First Five Trading Days

Image by Fisherman's Daughter

One of my favorite stock market indicators is the First Five Trading Days.  Historically, if the stock market goes up for the first five trading days, there is a 69% chance the stock market will be up for the entire year.  The more positive the first five days are, the more likely it will be a good year.  For 2012, the first five trading days were definitely positive.

• Dow +1.43%
• NASDAQ +2.65%
• S&P 500 +1.82%

Stock market indicators shouldn’t always be relied upon, because they seem to fail investors at the worst possible time.  Many feel the First Five indicator is hyped more by brokers than is justified by the returns.  But, a solid start to a new year is always welcome, especially after the lackluster performance from last year.

The Economy is Improving

I wouldn’t say the economy is great, especially for the working class, but it is definitely getting better.  The stubborn unemployment rate is slowly dropping and consumer optimism is starting to return.  Retail sales are up slightly, especially for automobiles.  There is a lot of pent up demand from consumers who have tightened their belts for the past couple of years.  Their cars, computers and appliances are starting to wear out and need replacement.

The bad news for the markets is that profits are shrinking as companies are forced to hire and inflation is taking a bite out of their bottom lines.  They had a field day during the recession with drastic layoffs and squeezing the remaining employees for maximum productivity.  But, the tide is starting to turn and opportunities are opening up for skilled employees.  Wages will start to rise.

It’s an Election Year

Election years have had a very positive correlation to the stock market.  Looking at the last 21 election years since 1928, all but three have been positive for the S&P 500.  Of course, one of those three election years was 2008 and we all know how badly that turned out.  The average S&P return during these past 21 election years is around 11.8%, which I would gladly take this year.

This election year is about a lot more than just a quick pop in the S&P 500.  It’s about the future direction of our country and our economy.  Do we continue to slide into debt while special interests loot our treasury?  Or, do we return to the economic powerhouse that has led the world for the past century?  Only time will tell.

The Bottom Line

The bottom line is that past performance isn’t a guarantee of future results.  We are still living in troubled times, considering the shaky state of our financial system and the massive federal deficit.  But, unless there is a major financial meltdown of some kind, 2012 should be a pretty good year.

“Cheers to a new year and another chance for us to get it right.”

Oprah Winfrey – American Talk Show Host

Recommended Reading

Squirrelers - Looking Forward to your Financial Success in 2012
Money Cone - 10 Stocks for 2012 and Beyond
Wall Street Journal - First Five Days of Trading Suggest More Upside

This post was featured on the Carnival of Personal Finance over at Diva in Debt.  If you aren’t familiar with the Carnival of Personal Finance, you need to check it out.  It’s where all the cool bloggers hang out.

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The Stock Market is Rigged

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The stock market is definitely rigged.  I have said it here before on this blog and I will say it again.  Between the super-fast trading networks, dark pools, rampant insider trading and the massive amount of leverage from derivatives, the markets are being manipulated and small investors are getting taken.  It doesn’t matter whether you have a 401K, mutual funds or a brokerage account, you don’t get a fair shot.

The big boys are getting away with murder and regulators can’t seem to reel them in.  Even worse, there is so much corruption and influence peddling between Wall Street and Washington, people are literally buying outcomes in the market.  Congress is along for the ride, trading on privileged information that isn’t available to the public.  They are creating laws and making policy decisions on the companies they own stock in.

Check out what’s happening in the financial news right now.

• Members of Congress are accused of insider trading, yet they seem to be immune to action from the SEC.  Meanwhile, others go to jail for this.
• MF Global collapsed in October with former U.S. Senator Jon Corzine at the helm.  Investors may have lost between $600 million and $1.2 billion.
• Citigroup’s proposed $285 million settlement with the SEC was rejected by a judge for being too lenient.  Investors lost over $700 million on the deal.
• J.P. Morgan was recently fined 33 million pounds for not properly separating an average of $8.6 billion of their client’s funds from their own.

Sources: Business Week, USA Today, Huffington Post

Housing is Still Overvalued

Real estate is traditionally a good hedge against inflation and a great place to generate income.  But, it’s still overvalued where I live and likely to drop some more.  I base my guesstimate on the fact that real wages have stagnated and it’s way cheaper to rent in many areas.  It’s virtually impossible to buy a property here and rent it out for even close to break-even.  I could buy somewhere with lower housing costs, but I don’t want the hassle and expense of being a long-distance landlord.  I would give my left eye to have a nice little triplex at the beach, but it’s an expensive proposition.

Other problems with real estate are that it is highly leveraged and illiquid.  It requires a big down-payment, a lot of debt and massive liability.  If the tenants stop paying or they trash the place, you are out a lot of money.  If someone gets hurt on your property, you are getting sued.  The laws in my state are very lenient on deadbeat tenants.  Besides, my goal is to work less and enjoy life more.  Investment properties are a lot of work.

