Should you buy or rent your house?

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A few years back, I wrote a blog comparing the financials of renting versus buying your house. Back then renting came out ahead when you just looked at the dollars, which was a bit surprising. It seemed to buck conventional wisdom that buying is also the best option.

This seems especially important in light of some of the tax changes that impact your mortgage and property tax deductibility.

For this post, I want to look at the choice from a purely financial perspective.  And what better way to do that than break it down Dr Jack style?  Just to put a little meat on the analytical bone, let’s assume we have a home that we could buy for $400,000 or we could rent for $2000 (I did a quick search on Zillow in a few different markets and this seemed reasonable).

UP-FRONT COSTS:  When you rent, you have to give a deposit which is typically something like one month of rent, so that’s $2000.  Not a big deal in the grand scheme of things.  When you buy, your down payment is in the range of 20% (or maybe even higher since the 2008 financial crisis—the Fox family had to put 25% down on our house).  That would mean $80,000 if you’re buying.

At first glance that may not seem like a big deal because it’s still your money, it just happens to be “invested” (did you notice how I used quotes there?) in your home.  However, when your $80,000 is tied up in your house you can’t invest it (no quotes there) in the stock market.  Since the stock market historically returns about 6% that means you’re passing up $4800 per year on average.  Over an investing career that ends up being a TON of money.

Advantage: Bid advantage to RENTING

RISING INTEREST RATES: We’ve been living the last decade with historically low interest rates. A 30-year fixed loan was in the 3.5% range, and all was well. Since then interest rates have steadily crept up.

The math on interest rate increases is pretty powerful. A 1% increase would increase your monthly mortgage payment about $3200 per year or about $280 per month.

A couple months ago, interest rates rose to about 5%, but since then it has settled down to about 4%. Either way, interest rates are going up, and it seems that will probably be the long-term trend.

Advantage: RENTING

MONTHLY PAYMENT:  The most common knock I hear on renting is “every month you pay rent, you’re throwing that money away.”  I hate that comment, and part of this post is to show how little sense that makes.  Obviously when you are renting, your monthly payment is your rent, $2000 in this example.

When you buy, your monthly payment is your mortgage (here we aren’t going to include insurance and taxes, that will come later).  If you have a typical 30-year mortgage, let’s say at 4.5% interest, your payment is going to be about $1620 per month.  That’s quite a bit less than you’re paying in rent, so obviously that’s an advantage for buying, but then there’s another little bit of good news.  That $1620 you’re paying is mostly interest, but a small amount is going towards paying down your loan.  In a way that can be seen as you “saving” money.  In this example the amount going towards you’re loan would be about $200 per month.  So that’s pretty nice. Of course that “forced savings” has a low return compared to the stock market, so it’s not as good as it could be.

Of course, that means that about $1400 per month is going to interest.  So when people say that you’re throwing away your rent, can’t you say the same thing for the interest on your mortgage?  Either way, this is definitely an advantage to buying.

Advantage: BUYING

OTHER COSTS:  With renting, once you pay that rent check, you’re pretty much done.  With buying you have a lot of other expenses that nickel-and-dime you to death.  Property taxes have to be paid (let’s say 1% of the property value so that’s $333 per month).  If you live in a condo complex or an association you might have monthly dues that could range from pretty minor to a significant chunk of money (when the Foxes lived in a condo in downtown Chicago, our monthly association fees were $900 per month—ouch!!!).  Those can definitely add up, so that’s a nice advantage to renting.

Advantage: RENTING

TAX ADVANTAGES: This is where a huge change has happened recently. Before, all your mortgage interest and property taxes were tax deductible. Now there is a $10,000 limit on those deductions. In a lot of scenarios, your property taxes won’t be tax deductible. Because of the higher standard deduction, a lot of times it won’t make sense to deduct your mortgage interest either.

Before, the deduction for your mortgage interest and property taxes might be worth about $600 per month.  Now that is certainly less, maybe all the way down to nothing.

Advantage: WASH

INFLATION:  Once you buy your house your biggest cost, your mortgage, is going to stay put.  We’ve talked about inflation before, and the enormous impact that even a little inflation can have on expenses after many years, so this seems pretty awesome that you don’t need to worry about it for your biggest expense.

With rent “that’s where they get you”.  Rents almost always go up.  Often there are laws that put a cap on how much they can go up, 2% seems a number I’ve heard before, so that provides some relief, but even that 2% can be a big deal.  If today your rent is $2000, in 10 years it would be $2440, in 20 years it would be $2970, and in 50 years it would be $5390.  That sucks, especially when compared to buying where your mortgage payment will always stay the same.

Advantage: Big advantage to BUYING

SELF-DETERMINATION:  A neighbor was renting a few houses down from us.  The family loved the house, loved the neighborhood, loved the neighbors (of course they did).  But one day the landlord called her and said she wasn’t renewing the lease because she (the landlord) was moving into the house.  That family that was renting was FORCED to move even though they didn’t want to.  That sucks.

When you rent, you’re definitely at the whim of your landlord.  If you buy, you are in control of your own destiny, baby.  Get drunk off that power.

Advantage: BUYING

UPKEEP:  One of the super-nice things about renting is that you don’t need to worry about when things break down.  If there is a problem with the toilet, call the landlord.  Water damage from the really bad storm, call the landlord.  Fridge on the fritz, whatever—call the landlord.   In general this is an awesome advantage.  This is even better if you’re not a very handy person.

If you own a home, whenever anything goes wrong you need to fix it yourself (hence my “handy” comment) or worse you have to pay someone to fix it for you.  There’s no perfect estimate, but a generally accepted rule is you should plan on spending 1% of the home’s value on maintenance.  In our example that would be about $4000 per year.

Advantage:  RENTING

NICENESS:  As an owner, if you want to make your place nicer you absolutely can.  If you want a pool, build it; hardwood floors, install them; custom closets, wallpaper, nice landscaping, and on and on.  As a renter there’s a reluctance to do it because in some sense you’re paying to make someone else’s property nicer.  If you rent there for years and years, maybe that’s not a huge deal, but that “self-determination” issue rears its ugly head.

I don’t have statistics on this, but I bet that most renters would love to make their place nicer, but just don’t because there is some deep attitude that you don’t do that when you rent.  I totally get it and understand it, but it sucks that this keeps you from making your place as nice as it would otherwise be.

