Category Archives: Uncategorized

How Much Do You Need to Save for Retirement?

In the financial advisory business, one of the most pressing and controversial topics is how much money people need to save during their working years in order to provide for long-term retirement income.  The research on this topic has evolved quite a lot in recent years, and a recent issue of Money magazine features a series of articles representing the current view on this critical topic.  These articles, based around interviews with a number of the current thought leaders on this topic, deserve to be widely read and discussed.

The series of articles in Money kicks off with perspectives by Wade Pfau.  Pfau’s introductory piece suggests a difficult future for American workers.  A traditional rule-of-thumb in retirement planning is called the 4% rule.  This rule states that a retiree can plan to draw annual income equal to 4% of the value of her portfolio in the first year of retirement and increase this amount each year to keep up with inflation.  Someone who retires with a $1 Million portfolio could draw $40,000 in income in the first year of retirement and then increase that by 2.5%-3% per year, and have a high level of confidence that the portfolio will last thirty years.  It is assumed that the portfolio is invested in 60%-70% stocks and 30%-40% bonds.  The 4% rule was originally derived based on the long-term historical returns and risks for stocks and bonds.  The problem that Pfau has noted, however, is that both stocks and bonds are fairly expensive today relative to their values over the period of time used to calculate the 4% rule.  For bonds, this means that yields are well below their historical averages and historical yields are a good predictor of the future return from bonds.  The expected return from stocks is partly determined by the average price-to-earnings (P/E) ratio, and the P/E for stocks is currently well-above the long-term historical average.  High P/E tends to predict lower future returns for stocks, and vice versa.  For a detailed discussion of these relationships, see this paper.  In light of current prices of stocks and bonds, Pfau concludes that the 4% rule is far too optimistic and proposes that investors plan for something closer to a 3% draw rate from their portfolios in retirement.  I also explored this topic in an article last year.

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Estimating the Real Costs of Investing

One of the least-understood aspects of investing among individual investors is the total costs associated with building and maintaining a portfolio.  In comparison to the huge rises and falls that we see in the market, the expenses associated with mutual funds or brokerage costs may sound small.  Over long periods of time, however, the ups and downs of the market tend to average out.  The effect of those costs  however is persistent and continuous. 

There are a range of costs associated with investing in funds beyond the stated expense ratio.  In a new article in the Financial Analysts Journal, John Bogle presents a new summary of the average all-in costs associated with investing in stock index funds and in actively-managed stock funds.  Mr. Bogle is a long-term and tireless advocate of the idea that actively-managed mutual funds are a mistake for investors, so the content of the article is not surprising.  He has written similar pieces in the past.  In this article, he provides updated numbers, backed up by a range of academic analysis.  His summary of costs is provided in Table 1 of his article:

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There are three types of expenses, in addition to the standard expense ratio.  First are transaction costs, which are simply a fund’s trading costs.  This cost includes brokerage fees incurred by the fund, the impact of the bid-ask spread, and related expenses.  Mr. Bogle estimates this cost at 0.5% per year for active funds and at 0% for index funds.  He justifies the zero cost for index funds on the basis of the fact that the long-term returns of index funds are essentially identical to the performance of the index net of the index funds’ expense ratio.  The second source of additional cost for active funds is cash drag.  Many actively managed funds are not fully invested all of the time and carry a portion of their assets in cash.  To the extent that this cash does not accrue returns comparable to the equity index, this is a drag on performance.  Mr. Bogle estimates this lost return due to cash holdings at 0.15% per year.  The final additional cost that Mr. Bogle includes is sales charges / fees.  This cost is supposed to capture sales loads and any incremental costs associated with an investment advisor such as advisory fees.  Mr. Bogle freely acknowledges that this cost estimate is exceedingly open for debate. 

When he adds all of these costs together, Mr. Bogle estimates that the average actively-managed fund costs investors 2.27% per year as compared to the market index, while the index fund costs only 0.06% per year. 

The Investment Company Institute (ICI) estimates that the asset-weighted average expense ratio of actively-managed mutual funds is 0.92% per year, for reference.  The ICI also reports that the most expensive funds can have much higher expense ratios.  They find that the most expensive 10% of equity funds have an average expense ratio of 2.2%. 

Mr. Bogle, in his examples, assumes that stocks will return an average of 7% per year.  This number is highly uncertain.  The trailing 10-year annualized return of the S&P500 is 6.8% per year, but the trailing 15-year annualized return for the S&P500 is 4.2%.  A 2.2% total expense is more than 30% of the total return from investing in the stock market if the market returns 7%.  Because of compounding, the long-term impact of these costs increases over time. 

The average costs from Mr. Bogle’s article are not unreasonable.  There are probably many investors paying this much or more.  On the other hand, there are plenty of investors in active funds paying considerably less. 