Precious Metals are Sky High

I will be the first to admit that I completely missed the boat on gold, silver and other precious metals.  I have seen them do so poorly during my lifetime that I wrote them off as horrible investments.  I was very wrong, at least for the past couple of years.  Precious metals have outpaced most other investments, by a long-shot.  The truth is that precious metals have done so well mostly because currencies have done so poorly.  If you compare gold prices to the true U.S. rate of inflation (based on the 1990 CPI), it hasn’t really gained at all.

The past means little to an investor.  It’s the future that really matters.  What are the future prospects for precious metals?  Will the favorable trends continue for precious metals?  Or, will they crash and languish for decades, like they did in the ’80s?  Only time will tell.  I’m not so sure I want to bet a big portion of my future on shiny metals.  I would prefer an investment that actually provides a return based on income.  Precious metals are only a store of value.

Bonds & CDs have Low Yields

I have shied away from bonds because the interest rates are artificially low.  So, the yields on bonds are artificially low, especially considering the risk.  If the interest rates shoot up for any reason, it would greatly devalue most bonds.  People think it won’t happen, but it just happened in Italy and it could easily happen here.  That’s a lot of reasons not to like bonds.  Even the Bond King, Bill Gross from Pimco, is bearish on bonds right now.  They aren’t the safe haven for investors they once were.

Deposit investments, such as Money Markets and CDs, have horrible rates of returns.  So do U.S. Treasury bonds.  It’s almost as if they know investors have nowhere else to go and they are taking advantage.  For me, any investment that yields less than the true rate of inflation is a guaranteed money loser.  And, the risk is higher than people think.  Banks weren’t far from a massive collapse in 2008 and they aren’t that healthy now.  The U.S. government is in even worse shape and it deserved to be downgraded by S&P.

The Bottom Line

The bottom line is that there aren’t many attractive investment opportunities right now.  There is a minefield of risks and a dismal return.  If anyone knows of a sound investment please let me know, because I don’t see any.

“The investor of today does not profit from yesterday’s growth.”

Warren Buffett – Billionaire Investor

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The following is a guest post from Rob Bennett of A Rich Life.  Rob is a tireless critic of Buy and Hold investing.  Instead, he recommends Valuation Informed Index investing.  If you lost a bunch of money in the market, you should read this post.

I’m not a Buy-and-Holder. I believe that Yale Economics Professor Robert Shiller’s research has shown Buy-and-Hold to be a gravely flawed strategy and that Valuation-Informed Indexing (which teaches that investors must change their stock allocations in response to big valuation swings) is far more sensible and effective approach.

Shiller published his research showing that valuations affect long-term returns in 1981. The obvious question is — What took so long? Why is it that it is only in recent years that large numbers of investors have begun to wonder if Buy-and-Hold is dead?

I can offer six explanations.

1) The implications of Shiller’s research are so far reaching that even his supporters do not yet fully appreciate them.

Shiller showed that valuations affect long-term returns. To know what affects returns is to know what causes them.

What Shiller really showed is that overvaluation causes poor returns. His research is showing us for the first time in history how stock investing really works. Valuations are key.

Once we learn how stock investing really works, we become able to avoid the risks of stock investing. For those who understand Shiller’s research, stocks are a significantly less risky asset class than they are for all others.

This is of course wonderful news.  But it is not news that is easy to accept. Most advances in knowledge are
achieved in small steps. The Shiller Revolution represents a huge leap forward.  It is taking us some time to absorb how much we have learned.

2) In practical terms, Buy-and-Hold caused no problems for 15 years after Shiller published his research.

Buy-and-Hold never “worked” in an intellectual sense. It is rooted in a false premise (Buy-and-Hold assumes the efficient market theorized by University of Chicago Economics Professor Eugene
Fama).

Still, in a practical sense, Buy-and-Hold worked just fine from 1981, when Shiller published his
groundbreaking research, until 1996, when stocks prices first rose to insanely dangerous levels. Both Buy-and-and-Holders and Valuation-Informed Indexers go with high stock allocations at times when prices are reasonable. So Buy-and-Holders were adopting proper stock allocations for the wrong theoretical reasons for those 15 years. It was a case of “no harm, no foul.”

3) The extent of the problem with Buy-and-Hold did not become apparent until the 2008 crash.

Shiller predicted in Federal Reserve testimony delivered in 1996 that those going with high stock allocations at the prices that applied at the time would live to regret it within 10 years or so.
We know today that he was right. Those who went with far safer asset classes (TIPS, IBonds or CDs) are now ahead of those who invested in stocks at the time.

But Shiller’s prediction was not proven correct in the eyes of many until prices crashed in late 2008. Stocks started performing poorly in 2000. But the losses suffered  by stock investors were not big enough to impress those who believed in Buy-and-Hold until the crash hit.