Advantage: BUYING

WORST-CASE SCENARIO:  I’m not talking about your hot-water heater going bad or having to replace the roof (those we captured in “Upkeep”).  Here I’m talking about real worst case scenarios like a natural disaster (in California earthquakes aren’t covered by most homeowners insurance policies; you can get earthquake insurance which is really expensive, so most don’t get it), or the neighborhood really turns bad, or termites or black mold infestations happen inside the walls.  Let your imagination run with this for a second and you can really think of some nasty stuff.

As a renter, you can pick up and leave the nightmare behind.  Just go somewhere else and start paying someone else rent, and problem solved.  Not so if you own the home.  Your single largest investment is at risk.  Sucks to be you.

By its nature, the worst-case scenario isn’t very likely, but still it could happen.  This is one of the things that keeps me up at night as a homeowner.

Advantage: RENTING

ASSET ALLOCATION:  A mortgage is a “forced savings” program in a way.  Every month you’re making a mortgage payment and part of that goes towards your equity that you can use as you get older (reverse mortgages, cash-out refinances) or pass on to your heirs.  After 30 years your house will probably be paid off and you’ll have a tidy little sum of cash to supplement your portfolio.  Also, because home values tend to be much steadier than stocks, in a way this investment might seem like a bond.

We saw how crazy important asset allocation is, so if you have a lot of home equity, that might make you feel more comfortable to put a bigger portion of your portfolio into stocks which historically have a higher return.  This is a bit of a tricky one, but there’s definitely some level of advantage there.

Advantage: WASH

REALTOR COSTS:  There will come a time when you are ready to leave your current home and move somewhere else.  If you’re renting this is easy (but not super-easy).  Usually, you’ll wait for your lease to expire and then head on down the road.  If you need to move right away and your lease isn’t up for a while, that can create a bit of a challenge of breaking you’re lease.  That could be as easy as paying a penalty of a month’s rent, or your landlord could play hardball and hold you to your lease until the end.  So this can be a pain, but more in the “moderate” zone.

When you own a home and have to sell it, that is a monumental undertaking.  Getting a home ready for sale, listing it, showing it, and ultimately closing the sale can take months from beginning to end.  Also, it’s not cheap.  While realtor fees vary, they average about 6% of the home’s value.  In our little example that would be $24,000.  That is a lot of money.  If you’ve been in the house for 30 years, that will amortize to less than $1000 per year, but if you’ve only been living there a few years that could be thousands of dollars per year that you need to tack on the to “Buy” expense column.

Advantage: Big advantage to RENTING

PRICE APPRECIATION:  We saved the best for last, kind of.  When you own your home, you get to take advantage of any price increases that your home experiences.  Of course, if your home goes down in value, you suffer those loses too.  However, like stocks, homes have historically increased in value over time, with notable exceptions like when home values crashed in 2008.

That’s great news, right?  No question.  However, it’s not as good as most people think.  You hear all sorts of crazy stories about people making a killing off their house, but those tend to be anecdotes rather than the rule.  The numbers are hard to come by but I think the most definitive and well-respected data, the Case-Shiller index (developed by my BFF Robert Schiller) shows that prices for existing homes have only increased 0.5% over the past 40 years after you account for inflation.

THAT’S CRAZY.  That goes against everything we hear.  How can that be?  Well his index controls for things like home sizes getting bigger, houses getting nicer features, etc.  So it really tries to do an apple-to-apples comparison of what you can expect will happen to your home.  So home prices do tend upward, but just not at anywhere near the pace that we’ve come to believe.

Advantage: BUYING

Buy Rent
Investment return on down payment $400
Interest/rent $1,333 $2,000
Property taxes $333
Tax advantage $0
Maintenance $333
Realtor fees (5 years) $400
TOTAL $2,800 $2,000

If you put it all together Buying “loses” with a score of 5-6-2.  Furthermore the math shows that Renting comes out ahead on a monthly expense basis, and it has become an even bigger advantage with the new tax laws.  Yet, Buying wins on a lot of those intangibles. Ahhhh, this is why the decision is so complex.  Hopefully you saw my point that buying isn’t the unambiguously better option.

If you look at the numbers, it really breaks down to two major factors—realtor costs and price appreciation.  The longer you’re in your home, the more years you can spread that 6% realty fee over.  So if you’re planning on moving after a few years, that becomes a major disadvantage to buying.  Your home appreciating in the icing on the cake that can really make the whole difference.  However, the Case-Schiller index showed that prices don’t rise nearly as fast as everyone seems to think (hence, I didn’t even include it in the expense comparison).

It’s a tough call, but the dollars are real. Renting costs about $800 less than Buying in our example; that 40%!!!

The Fox family owns our home, and it has turned out to be the best investment we’ve ever made.  We bought in 2010 when the housing market in Southern California had been thoroughly thrashed by the 2008 crisis.  In the past 5 years our home has rebounded, more than doubling in value.  We would have missed all that had we rented, but if I’m honest with myself, it was just really lucky timing.  Sometimes it’s better to be lucky that good.

Do you rent or do you own?  What do you think?

Should you invest in gold?

Long before there were ever stocks or bonds, the original investment was gold.  Heck, even before there was paper currency or even coins, gold was the original “money”. 

That begs the question, What role should gold have in your portfolio?  If you don’t want to read to the end, my quick answer is “None”.  However, if you want to have a bit of a better answer, let’s dig in.

Gold as an investment

Just like stocks and bonds, gold is an investment.  The idea is to buy it and have it increase in value.  Makes sense.  And historically, it seems to have been a good one—back in 1950 an ounce of gold was worth about $375 and today it’s worth about $1300.  Not bad (or is it???).

However, there is a major difference between gold (and broadly commodities) as an investment compared to stocks and bonds.  Gold is a store of value.  If you buy gold it doesn’t “do” anything.  It just sits in a vault collecting dust until you sell it to someone else.

That’s very different from stocks and bonds.  When you buy a stock that money “does” something.  It builds a factory that produces stuff or it buys a car that delivers goods or on and on.  What ever it is, it’s creating something of value, making the pie bigger.  That is a huge difference compared to gold, and it’s a huge advantage that stocks and bonds have over gold.  You actually see that play out by looking at the long-term investment performance of gold versus stocks.

Golden diversification

Statistically speaking, gold gives an investor more diversification than probably any other asset.  We all know that diversification is a good thing, so this means that gold is a great investment, right?

Well, not really.  Stick with me on this one.  Gold is negatively correlated with stocks (for you fellow statistics nerds, the correlation is about -0.12).  Basically, that means when stocks go up gold tends to go down, and when stocks go down gold tends to go up. 

