperforming, actively managed fund (that just received 5 stars) by 5.5%!
At this point you must go back and read the above sentence again, and
again, and again to understand that 1% of assets is not the same as beating the
index by 1%.
The real moral of the story is:
where are you going to find an actively managed mutual fund that can beat the
index consistently over the period of 20 years in such a way that it is worth
the extra expense ratio (I am not even talking about load funds!)
Cheer up:
�This week our friend Al Franken
is launching an all liberal radio network called Air America. They say the
purpose of Air America is to balance out all the conservatives in the media
except of course for NPR, CNN, ABC, CBS, NBC, and the New York Times.� Jay Leno
�Kerry has had surgery to repair
his right shoulder. He hurt it when he switched his position on Iraq.� Kilborn
�If you�ve been watching the news
at all, I�m sure you know that Saddam Hussein has hired a French lawyer. I
believe his name is Jacque Cochran.� Jay Leno