4) An entire industry has been built up to promote Buy-and-Hold.

It’s wonderful news that we now know how to invest in a way far more effective than the way advocated by
Buy-and-Hold enthusiasts. Making the transition to Valuation-Informed Indexing is not a simple business, however.

There are now thousands of books promoting Buy-and-Hold. There are hundreds of calculators promoting
Buy-and-Hold. There are thousands of experts who made their reputations promoting Buy-and-Hold. In short, there are lots of powerful people and institutions with a strong financial interest in promoting the failed strategy rather than its replacement.

5) Most investors are emotionally invested in Buy-and-Hold.

What the research says will win the day in the long run. But we humans are not entirely rational creatures. We allow our emotions to influence what research we are willing to consider.

Millions of people have staked their retirements on Buy-and-Hold and told friends or co-workers or neighbors about it. These millions of people very, very much do not want to acknowledge the flaws in the Buy-and-Hold Model regardless of how exciting an approach Valuation-Informed Indexing might appear to be according to the research.

6) We have so far only seen a small portion of the damage that Buy-and-Hold will likely do to us.

This is the fourth time in U.S. history that Buy-and-Hold strategies have become popular. On the earlier three occasions, we ended up with stock prices at one-half of fair value. The inevitable return to fair value prices always causes an economic collapse and the economic collapse always causes prices to fall far below fair value.

That’s a price drop of 60 percent from where we stand today. After that price drop, we will likely be in living in the Second Great Depression and no one will be singing the praises of Buy-and-Hold anymore. Until we get there, it will remain possible for many to keep their hopes in Buy-and-Hold alive.

The question is not — Is Buy-and-Hold dead? Buy-and-Hold has been dead intellectually for three decades.  The question is — When are enough of us going to acknowledge what the research says and begin making the changes we need to get our economy and our retirement portfolios back on track?

Rob Bennett believes that IBonds are a greatly under-appreciated asset class. His bio is here.

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1. Earnings = Value

Image by Bitterjug

Warren Buffett says he likes to invest in companies that have a “moat” around them.  In other words, he likes to invest in companies that have an insurmountable competitive advantage.  The reason this is so important is because investors can count on the future earnings.  Companies with no competitive advantage may see their earnings disappear suddenly and the market value will disappear with it  Even worse are companies with no earnings.  There were a lot of companies like this during the dotcom era and most of them are long gone, along with the investor’s money.

Example: Google created the first search engine that returned relevant search results.  Anyone who has used an older search engine like Alta Vista understands how much better Google is.  Anyone who hasn’t takes their amazing technology for granted.  But, that’s not the reason Google’s stock soared while the other search engines went out of business.  Google figured out how to earn revenue from their search engine, without selling out their users.  Their Adsense and Adwords campaigns changed the game of paid search forever.  By using a fremium revenue model, with clearly identified free and paid search results, they make billions.  And, their huge earnings justify their huge market cap.

2. Customers = Revenue

I rarely invest in social networks or other online businesses.  The reason is that online businesses can be quickly replicated and displaced.  There are no factories, patents, products or infrastructure to protect earnings and retain customers.  Online customers are fickle and highly price conscious.  Dozens of competitors are only a click away.  Customers are the lifeblood of a business, because they generate the revenue.  Without their customers, all a company has left are expenses.  Some companies, such as banks and telecom providers are often abusive to customers.  This is dangerous for investors, because customers will defect as soon as new technologies or competitors are available.

Example: Blockbuster recently filed for bankruptcy after dominating the video rental business for more than a decade.  There are many reasons for their spectacular downfall, including the inability to adopt new technology, such as video streaming.  But, their rapid decline seems to have started with the immensely unpopular late fees.  Customers felt they were being taken advantage of by Blockbuster, who used the high late fees to pad their bottom line.  As soon as more consumer-friendly options appeared, such as Netflix and Red Box, customers abandoned Blockbuster in droves.

3. Trendy = Treacherous

Corporate conglomerates are about as boring as a box of rocks.  But, when you invest in one, you aren’t investing in pet rocks.  Flashy, hot and trendy companies are exciting to invest in.  But, they are also very risky for the bottom line.  They often disappear as quickly as they came.  Think about all of the hot companies from 10 years ago.  How many are still in business?  Of those, how many are still worth a fraction of what they once were?  Not many.  Using social networks as an example, think about AOL, Geocities, Friendster and MySpace.  Who will still be on Facebook and Twitter in the future?  Other types of companies to watch out for are retail, clothing and restaurants.  Customer tastes change quickly.

Example: General Electric (GE) was founded in 1890 by Tomas Edison.  It is the only company remaining from the original 12 Dow Jones Industrial companies.  Although it was originally founded as an electric company, most of its revenue now comes from its financial and media empires.  It is also involved in aviation, locomotives, appliances, oil & gas, nuclear power and renewable energy.  Profits for GE in 2010 were $14.2 billion on revenues of $150 billion.  They have $79 billion in cash and are ranked by Forbes as the second largest company in the world.