Over the short term, that’s probably a pretty good thing, especially if you want to make sure that your investments don’t tank.  In fact, that’s one of the reasons gold is sometimes called “portfolio insurance”.  It helps protect the value of your portfolio if stocks start falling, since gold tends to go up when stocks go down.

However, over the long-term, that’s super counter-productive.  We all know that over longer periods of time, stocks have a very strong upward trend.  If gold is negatively correlated with stocks, and if over the long-term stocks nearly always go up, then that means that over the long-term gold nearly always goes (wait for it) . . . down.

That doesn’t seem right, but the data is solid.  Look back to 1950: an ounce of gold cost $375.  About 70 years later, in 2019, it’s about $1300.  That’s an increase of about 250% which might seem pretty good, but over 70 years that’s actually pretty bad, about 1.8% per year.

Contrast that with stocks.  Back in 1950 the S&P 500 started at 17, and today it’s at about 2900.  That’s an increase of about 17,000%, or about 7.7% per year.  WOW!!!

Just to add salt in the wound, inflation (it pains me to say since I think the data is suspect) was about 3.5% since 1950.  Put all that together, and gold has actually lost purchasing power since 1950.  Yikes!!!

A matter of faith

Fundamentally, if you have faith that the world will continue to operate with some sense of order, then gold isn’t a very good investment.  So long as people accept those green pieces of paper you call dollars in exchange for goods and services and our laws continue to work, gold is just a shiny yellow metal.

However, if society unravels, then gold becomes the universal currency.  The 1930s (Great Depression), the 1970s (OPEC shock), and 2008 (Great Recession) were all periods where gold experienced huge price increases.  Those are also when the viability of the financial world order were in question.  Each time, people were actively questioning if capitalism and banks and the general financial ecosystem worked. 

People got all worked up and thought we were on the brink of oblivion.  Gold became a “safe haven”. People knew no matter what happened, that shiny yellow metal would be worth something.  They didn’t necessarily believe that about pieces of paper called dollars, euros, and yuans.

Yet, the world order hasn’t crumbled.  Fiat currencies are still worth something.  Laws still work, so that stock you own means that 1/1,000,000 of that factory and all it’s input belongs to you.  Hence, gold remains just a shiny, yellow metal.  

The bottom line is that stocks have been a great long-term investment, and gold hasn’t.  And that’s directly tied to the world maintaining a sense of order.  So long as you think that world order is durable and we’re not going to descend into anarchy Walking-Dead style, then gold isn’t going to be a good investment.

So the survey says: “Stay away from gold as an investment in your portfolio.”

The best time to take social security

Social-Security-SSA

In the United States, Social Security is an important part of most peoples’ retirements, actually probably too important in many instances.  Social Security is a fairly simple program that was designed to be pretty idiot-proof.  You don’t really need to make many decisions for it, which contrasts sharply with all the decisions you need to make on your other investments (like tax strategiesasset allocationpicking investments, etc.).

With Social Security, you just work and the government takes its 12.4% (6.2% from you and 6.2% from your employer) of your compensation.  In fact, you don’t really have a choice in the matter and the government does it automatically.  Then when you get old, the government gives you a monthly pension.  Not real complicated on your end.

However, there is one really important decision you need to make regarding Social Security: when you start taking it.  Basically, you have three options: 1) Early retirement-when you turn 62; 2) Regular retirement-when you turn 67 for most of us; 3) Late retirement-when you turn 70.  And as you would expect, if you start taking Social Security later, you get a larger monthly check from the government.

This is obviously an important choice to make, and it’s one that gets a lot of press coverage with all sorts of people opining on what to do (I guess with this post, I am adding my opines to those ranks).  Generally speaking, the advice slants towards taking it later.  Yet, I wonder if that’s really good advice.  Using my handy-dandy computer, let’s go to the numbers to see what they tell us.

I checked my Social Security statement and I’ll be able to pick from one of the three choices:

Age to start taking Social SecurityMonthly check
Early retirement—age 62$1800
Full retirement—age 67$2600
Delayed retirement—age 70$3200

As you would expect, the answer to this riddle is a morbid one.  When do you expect to die?  The longer you live, the more it makes sense to delay taking Social Security so you can get the bigger check.  That’s not a tremendous insight, but when you do the math, you start to see some interesting things going on.  I fully appreciate that Social Security is very nuanced and complex, so I am just covering the simple basics here.

In my analysis to be able to compare the different scenarios, I assumed that I saved all the Social Security checks and was able to invest them at 4%, about the historic rate for a bond.  If you do that the table above expands to this:

Age to start taking Social SecurityMonthly checkHighest value
Early retirement—age 62$1800Die before age 79
Full retirement—age 67$2600Die between age 80 and 84
Delayed retirement—age 70$3200Die after age 85
Capture

That’s pretty profound actually.  The average life expectancy in the United States is 76 for men and 81 for women.  Doesn’t that mean that most of us should be taking Social Security with the early option?  That contradicts most of the advice out there on this topic.  That, ladies and gentlemen, is why Stocky is here for you.  This is where it starts to get fun, and we can apply a little game theory (awesome!!!).

When to start Social Security?

Actually, once you reach age 62, the life expectancy of those still alive (and able to make the decision on Social Security) is 82 for men and 85 for women.  This makes sense because you’ve survived to 62 so by definition you didn’t die before then (awesome insight, Stocky), and those early deaths pull down that initial life expectancy model.

Since women are better than men as a general rule (Foxy Lady took over typing for just a second there), let’s look at this decision as a 62 year-old-woman.  She needs to make a decision on when to take Social Security.  She knows her life expectancy at this point is 85, which means there’s about a 50% chance she makes it to 85.  So the worst choice for a 62 year-old is to take the early retirement option.  She’s probably going to live long enough that either full retirement or delayed retirement is the better option.

At 62 she does the smart thing, and decides to wait.  Her next decision comes at age 67, assuming she lives that long (there’s about a 5% chance she’ll die during those five years).  But a similar thing happens—when she was 62 her life expectancy was 85 (right on the border of picking between full retirement and delayed retirement), but now that she’s 67 her life expectancy jumps up a year to 86.  So if she makes it to 67 then she’s better off taking the delayed retirement (of course, there’s about a 4% chance she’ll die before she makes it to 70).