Where does all of this leave investors?  First and foremost, it should be clear that costs matter a great deal.  There will always be expenses associated with investing, but they vary widely.  Over a lifetime, managing the expenses of investing can have a dramatic impact on your ability to build substantial savings.  Whether or not you believe that actively-managed funds are worth their cost, every investor should know their own asset-weighted expense ratio. 

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Handcuff Volunteers and the Rally of 2013

The S&P500 is up by 26% for the year-to-date, despite the fact that employment growth is anemic, the labor participation rate is at its lowest point in thirty five years, and inflation-adjusted GDP growth is experiencing a long-term slowing (see chart below).  GDP turns negative in recessions—this is the definition of a recession—but has historically recovered much faster than we have seen in the post 2008 years. Continue reading

Implications of Robust Corporate Profits and Stagnant Wages

One of the most important economic trends to emerge in recent years is that gains in corporate profitability are not translating to wage increases or more hiring.  The New York Times just published an article on this disconnect, but it’s nothing new.  The basic story is simple.  Even as corporate profits have increased at a healthy clip, there has not been a similar gain for workers in terms of new hiring or increased compensation for current employees.   Continue reading

Folio Investing Celebrates Its Target Date Folios’ Five-Year Record of Outperformance

Folio Investing’s Successful ETF-Based Alternative to Legacy Target-Date Funds Offers Superior Diversification, Risk Targeting and Flexibility; Firm Seeks Distribution Partner to Broaden Availability

Folio Investing announced today that, over the five years since they were brought to market in December 2007, its Target Date Folios have significantly outperformed traditional target-date funds. The Folios have provided both higher returns and lower volatility than the competing funds during this tumultuous period. Continue reading

Sector Watch: Municipal Bonds

Municipal bonds are issued by states and municipalities and typically have tax advantages relative to other fixed income assets.  In general, income from muni bonds is tax exempt at the federal level and at the state level for investors living in the issuing state.  Municipal bonds have historically been favored by investors in high tax brackets who, of course, derive more benefit from the tax exemptions by virtue of being in the highest tax brackets. Continue reading

Tax Loss Harvesting: Five Tips to Keep More of What’s Yours

Here at the Portfolioist, we frequently turn to Steve Thorpe, founder of Pragmatic Portfolios, LLC to share his insights on the topic of Tax Loss Harvesting. Here are 5 of his Tax Loss Harvesting Tips to help keep more of your money when tax time rolls around.

It’s impossible to reliably predict future changes within the investment markets, however there are numerous ways for investors to favorably influence their own results. Important areas to focus on include developing an investment plan, saving regularly, diversifying widely, adhering to an appropriate asset allocation, and paying attention to all forms of costs – including taxes. For many investors, tax loss harvesting can improve their after-tax bottom line, sometimes to the tune of thousands of dollars per year. Continue reading

Financial Products are Sold, Not Bought

Guest post by Contributing Editor, Robert P. Seawright, Chief Investment and Information Officer for Madison Avenue Securities.

Critics of the financial services industry (often with good reason) frequently remind consumers that financial products are typically “sold” rather than “bought” and implore them not to fall into that trap.  The concept here is that financial products are “sold” — pushed upon a consuming public that doesn’t understand them or perhaps even want or need them.  Instead, the alleged basis for their continued vibrancy and ongoing sales is that advisors get paid big bucks to sell them. Continue reading

The Power of Effective Diversification: Part II

Last week, I posted an article discussing how diversification is one of the most misunderstood concepts in investing. In today’s post I continue with the second half of this two-part series titled, “The Power of Effective Diversification.”

In Part I of this article, I discussed the difference between naive diversification (holding lots of stuff in a portfolio) and real diversification (combining assets in a portfolio to create risk offsets).  I also showed how a well-diversified portfolio can maintain the ability to participate in market rallies while still mitigating risk.  In Part II, we will explore what an effectively diversified portfolio looks like today. Continue reading

Tax Loss Harvesting: Share Your Pain with Uncle Sam

Summer is winding down. And believe it or not, 2012 is more than half way over, which means it’s a good time for investors to start thinking about the year-end tax implications of their portfolios.

We invited Steve Thorpe, Founder of Pragmatic Portfolios, LLC to share some insights on Tax Loss Harvesting. Enjoy.

Tax Loss Harvesting: Why Should You Care?

Would you invest a few hours to reduce this year’s taxes by $1,000 or more?

For investors with taxable investment accounts, this is often possible by taking advantage of tax loss harvesting (TLH). This perfectly legal strategy makes lemonade from lemons, allowing Uncle Sam to share part of the pain of the losses inevitably experienced by investors at some points during their investing career.

Between now and Continue reading