4. Premium = Profits

The absolute worst thing any company can possibly be is the lowest cost provider.  Margins are razor thin, which increases the risk of going out of business.  Customers have no loyalty and products have no particular appeal.  Investors should avoid low-margin companies and instead invest in companies with premium products or services.  These companies have a loyal base of customers and products that are unique or innovative.  Customers will happily pay a premium and the earnings and stock prices reflect this.

Example: Apple Inc. recently became the largest technology company by market capitalization in the world.  There is no big secret to their success.  Their products are slick, reliable, popular and often technologically superior to others.  Users are fiercely loyal and competitors are envious.  Their products are expensive and their gross margins are high.  But, the products continue to sell and their stock price continues to rise.

The Bottom Line

The bottom line is that stock market investing is risky enough without buying flash-in-the-pan companies.  By investing in companies with stable earnings, premium products and loyal customers, you will avoid losing your shirt on the next MySpace.

“Never invest in a business you cannot understand.”

Warren Buffett – Billionaire Value Investor

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Buy Like Buffet - Whatever Happened to MySpace?
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This post was featured on the Carnival of Personal Finance over at Prarie Eco Thrifter.  This is by far the classiest Carnival on the net.  Check it out.

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If it Sounds too Good to be True, it Probably Is

Many of the people on the forums complaining about this scam had paid many times what the Dinar were worth and they weren’t aware that Dinar are only redeemable in Iraq.  If the Iraqi Dinar is ever accepted back into the global monetary system, they will likely be re-issued, making the existing notes worthless.

The Smell Test

There have always been fraud and scams, as long as there have been people to swindle.  Since the age of the Internet and email, it has become possible to scam thousands of people all around the world, from anywhere on the planet.  It’s more important than ever to check the fundamentals of any opportunity, before you invest your money.

Taking investment advice from a friend or associate can be a costly mistake, since they may be just one step above you in a scam or a Ponzi scheme.  Or, they may not understand the fundamental risk and value of an investment, causing them to overestimate what its worth.  Before you act on someone’s advice, always verify the investment’s fundamentals for yourself.

Den of Thieves

Wall Street has become a rigged casino, with investment banks and hedge funds looking out for themselves, instead of their customers.  Often, they are betting against their own customers and profiting from the bad positions they have recommend to them.  Insider trading is rampant and the SEC only catches a fraction of the people and companies engaging in fraud.

Even your friendly neighborhood investment advisor has to earn a living by recommending fee-laden products.  And, sometimes they have been known to skip town with their client’s assets.  Investment advisors can be a valuable resource, but you must verify they have your best interests in mind.

The Bottom Line

The bottom line is investing has become a minefield of shaky investments and conflicts of interest.  Don’t wander in without first looking where you are about to step.  After all, the first rule of investing is to not lose money.

“Beware of false knowledge; it is more dangerous than ignorance.”

George Bernard Shaw – Irish Playwright

Recommended Reading

Mint Blog - New Investment Scam: Buying the Iraqi Dinar
Bucksome Boomer - Secrets to Avoiding Work at Home Job Scams
Stumble Forward - Seniors are being Taken Advantage to buy Life Insurance

This post was featured on the Carnival of Personal Finance over at Make Money Online.  If you aren’t familiar with the Carnival of Personal Finance, you need to check it out. It’s the greatest carnival on the net.

This post was also featured on:

Invest it Wisely – Midweek-Reading: Tis the Season
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Thank you for the links to my blog.

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Don’t Miss the Profits

Image by Kevin Hutchinson

Last year, I wrote a post called How to Profit from the January Effect.  It was an informative post, but I published it in January, after the January Effect had largely run its course.  This year, I wanted to give everyone a heads up, so they can position themselves to profit.  Since the Dow was up almost 400 points last week, it’s possible the January effect started early this year. 

The January Effect is caused by investors who sell at the end of the year for tax purposes and then buy again in January.  This causes a surge in the prices of small-cap stocks, which may lift the broader market.  It is also possible this surge is helped by year-end bonuses, some of which is invested in the market.  Like the Christmas shopping season, the January Effect seems to start earlier every year.   I believe it’s already well under way this year and it will continue for a couple more weeks. 

How you Can Profit

Since the January effect benefits small cap stocks more than blue chips, you may want to shift some of your investments.  If you are going to make a year-end IRA contribution or stash away some of that Christmas bonus, consider small cap stocks or mutual funds.  Between the January effect and the economic recovery, I believe small cap stocks will outperform the broader markets and that is where I’ve chosen to invest. 

If you have some cash on the sidelines, now is generally a great time to invest it.  In a good year, you can often make a better return in December in stocks than you would if you left your money sitting in bonds or a savings account for the entire year.  