That’s a little bit weird though, isn’t it?  It kind of feels like you’re that horse with a carrot dangling over his head, keeping him walking forward.  It’s a bit of a conundrum.  At any given time, you’re better off delaying starting your Social Security, so the math tells you to keep waiting and waiting.  But if the dice come up snake eyes and you die, then you miss out on everything (not strictly true, but true enough for our analysis).

And keep in mind that since Foxy Lady hijacked Stocky’s computer, we’ve done this analysis for women.  The math tells you that it’s just about a wash between taking Social Security at 67 or 70.  Since women live on average 3 years longer, for men you would think it means that the advantage leans towards taking it early.

What does it really matter?

So the analysis tells us that we’re better off waiting if you’re a woman and it’s really close if you’re a man.  And of course the longer we wait, the further we come out ahead by taking delayed retirement instead of early or full retirement.  But how big of numbers are we talking?

Remember, the cut off for when full retirement becomes better is at about 80 years old.  The cut off for when delayed retirement becomes better is about 85 years old.

Future value of Social Security payments
AgeEarly retirement (62)Full retirement (67)Delayed retirement (70)
85$1,031,256$1,119,603$1,125,233
90$1,450,231$1,644,630$1,716,663
100$2,647,751$3,158,200$3,431,844

Those are meaningful differences.  If you make it to 100 years old, delayed retirement comes out about $800,000 higher than early retirement.  However, those are in future dollars, 38 years into the future if you’re 62 today and faced with this decision.  That $800,000 when you’re 100 would be worth about $370,000 today.  Of course that’s if you make it to 100, which isn’t really likely (about a 3% chance).

If you make it to 90 years old (you have less than a 30% chance) then the difference is about $260,000 in future dollars which is about $150,000 today.

Wrapping up, I’m really torn on this.  There’s a little bit of a prisoner’s dilemma type thing working that keeps making you want to push back when you start collecting.  And then when you look at the upside of delaying retirement, the numbers are pretty big (whenever you’re talking about hundreds of thousands of dollars, that’s real money), but the chances of us making it to that super-golden age are pretty small.

I suppose it’s best to wait, but I’m giving that a pretty “luke-warm” endorsement.  It certainly isn’t the “slam dunk” that so many pundits make it out to be.

Actually, I think the way the Social Security administration sets it up, the options are all pretty similar.  We all have this personal belief that we’ll live longer than average (but not everyone can live longer than average, expect if you’re from Lake Wobegon, MN).  And that makes us think we’re better off waiting, but it probably is all pretty equal.

Paying off your mortgage now a good thing?

Today we celebrate Tax Day.  Celebrate isn’t quite the best word, but let’s paint a happy face on this.

There a million things we can talk about with regard to taxes and personal finance, but let’s focus on one of the big changes that hit in 2018 that fundamentally affects a MAJOR financial decision we make—the mortgage on your house.

The major tax overhaul that passed at the end of 2017 is probably the biggest in my adult life.  It puts a few tried-and-true nuggets of tax wisdom on their head, particularly how “itemized deductions” are treated, including your mortgage.  Let’s dive in and see how that changes things.

Quick primer on how taxes were

Remember, I’m not an accountant, so this is my best understanding of how things were and are. 

Before, you as a tax payer had to decide to take the standard deduction or itemize your deductions.  You can only do one or the other, so the general idea is to do whichever is “greater”.

Standard Deduction 2017 2018
Single $6,350 $12,000
Married $12,700 $24,000

When you take the standard deduction, as the name implies, you just get to reduce your taxable income by a standard amount.  In 2017, if you were a married couple, that amount was $12,700.

The alternative is to itemize your deductions.  Things can certainly get complicated, but for most people your itemized deductions are your state income taxes, and if you own your own home your property taxes and the interest on your mortgage.  If those three items were more than $12,700 then it made sense to itemize your deductions.

In 2017, for the Fox family, our state taxes were about $10,000, property taxes about $6,000, and interest on our mortgage about $9,000.  All that adds up to about $25,000.  So, it made a lot of sense for us to itemize our deductions.  We got to reduce our taxable income by $25k instead of $13k.  That probably saved us about $4,000 in taxes.  Not bad.

Quick primer on what changed for 2018

There were a ton of changes in the new tax law (I think the actual document was well over 1000 pages—Yikes!!!).  But let’s hit the highlights.

The same logic holds where as a taxpayer, you should pick whichever is greater, itemizing your deductions or taking the standard deduction.  But that’s where some major changes occurred.

First, you can see that the standard deductions nearly doubled.  That alone makes the number of taxpayers who would take the standard deduction much higher than before. 

Looking at our situation from 2017, we had $25,000 in standard deductions while the standard deduction is $24,000.  Back in 2017 it was a no-brainer, but in 2018 it became nearly a wash.  But that’s just the tip of the iceberg.

The second major change is that there is a limit of how much you can deduct on your itemized deductions for state and property taxes.  In 2017 there was no limit, so in our situation we were able to deduct $16,000 ($10k for state taxes and $6k for property taxes). 

Now the limit is $10,000.  That’s a major game changer.  Using our 2017 numbers instead of deducting $16,000 for state and property taxes, we hit the limit of $10,000.  Add the $9,000 for mortgage interest and we can only deduct $19,000.  That is much less than the $24,000 standard deduction, so with the new tax laws, we will take the standard deduction

Basically, for it to make sense for you to itemize your deductions, you need to have over $14,000 of interest expense on your mortgage.  Just using round numbers, if your interest rate is 4% (and if it’s higher than that, you should refinance 😊), that means you’d have a $350,000 mortgage.  Anything less than that, and you’re better off taking the standard deduction.

How this affects your mortgage

Let’s bring this full circle, back to the headline of this post—How does all this affect your mortgage?

Remember that we have talked extensively about debt.  I told you how we could have gone mortgage-free but decided not to, how we took a car loan when we didn’t need to and that was a good thing, and in general the approach we use for debt.

If you boil it all down, basically you should take on debt if the interest rate is really low.  However, the tax change “increases” your mortgage rate because it’s not going to make sense to be able to deduct the interest.

Before if you had a 4% mortgage, after you deduct the interest on that mortgage from your taxes, it might seem more like a 2.5% to 3% rate.  Obviously, that’s a big difference.  Maybe your internal calculations look at a loan at 4% as high enough to pay off fast, but not one at 2.5%.  Makes sense.

However, now most of us can’t deduct that mortgage interest.

Mortgage rates are rising

For the past several years, we have been enjoying historically low interest rates which have translated to historically low mortgage rates.  However, that has been changing.  A few years back a 30-year mortgage might have been at 3.5% while now it is at 5%.

If you combine that impact with the tax deductibility, you have a major impact.  Before you had a low rate that was tax deductible.  Let’s say it was a 3.5% rate that “felt” like 2.5% after you deducted the interest on your taxes.

Now if you get a mortgage that rate will be 5%.  That’s an enormous change, big enough to fundamentally shift the decision of whether or not you should pay off your mortgage faster.

Remember, that paying off a loan is basically making an “risk-free” investment, similar to a bond.  Before, paying off your mortgage would give you a 2.5% guaranteed return.  That’s not great.  For the Fox family, we looked at that as too low.  We’d rather take on more risk and invest that money in the stock market. 

Now with the changes, being able to get a 5% guaranteed return changes our decision.  We wouldn’t do it at 2.5% but we would at 5%.  This becomes real because now Foxy Lady and I will start using extra cash we have to pay off our mortgage faster.

This is a huge game changer that impacts millions of Americans.  It changed a central decision we had to make for personal finance.  Maybe it will change that for you too.

Top 5 Reasons We’re in the Golden Age of Investing

39Thegoldenage

You hear all the time that this is a terrible time to be an investor.  Maybe it’s after the fallout of some scandal, Enron and Worldcom from the early 2000s or Bernie Madoff from 2008 come to mind.  Or maybe it’s that the market is evolving and people caught on the wrong side of that start to complain.  A while back Michael Lewis published Flash Boys which looked at high frequency trading.  One of the takeaways was that Wall Street giants were rigging the game to their advantage at the cost of smaller investors.

flash boys

Of course, it wasn’t limited to Michael Lewis. We seem to be constantly barraged with stories about how investing is terrible now, the odds are stacked against the little guy, the fat cats are taking advantage of everyone.

I’m not an expert on high frequency trading or the million other death knells that people always point to when showing that the market is all screwed up.  The eternal optimist, I actually think this is a great time to be an investor.  Here are my top 5 reasons why we are in the golden age of investing.

5. Decimal stock prices: Today if you look up the price for a stock you get something normal looking like $40.63. However, before 2001, stock prices were quoted in fractions, so that same stock wouldn’t be $40.63, it would be 40⅝.  First off, that was a royal pain the butt.  Quick, which would cost more $20.30 or 20⅜? (20⅜ is more).  We all remember fractions from elementary school, but they aren’t really intuitive in financial applications.

Secondly, it cost you real money.  All stocks have a bid/ask spread which is the difference between what someone will sell something for and what they will buy it for.  That difference is the profit that market makers get.  As an investor you pay that spread, so the larger the spread the worse for you and the better for them.  When stocks were in fractions, just the nature of fractions made the spread fairly large.  So you might have an bid of 20⅜ and an ask of 20½.  That’s a spread of 12.5 cents for every share you trade.  That may not seem like a lot, but over hundreds or thousands of shares that starts to add up.

When stocks became decimalized, that 20⅜ became $20.38 and that 20½ became $20.50.  But then competition among market makers squeezed the spread to something like $20.41 and $20.42.  It’s not uncommon to see spreads of only a penny (see a recent quote I pulled up for Medtronic).  That is real savings that goes into your pocket.  In 2001 the SEC mandated all stocks be quoted in decimals and that was a real win-win: investing became computationally easier and less expensive.

Medtronic chart

4. Internet trading: You could have a whole post on how the internet has revolutionized personal finance (hmmmm, maybe I’ll do that). But here I’ll focus on internet trading and generally managing your investments online.  When I started investing in the mid-1990s the main way you invested was by calling your broker and having her execute the trades you wanted.

Think about that for a second.  You had to call someone, hope they answered, tell them what you wanted to do, and then have them do it.  That just seems really inefficient.  Later, some mutual fund companies got to the point where you could trade using your touch-tone phone (“press 1 to buy shares, press 2 to sell shares”), but even that was pretty kludgy.

Of course, once the internet came out, investing proved to be one of the ready-made applications for cyberspace.  You could actually see your investments on a screen, in real time, push buttons to do what you wanted.  Even set up things like automatic investments or withdraws.  No question, it’s so much easier now than it was.

3. Low costs: With the internet and the incredible efficiency it brought, the costs of investing plummeted. Brokerage fees on some of my first trades were in the $50-75 range.  That was with a full-service broker.  Also there were ways that they nickel-and-dimed you with things like “odd lot hikeys” which was an extra charge if you bought less than 100 shares.  Such a bunch of crap.

That was about the same time that “discount brokers” were becoming popular and started offering internet trades for $14.95.  Once that genie got out of the bottle, there was no end to how low trades could go, and it made sense.  All the stuff became automated, so the costs dwindled to almost nothing.  Now you can find $4.95 trades and places like Vanguard offer $2 trades if you know where to look.

Think about that for a second.  If you did 10 trades a year, in the old days (dang, that makes me sound old) that would have cost you $1500 per year (remember you get charged for buying and selling).  Over an investing career, that $1500 each year could add up to almost a quarter of a million dollars!!!  Maybe Michael Lewis will complain that investors are getting swindled out of a penny or two a share because of high-frequency traders, but that’s a drop in the bucket to what they’re saving by tiny, tiny trading costs.

2. Computing power: As reader Andrew H said in a comment, technology has advanced so rapidly that your iPhone has much, much more computing power than the Apollo 11 spacecraft. Computing technology has become amazing powerful and amazingly cheap in the past couple decades.  A $300 laptop with Excel can allow you to do amazingly large and complex analyses that would have seemed magical just 30 years ago.

One of the huge applications for this analytic power is personal finance and better understanding the stock market.  Many of my posts on this blog are just that—taking data and using Excel to make sense of stuff.  Are you better of investing a windfall at once or over time?  How often would you have lost money in the stock market historically?  Those are fairly large analyses that would have been a massive undertaking 30 years ago, probably only possible at a major investing house or a university.  Today, they’re done by a nerd with a cheap computer and too much time on his hands.

That computing power has been an amazing equalizer on the financial playing field.  Now individual investors can figure things out for themselves instead of having to listen to brokers like they were priests from some secretive cult.  That’s an enormous improvement.

1. Access to information: This is a biggie. The amount of information available to us now with the internet is mind-boggling.  When I was a kid your source of information on stocks and investing was the evening news (“stocks were up 52 points today”) and the newspaper where you could look up the price of a stock from the previous day.  That was it???  That was it!!!