Finishing the Year

Investing is a lot like sports.  You can stumble though the first three quarters and still win the game at the buzzer.  Finishing strong is a critical strategy for success in any competition, especially investing.  Just a few extra percentage points per year can double your total return over time. 

Last year’s Santa Clause Rally yielded a 7.5% gain for the Russell 2000 index, which is a pretty good year for most types of investments.  This year, the Russell 2000 index is already up 4.6%, since the beginning of December and it’s up 22% since a low in September.

The Bottom Line

The bottom line is that the January Effect has happened in 13 of the last 16 years.  That’s about as close as you can get to a sure thing in the stock market these days.  When it comes to easy money, I always take advantage. 

“The key to making money in stocks is not to get scared out of them.” 

Peter Lynch - Former Manager of Fidelity Magellan Fund 

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This is the fifth in a series of five posts on mutual funds.  

Why I Invest in Mutual Funds
How to Pick a Mutual Fund – Return
How to Pick a Mutual Fund – Type
How to Pick a Mutual Fund – Fees
How to Pick a Mutual Fund – Risk

Disclaimer: I’m not an investment professional nor am I licensed to sell securities.  This information is provided for entertainment purposes.  Before investing, you should seek the advice of an investment professional.  I’m not affiliated with nor do I receive compensation from mutual fund companies. 

Asset Diversification

Image by KYZ

One of the great benefits of a mutual fund is that you can have diversification, even with a fairly small investment.  For example, you can’t buy 500 individual stocks for $1,000, but you can buy shares in an index fund.  You can even choose Balanced funds that automatically maintain diversification for you. 

One mistake I have seen (and made myself) is to concentrate in one type of market or asset class at the expense of diversification.  This makes a portfolio much more volatile and prone to losses.  I now avoid sector and specialty funds and instead invest in a more diversified way. 

Market Volatility

A fund’s market volatility is measured by an indicator called its Beta.  The Beta shows how volatile a fund is compared to its benchmark index.  For example, a growth fund with a Beta of 1 would have the same volatility as the S&P 500.  If a fund’s Beta is higher than 1, it is more volatile.  If a fund’s Beta is lower than 1, it’s less volatile.  There are other volatility indicators, including Standard Deviation and R-Squared, but Beta is the easiest to use and understand.

The way the stock market has been acting lately, volatility is on everyone’s mind.  Nobody cares about volatility when the market is rising, but it gets everyone’s attention when it comes crashing down.  People who thought they had a high risk tolerance weren’t so comfortable when the market dropped by 40% in 2008.  Many retirees went back to work and aging workers put off retirement.  In my opinion, market volatility has increased recently because of leveraged derivatives and super-fast trading computers. 

Investors with a low risk tolerance and people who will need their money soon (i.e. retirement and college funds) should avoid funds with a high Beta. 

Strength & Stability

The strength and stability of a mutual fund company is important is because mutual funds aren’t insured by the FDIC, like a CD or a bank account.  Mutual funds are insured by the SIPC (Securities Investor Protection Corporation), which is not a government agency, but a private corporation.  The good news is that mutual fund companies rarely become insolvent and the SIPC protects accounts up to $500,000.  The bad news is that I have no idea if the SIPC has sufficient reserves or could refund your deposits promptly.  You are better off investing with a top-tier fund company that has assets and experience. 

I used to invest with a single fund company that had really great 10 year performance.  But, they didn’t have a transaction website or any of the online services.  I didn’t have a lot of money in this fund, so I wasn’t really worried about losing it.  But, accessing my account was like being stuck in the ’80s.  I had to call to invest, look in the paper to get my NAV and wait for a statement to find out how many shares I had.  After a couple of years, their performance started to wane and I moved my account to a larger company. 

I strongly recommend avoiding small mutual fund companies. 

Honesty & Integrity

Some of the funds I owned were involved in The Mutual Fund Scandal of 2003.  Invesco, Janus and a number of other fund companies allowed institutional customers to time the market.  This meant they traded more frequently than was allowed in the fund’s prospectus.  As a small investor, I don’t like the big guys getting an unfair advantage over me.  And, I won’t entrust my money to a company who engages in unethical behavior. 

So, I voted with my feet and transferred my investments to T. Rowe Price.  I’m sure these two multi-billion dollar fund companies weren’t concerned with losing my tens of thousands of dollars, but that’s not the point.  The point is that I expect honest dealings from my fund companies and I refuse to do business with those who bend the rules.  If more investors held this standard, I believe we would see a lot less of these indiscretions on Wall Street. 

The Bottom Line

The bottom line is you can’t control risk; you can only hope to avoid it.  The best way to do this is to steer clear of sensational promises and fast money schemes.  Invest with a company you can trust with your future. 