Today you have real-time price quotes, you have real-time news, you have real-time analysis.  You also have troves of data, and nearly all of it is free.  All the analyses I have done is with free data on historic stock prices and inflation.  That’s nice if you’re a dork like me, but how does this help normal people?

In investing, information is power, and we live in a time where that power is freely given to all.  Let’s say you wanted to invest in Ford in 1990.  How would you go about researching your investment decision?  Maybe call Ford’s investor relations to have them mail you some annual reports, possibly go to the library to find some articles on the company, probably stored on microfiche.  That’s crazy.  Today you can find all that information plus about 1000 times more in less than 5 minutes on your computer.  It truly is a completely different ballgame, and one that is very much to our advantage compared to what it had been.

Bonus reason—financial understanding:  I couldn’t stop at five reasons, so I am including a sixth (the “Top 6” just doesn’t have the same ring).  There has been tremendous research into financial markets and how they behave over the last couple decades.  While markets are still very unpredictable by their nature, we understand them much better.  Ideas like price-to-earnings ratio, index mutual fundsefficient markets, and a thousand others help us better understand how and why the stock market does what it does and that allows us to be better investors.

In a similar vein, the central bankers who guide our economy, and by extension the stock market, have learned a lot too.  One of the theories on why the Great Depression was as bad as it was is because President Hoover and his advisors did all the wrong things.  It’s not that they were vindictive and wanted to drive the country into a calamitous financial train wreck, but they just didn’t know what to do.

I absolutely believe the reason we haven’t had another Great Depression, including the Great Recession where we emerged largely unscathed, is because our central bankers are a lot smarter.  Paul Volker, Alan Greenspan, Ben Bernanke, Janet Yellen, and now Jerome Powell all studied the Great Depression and other financial disasters and learned what those people did wrong and how similar fates can be avoided in the future.  That understanding has saved us a lot of pain.

So there you have it.  Sure, investing isn’t always a smooth path, and as Michael Lewis points out, there are always bad apples that are trying to screw things up.  But with all that, don’t lose sight of the fact that investing today is soooooooo much better than it has ever been before.

What do you think?  Are my glasses too rose-colored?  Are there other awesome developments that deserved a place in the top 5?

The mutual fund fee arms race

A few weeks ago we talked about mutual fund fees.  There’s a big range, and one of the ways I win when investing is by minimizing the fee that I pay.  It begs the question: How low can mutual fund fees go?

Quick historical perspective

Mutual funds have been around for a long time, dating back to 1924 with Massachusetts Investors Trust.  Back then they had a management team that actively picked which stocks to invest in, very similar to the actively managed mutual funds of today.  Just like today, those mutual fund managers were paid handsomely.

In 1976 Vanguard started the first index mutual fund based on the S&P 500.  Just like today, the index mutual fund had costs significantly lower than its actively managed peers.  At first, the index idea didn’t catch on, but over the next 40 years it became the dominant investment vehicle for ordinary foxes. 

Race to the bottom for fees

Because index mutual funds are a bit of a commodity, the real differentiator is management fees.  I started investing in 1996 and I remember that my S&P 500 had a management fee of 0.30%.  At the time that seemed super low.  Today, that same mutual fund has a management fee of 0.14%, and if you get their Admiral Shares (at least $10,000 invested) the fee goes down to 0.04%.  DEFLATION!!!

Of course, that begs the question, how low could management fees go?  Fidelity answered that this summer when they launched a line of index mutual funds with a management fee of 0.00%–NO FEE!!!

There’s no such thing as a free lunch, so why would Fidelity do this?  It seems like a simple marketing ploy of having a loss leader.  They’ll lose a little bit on these mutual funds to get customers with the hopes that they get other products/services from Fidelity.

How big a deal is this?

Obviously getting something for free is better than paying for it.  Let’s figure out how big a deal this really is.

As we just said, Vanguard offers a US index mutual fund with a 0.04% fee.  International funds are a bit more expensive to manage and Vanguard’s is at 0.11%.  If you’re diversified as I have suggested in our Three Ingredients post, let’s assume your average management fee is 0.08%. 

So how much are you saving by going with Fidelity’s zero-fee mutual funds over Vanguard’s index funds?  If you had a million dollar portfolio, that would come to about $800 per year.  That’s not a ton of money, but it’s enough for Foxy Lady and I to go out to dinner once a month, so that’s kinda nice.

But the real value comes in when that money compounds over time.  Over an investing lifetime that little bit would add up to about $41k.  Again, that may not seem like a lot, but it’s about as much as the average American has saved, so maybe it is a lot.

For us, I think we’ve been with Vanguard so long that it would be hard to convert over to Fidelity’s zero-fee funds.  There’s the tax implications of selling the funds and paying capital gains which would be a lot.  Plus, there’s the inconvenience of resetting everything up again.  Finally, there’s the risk that I would get caught out of the market while my money was being transferred.

The first reason (the taxes) is probably the real reason.  $800 per year pays for a lot of hassle.  However, if I was advising someone just starting out who hadn’t already chosen Vanguard, I think this would certainly tip the scales in Fidelity’s favor—I would recommend they go with Fidelity and those zero-fee funds.

Either way, the point is that management fees are really going to the basement and then lower.  That’s a real boon for investors. 

The Fox family’s 2018 investment performance

2018 was an “interesting” year for stocks.  Everyone wants to think “this one was different” but 2018 did seem to be pretty crazy. 

We had some wild swings pretty much the whole year: from January to December.  Going into December, I was marveling at what a genius I was with my prediction from the beginning of 2018 that the market would be up about 5% for the year.  Going into December it looked like I was going to be spot on . . . and then the bottom fell out of the market and you have where we are now.

Our stock performance

Just like most everyone else, we had a down year.  Of course, since we only invest in index mutual funds, by definition whatever the market did is the return we got.

Investment Ticker % of total portfolio 2018 return
US stocks VTSAX 50% -8%
Int stocks VTIAX 45% -18%
REITs VGSLX 5% -12%
TOTAL -12%

We were down 12%, and obviously that sucks, but . . .   There’s really no “but” so let’s not try to sugarcoat it, but maybe there is a silver lining.  Since the Great Recession in 2008, stock were up about 150% (about 11% annually) and had a 10 year winning streak. 

Dark blue was US stocks (down 8%) and light blue was International stocks (down 18%)

This year we had a down year, so it’s a bit hard to complain.  Historically, stocks are down for the year about 30% of the time.  We were probably due, so we shouldn’t get too greedy.  Still, it isn’t fun to go through a down market, but that’s life.

Notice any changes?

We also made a few simplifying changes to our portfolio starting in late 2017 and continuing into 2018.  At the end of 2017 we sold all our commodities as I discussed here.  In 2018, we also exited our Lending Club investment which was also a disappointment (although not nearly as bad as the commodities). 

That took us from five investments (US stock index fund, Int stock index fund, REIT fund, commodities ETF, and Lending Club) down to three.  If you remember the post on Three Investing Ingredients, I was getting closer to following my own advice.  The only thing still there was REITs.  In late 2018 we finally sold those off, so as of now, we are totally following the Three Investing Ingredients.  It’s nice to get back to basics.

At the beginning of 2020 when you read about how we did in 2019, there should only be two investments.

Inflation

The other thing I always look at at the end of the year is inflation.  US inflation came in at 2.4%.  It’s been inching up steadily over the past few years, and now it’s the highest it’s been since before the Great Recession.  Even so, 2.4% is still incredibly low.

We spend a ton of time talking about the impact inflation will have on your portfolio.  A few years back I even wrote almost a love note to the investing gods for 2015 being a no-inflation year.  The fact that inflation remains very tame compared to historical standards—I use 3% as a target for inflation—means we’re ahead of the game.

Wrapping it all up

Let’s chalk up 2019 to a crazy year and a “bad” year.  But we know sometimes we have bad years.  In the grand scheme of things it definitely could have been worse.

MY 2019 PREDICTION—I think our new normal for the next several years will be a lot of volatility, like we saw in 2018 and so far in 2019.  I never like trying to predict the stock market, but it just “feels” like we’re in for another down year.  I predict down 7%.  Of course I’ll use this as an opportunity to keep socking money away and buy stocks at prices that in 10 years will look bargains.

Putting a bow on December 2018

The new year is a great time to take account of things in life.  We look at the year just ended, reflect on our successes and failures, decide how this year will be better, make our resolutions, and take on the new year.

I was all prepared to write a few posts on all that, but then the tidal wave that was December 2018 hit.  I posted last week right at its depths, but even the craziness of the last few days of the year require, neh demand, its own post.  So let’s put a bow on that crazy month.

As bad as it was . . .

I posted last Monday, Christmas Eve, that with a bit over a week to go, December 2018 had already become the 4th worst month in the 69-year history of the S&P 500.  Going into that trading day, we were down 12% for the month, and then in an act worthy of Old Testament God, the market plunged that day another 3%.  Just in time for the holiday.  Thanks a lot.

It was bad and we were in the teeth of an all-time bad stock market plunge.  If you think of it as the 4th worst (or 3rd worst after that Monday) month in almost 70 years, you’d expect something like this once every 25 years or so.  That’s a generational storm.  Batten down the hatches.

. . . and how it ended

But there’s a reason that December ends after the 31st day and not the 24th day.  The day after Christmas (obviously markets were closed for Christmas), the markets increased 5% which is a crazy high amount.

Before we look at the larger picture, let’s just reflect on December 26 for a second.  It was the largest point gain day for both the S&P 500 and the Dow Jones Industrial Average.  Also, it was the 18th largest percentage increase for the S&P—top 18 out of over 17,000 trading days since 1950.  Not bad.

Back to the story, so Wednesday there was a big recovery but we were still down a lot.  But the market kept chugging along each day, and it ended the month up 7% for the lows on Christmas Eve.  Let’s not fool ourselves.  It was still down 9% for the month, but compared to where we were as Santa was loading up the sleigh, that’s not that bad.

In fact, while there’s no doubt that December 2018 was a bad month, it didn’t even rank in the Top 10 worst months of all time (it was at 11).  Not that that should make you feel good, but we were thinking we were being hit with a generational storm, and it ended up being an every 5 or 6-year storm.  Those things happen.

The stock market is a very complex human experiment, but in a lot of ways it’s very simple.  I think the crazy roller coaster ride in the month of December (and more broadly all of 2018) really illustrates this.  Things are never as bad as they seem, and the best strategy is usually to just sit tight and let the craziness work its way out of the system.

I hope everyone has a wonderful Christmas and New Year.  Next up you’ll see how the Fox family did on their investments including the wins and losses, so makes sure you have a box of tissues.

A month of freefall

Holy Crap!!!  I was all set to do a post on Fidelity’s zero-fee mutual funds as a follow up to last Wednesday’s post on index mutual funds.  But the stock market has had other ideas.  So far this month stocks have tumbled 12%.  12!!!

There seems like a lot going on that we need to process, so let’s start breaking this down.

Dec 2018 in context

There’s still a week to go, but as it stands right now, stocks are down 12% for the month.  Of course there’s one more week left in the month so things could go up and it won’t be as bad, or things could get worse and . . . well, let’s try to stay positive.

No matter how you slice it, 12% is a lot.  Just to put it in perspective, since 1950, when the S&P 500 started, there have been 828 months, and Dec 2018 ranks as the 4th worst month of all time.  In 70ish years we’re in the midst of the 4th worst month. 

Think of this as a generational storm.  I don’t know if that’s comforting or dispiriting.  Months like this happen, and it has been worse in the past, yet this is on the Mount Rushmore of all-time bad investing months.

Just in case you’re wondering what the 10 worst months for the S&P 500 are, here you go:

Month ending S&P 500 close Return
Oct-87 252 -21.8%
Oct-08 969 -16.9%
Aug-98 957 -14.6%
Dec-18 2417 -12.4%
Sep-74 64 -11.9%
Nov-73 96 -11.4%
Sep-02 815 -11.0%
Feb-09 735 -11.0%
Mar-80 102 -10.2%
Aug-90 323 -9.4%

Sit tight

What’s done is done.  The stock market has cratered, and unless you have a time machine, you just need to accept this really tough month and then look to the future.  That’s where I think things get a lot more comforting.

You can take that table above and then add two additional pieces of data: how stocks did in the next month and how stocks did over the next year.  That paints a completely different picture.