“Yes, risk taking is inherently failure-prone. Otherwise, it would be called sure-thing-taking.” 

Jim McMahon – Former Quarterback of the Chicago Bears 

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This is the fourth in a series of five posts on mutual funds.

Why I Invest in Mutual Funds
How to Pick a Mutual Fund – Return
How to Pick a Mutual Fund – Type
How to Pick a Mutual Fund – Fees
How to Pick a Mutual Fund – Risk 

Disclaimer: I’m not an investment professional nor am I licensed to sell securities.  This information is provided for entertainment purposes.  Before investing, you should seek the advice of an investment professional.  I’m not affiliated with nor do I receive compensation from mutual fund companies.

Management Fees

Image by Andrea Flannery

Management fees are charged by mutual fund companies to cover their operating expenses.  Fund companies have expensive trading and accounting operations, customer service departments and websites to maintain.  All of this is funded by the management fees collected from the fund holders. 

These fees are collected on a daily basis and the NAV (share price) of a fund is reduced after the fees are taken out.  Typical management fees can range from about .25-2.5% annually.  This is commonly known as the MER or Management Expense Ratio.

Fund companies that charge higher fees often try to justify them by claiming superior performance to other funds in their class.  But, statistics show clearly the funds with the lowest fees offer the highest returns, on average.  Excessive fees should be avoided at all costs.

Financial Advisers

The first and most important decision you should make is whether or not to use a financial adviser to choose a mutual fund.  Although an adviser can be a big help in choosing a fund and rolling over a 401K, this advice will cost you in the way of higher fees.  To be fair to financial advisers, they have to make a living for providing their advice.  And, they can be helpful to some people who have complex financial, tax or estate needs.

When it comes to mutual funds, I generally recommend you pick your own funds and keep the fees to a minimum.  If you aren’t confident in picking a fund, you can always select an Index fund that has low fees.  Or, you can pay a fee-based advisor to help you select a fund and then buy it yourself.

Share Classes

Some funds have different share classes, depending on whether you choose it yourself or it is selected for you by a financial adviser.  Adviser Class funds charge a higher MER in order to pay a sales commission to the adviser.  Adviser Class funds may even have two or three different levels of fees (B & C shares), depending on the option the financial advisor chooses.  Investor Class funds have a lower MER because they don’t have to pay any commissions.  The difference between A, B & C shares can be as high as 3% per year.

Sales Loads

When I first started investing in mutual funds, it was common for funds to have a sales load.  In fact, some of these loads were pretty high.  My first mutual fund had an 8.5% front-end load, because I purchased it through a financial adviser.  Consumers became weary of loads and began demanding no-load funds.  So, the fund industry created Adviser Class funds in order to pay sales commissions and still claim their funds were no-load.  In my opinion, the Adviser Class (aka back-end loads) can be worse than a front-end load, if you keep this fund for a long time.  Instead of paying a one-time fee, you pay every year.  Since loads do nothing, except reduce your return, they should be avoided at all costs.

Redemption Fees

Redemption fees are common in Adviser Class funds to ensure you keep them long enough to recapture the commission.  For Example, B shares may have a 1% higher MER and a 5% redemption fee, that goes down by 1% each year.  If you stay in for one year or five, they collect 5% for the commission.  The C shares may have a 2% higher MER and a 3 year redemption fee.  The C shares are the worst, performers over the long run.

I avoid any funds (or share classes) with a redemption fee.  I think it’s a bad idea for couple of reasons.  First, if you need your money for an emergency, you lose part of your investment at the worst time.  Second, if the fund has bad management or it performs poorly, you have to pay to get out.  Either way, it’s not in your best interest to get locked into an investment.

Marketing Fees

Some funds charge a marketing fee, also known as a 12b-1 fee.  The 12b-1 is based on a rule in the Investment Company Act of 1940.  These fees range from .25% to 1%, which is the maximum allowed by law.  Studies have shown roughly 40% of these fees go towards sales incentives.  Recently, the SEC has become critical of the 12b-1 fee and has even proposed replacing it.  Their contention is that customers are unfamiliar with these fees and are often unaware they are paying them.

For me, a 12b-1 fee is a huge red flag.  I generally avoid funds that have this fee, because I don’t want to pay for advertising or sales incentives (kickbacks).  My experience is the best performing funds have money pouring in faster than they can invest it.  They often have to close to new investors, just so they can continue their investment strategy.  Only funds that perform poorly have to advertise heavily and pay incentives to find customers.

Fund Types

Different fund types generally have different expense ratios.  For example, it takes a lot more time and research to run a Small Cap Emerging Growth fund than an Index or a Money Market fund.  So, you have to take the fund type into consideration when you are comparing fees.

The table below shows the highest fee I recommend by fund type.

The Bottom Line

The bottom line is that fees are a part of mutual fund life.  But, that’s no reason to give away most of your precious returns.  By avoiding commission-based advisers, marketing fees and loaded funds, you can keep most of your returns safely in your account.  That is right where they belong.

“Experience is a good school, but the fees are high.”

Heinrich Heine – German Poet

Recommended Reading

Stumble Forward – Mutual Fund Basics: The Guide to Getting Started
Five Cent Nickel – Avoiding and Reducing Mutual Fund Fees and Expenses
The Biz of Life – Expense Ratios a Better Predictor of Future Performance

Related Posts

• How to Pick a Mutual Fund – Return
• Why I Invest in Mutual Funds
• How to Pick a Mutual Fund – Risk
• The Wisdom of Sir John Templeton
• How to Pick a Mutual Fund – Type

This is the third in a series of five posts on mutual funds.

Why I Invest in Mutual Funds
How to Pick a Mutual Fund – Return
How to Pick a Mutual Fund – Type
How to Pick a Mutual Fund – Fees
How to Pick a Mutual Fund – Risk 

Disclaimer: I’m not an investment professional nor am I licensed to sell securities.  This information is provided for entertainment purposes.  Before investing, you should seek the advice of an investment professional.  I’m not affiliated with nor do I receive compensation from mutual fund companies. 

Asset Classes

Image by BombMan

Stocks - Stocks are considered an equity investment, because they represent partial ownership in a company.  They are volatile and can gain and lose value rapidly.  They are most suitable for investors looking for growth who can tolerate risk, such as younger investors.  They are not suitable for investors looking to preserve capital, such as retirees and near retirees. 

Because of the twin crashes of 2001 and 2008, this has been a lost decade for stocks.  However, stocks are historically the best performing asset class, over a long period of time.  Stocks are valued based on earnings, so if the companies’ earnings grow, their stock values will increase.  Also, many stocks pay dividends, which increase the return and provide income. 

Bonds - Bonds are considered income investments, because they pay interest to the bond holder.  They have more stable prices than stocks, which makes them suitable for people living on investment income.   They are better protected from bankruptcy than stocks.  And some bonds, such as municipal bonds, have tax advantages. 

One thing you have to worry about with bonds is rising interest rates and inflation.  If you own a bond paying 4% interest and inflation jumps or new bonds are issued at a higher rate, the value of your bond will drop.  Bonds can also appreciate if interest rates drop.  But, interest rates are close to zero right now, so that is unlikely to happen.  I’m not experienced in bond investing, so I will defer to others who are more knowledgeable. 

Real Estate - Real Estate funds (and their counterpart REITs) invest in properties, which are considered a real asset.  Real assets are considered an inflation hedge, because the value of the asset usually appreciates as prices go up.  Real estate also has an advantage in that it can generate cash flow from rents and the sale of properties. 

Despite the real estate crash, RE funds and REITs remain popular for investors because of the dividends.  I’m definitely no expert, but I am leery of real estate right now.  Even through residential real estate has fallen dramatically; I think we are far from the bottom.  The reason I say this is because real wages have been flat for years and the value of housing is based on qualified buyers.  Now that no-doc loans are gone, so are many of the qualified buyers.  Commercial real estate is a potential disaster.  I could envision a large contraction in retail and office space, even after the economy recovers.  Consumers and companies are wising up to this costly way of doing business in huge buildings.

Precious Metals - Precious metals are also considered a real asset and an inflation hedge.  Some metals, such as gold and platinum, have far outpaced most other investments over the last decade.  This investment is suitable for anyone looking to preserve capital and is recommended by most financial experts for a portion of your portfolio. 

I remember back in 1980, when my parents cashed in their silver at the height of the market for $20 per ounce.  Thirty years later, silver is trading around $15.  The point I wanted to make is that precious metals are simply a store of value.  Their intrinsic values can change based on demand and scarcity.  But, they don’t benefit from earnings and cash flow from rent or operations.  That’s why I don’t believe the breath-taking performance of gold will continue, unless inflation rises or the dollar drops significantly.  Once again, I’m no expert in precious metals.  I was completely wrong about gold exceeding $1,000 per ounce.  So, I’m probably not the person to ask. 

Money Markets - Money markets are considered a financial (paper) asset.  They are similar to other interest based investments, such as savings accounts and CDs.  They are suitable for risk averse investors, who are looking to preserve capital and can accept a low rate of return. 

Back in the ’80s, when they were returning 10%, money market funds were very popular.  I had one and my money seemed to be growing rapidly.  In reality, inflation was eroding my fund assets just as fast.  Now that interest rates are close to zero, money market funds aren’t so popular.  Why pay a management fee for an investment that pays very little interest?  It doesn’t make any sense.  No-fee money market funds are starting to appear. 

Investment Objective

The investment objective has a lot to do with your goals and demographics.  If you are young and looking to accumulate assets, you are probably suited for Growth investing.  If you are approaching retirement, you would probably want to take a Balanced approach.  If you are retired and need the cash flow from your investments, you are probably suited for Income investing.

Some of America’s most successful investors, such as Benjamin Graham and Warren Buffet, have focused on Value investing.  This is a proven strategy of finding stocks that are undervalued and waiting for them to appreciate.  Value investing takes a lot of time and patience.  There can be long periods when the market is over-valued and there aren’t many bargains to be found.  But, for disciplined investors, a value strategy can be very lucrative.

Active vs. Passive

One of the biggest arguments among fund investors (and finance bloggers) is whether you should choose active or passive management.  Active management means a fund manager chooses the stocks for a fund and they usually charge higher fees for this service.  Passive management means the fund manager buys a fixed set of stocks (usually tracking an Index like the S&P 500) and stays with them.  There are many credible arguments for passive index investing, including lower fees and turnover.  I recommend Index funds for people who aren’t confident picking a mutual fund.

Why I don’t invest in Index Funds.

I’m going to voice an opinion right here that may not be popular.  But, I have a duty to my readers, so I’m going to tell it like it is.  I’m not a big fan of passive index investing.  First, it’s been way too easy for me to pick actively managed funds that beat the indexes, including the increased fees.  Second, there are many laggard and dinosaur stocks in the indexes, which I would prefer to not own.  Third, I suspect the flood of new index investors caused a bubble in these stocks, which wasn’t supported by their earnings.  That’s why indexes such as the S&P 500 have been hammered lately.  It’s the same thing that happened to NASDAQ stocks after the dotcom bust.  I first witnessed this phenomenon when I owned shares of the Janus Twenty fund.  Money pouring into this popular fund shot the twenty stocks into the stratosphere.  Then, they came crashing back to earth.

Stock value is ultimately based on earnings.  Anything else is speculation. 

Market Capitalization

The size of a company, based on its outstanding stock value is called market capitalization.  This is calculated by taking the number of outstanding shares times the current share price.

The reason market cap is important for investors to understand is because these stocks generally behave in different ways.  Small Cap stocks have the best average growth rates.  But, they are also the most volatile and risky.  Large Cap stocks offer greater stability, but, their growth is slower.  Mid Cap stocks have become popular, because they offer some growth and stability.

Another important thing to know about is the popularity shift.  During boom times in the market, Small Cap stocks are hot, because they are growing quickly.  During market downturns, there is a “flight to quality”, which means people start moving their money into the more stable Large Caps.

Domestic vs. International

I recommend holding at least 25% of your portfolio in foreign funds.  This helps to protect against regional stock market panics and currency fluctuations.  The real question is, how much risk should you take with your international holdings?  Should you invest in large multinational companies for the stability?  Or, should you invest in emerging countries for the growth prospects?  That depends on your risk tolerance and investment objectives.

Sector Funds

These funds invest in specialized areas of the economy, such as medical, technology, finance and manufacturing.  They are offered to investors as a way to choose industries that may outpace the general economy.  Mutual fund companies like to show off their latest hot sector fund as an example of their earnings prowess.  But, if you check the returns on all of their sector funds, often two thirds of them are under-performing the market.

Being a long-term investor, I avoid sector funds.  The hot sectors change so fast that I don’t like keeping up with them.  And, the institutional investors are likely to beat you to the punch.  I learned my lesson with home builder and uranium mining stocks.  The whole point of owning a mutual fund is to have a well-diversified portfolio of stocks.  Sector funds are a risky gamble.

Asset Allocation

Most financial experts recommend a mix of stocks, bonds and precious metals in your portfolio.  This can protect you if one asset class crashes.  Also, different allocations are recommended for different investors.  As someone nears retirement, they should increase the percentage of bonds and precious metals and decrease the percentage of stocks.  This protects your portfolio from market crashes and inflation.  It also adds stability.

There are Asset Allocation funds that do this for you automatically.  All you have to do is to choose the fund with the right time horizon and the fund manager does the rest.  For example, if you plan to retire in 2032, you can pick a fund that allocates your investments based on that maturity date.

The Bottom Line

The bottom line is that there are thousands of combinations of fund types and most won’t be suitable for your investment objectives.  So, pick the types of funds that support your investment goals and ignore the rest.

“Wide diversification is only required when investors do not understand what they are doing.”

Warren Buffet – American Billionaire Investor

Recommended Reading

Invest it Wisely – How to Invest in Vanguard Funds Using ETFs
Len Penzo – REITs: A TIERed Investment for Dyslexics
Balance Junkie – Are Money Market Funds a Good Place to Park your Cash?

Related Posts

• How to Pick a Mutual Fund – Return
• The Wisdom of Sir John Templeton
• How to Pick a Mutual Fund – Fees
• Why I Invest in Mutual Funds
• My Visit with a Financial Advisor