Month S&P 500 close Return Next month return Next 12-month return
Oct-87 252 -21.8% -8.5% 21.1%
Oct-08 969 -16.9% -7.5% 15.6%
Aug-98 957 -14.6% 6.2% 29.8%
Dec-18 2417 -12.4%
Sep-74 64 -11.9% 16.3% 13.5%
Nov-73 96 -11.4% 1.7% -28.3%
Sep-02 815 -11.0% 8.6% 12.4%
Feb-09 735 -11.0% 8.5% 38.4%
Mar-80 102 -10.2% 4.1% 28.0%
Aug-90 323 -9.4% -5.1% 29.2%

Who knows what will happen in January 2019 or the next 12 months, much less the next week (I certainly don’t).  Yet if you use history as a guide, there’s a lot of reason for optimism.

Of the 9 months that made the top 10 that we have data on, 6 of those 9 month saw gains in the stock market the next month.  I would definitely take an even-money bet that January 2019 will be a up month.  But by no means is it a sure thing; look at Oct-87 and Oct-08, the two worst months.  Those were followed up by brutal months.

Things look even better if you push the time horizon out from one month to a year.  For those 9 really bad months, if you looked at the market a year later, things looked good, really good.  8 of those 9 examples saw the market up, and all of those up years were up double digits.  They made up for the bad month and then some.  Of course, November 1973 shows you that’s not a certainty, but the fact that almost 90% the time things recover fully makes me feel pretty good.

What’s going to happen?

As I was doing the research for this post, I was struck by the examples of those really bad months.  Some of them are explainable while others are a bit odd.  October 1987 was Black Monday; October 2008 and February 2009 were the Great Recession; September 2002 was the popping of the Dot Com bubble;and November 1973, September 1974, and March 1980 were all a part of the Stagflation lost decade of the Nixon and Carter debacles.

Those others are a bit odd in that there really wasn’t a powerful reason that has survived the test of time.  I am sure you could look it up, but off-hand I couldn’t tell you what happened in August 1998 or August 1990.  Things were going well and as you can clearly see, a year later that bad month was a distant blot in the rear-view mirror.

I feel like that is what we’ll think of for December 2018.  By all measures things are going well for the economy.  The economy seems to be growing well, unemployment is low, and inflation is tame (between 2-3%).  Those are generally the Big 3 that you look at to see how things are doing, and they all seem okay or even better than okay.

That’s not to say there aren’t risks.  Of course there are, but there always are.  Brexit seems like it will have a rocky landing, the trade war between the US and China looms large, Trump pulling troops out of Syria might destabilizing, sovereign debt continues to pile up, and on and on and on.  That’s true now but there were other “risks” you could have sighted for any of those other Top-10 bad months.  I don’t think things are particularly worse now.

As always, I am optimistic about the stock market.  I think this month will be similar to August 1998 or August 1990 in that the statistics show it was a bad month, but people can’t really tell you much about it because it was in the midst of good times. 

That said, I do think there is the potential that we might be in for a couple lean years, maybe of the +/- 5% variety.  Over the past 5 years, since 2013, the market is up 70%, so it doesn’t seem unreasonable that we’re “due” for a bad year or two.

Mutual fund management fees: the silent killer

“If you have to ask how much it costs, you can’t afford it.”—JP Morgan

Imagine that you’re going to buy something that costs over $1000, maybe a flat-screen TV or a new set of tires for your car.  At some point during your decision-making process would you ask how much what you were getting costs?  Of course you would.  Unless you’re JP Morgan, a normal person figures out what something costs before he or she buys it.

Yet that is exactly what happens when people invest their money in mutual funds; they have no idea how much they are paying the mutual fund company to invest their money.  I guarantee you ask 100 people who have 401k accounts how much they paid in management fees last year, and less than 5 will know, and those 5 would probably just get lucky.  Even humble Mr Fox couldn’t tell you how much I pay Vanguard each year in management fees(important statement so I had to revert to third person), and I’m obsessed with this stuff.

And the crazy thing is with investing there are so many unknowns and random events, namely how your investments are going to do in the future, but one of the things we can control, how much we spend on mutual fund management fees, receives so little focus and attention.

Why are management fees swept under the rug?

First, investment companies have every incentive to hide the fact that these even exist.  Obviously,if Vanguard or Fidelity or American Funds can convince naïve investors that there’s no charge for investing their money, they’re more likely to do it—that’s economics 101.  SEC rules require that funds publish their management fees, yet they tend to be in the smaller print, much less conspicuous than the proclamation that “Our fund has beaten its comparable benchmark 7 of the last 10 years, before fees.”

Second, the amounts tend to seem small.  An actively-managed mutual fund with really high fees could be in the 1.5% range while a really large index mutual fund might bottom out at less than 0.1%.  That spread of 1.4% from high to low may not seem like a lot on its surface, but that’s a 15x range.  Also, due to the magic of compounding, over time, those fees would really add up.  That difference in management fees could lead to a 13% difference in a person’s nest egg; that’s the difference between someone with high expenses having $500,000 in their 401k after a 30 year career and $565,000. That’s real money!!!

What are the key determinants in how much a mutual fund charges for fees?

The single biggest factor in how much a mutual fund charges in management fees is whether it is a passively managed index fund or an actively managed fund.  Index mutual funds don’t require much oversight.  They find the index they want to mimic, like the S&P 500, then they have a computer program that monitors the fund’s holdings and makes small course-correction trades to ensure that the composition of the fund is as close to the index as possible.  You have a couple people make sure the computer doesn’t go crazy and you’re set.  There are still costs like accounting,marketing, keeping the website up, sending out account statements, etc., but it’s a pretty lean operation.

Also, with index mutual funds, in many ways they’re a commodity.  Any S&P 500 index fund performs 99.99% identically to any other; that’s the very essence of an index mutual fund.  So if there is no difference in the product, then companies must differentiate on cost.  Not surprisingly, what is largely considered the best S&P 500 index fund (if you count it in terms of amount invested)is the one with the lowest costs: the Vanguard S&P 500 Index (VFINX).

Now on the complete other end of the expense spectrum you have the exorbitant fees associated with actively-managed mutual funds.  There are mutual fund managers who get six-,seven-, and sometimes even eight-figure compensation packages.  What justifies such astronomical pay?  Just like free-agents in baseball these fund managers who are perceived as the best can go to the highest bidder, becoming celebrities in their own right (see: Lynch, Peter). 

Beyond the compensation for the fund managers, these funds have a lot of costs.  There are all sorts of industry and trade conferences that fund managers go to.  And if you think they fly coach and stay at a Holiday Inn, I have a bridge to sell you. They work in glass palaces in downtown Boston and New York.  Let me just say I once went into Fidelity’s headquarters in Boston and to quote a line from one of my favorite investing movies, Barbarians at the Gates, “it makes Buckingham Palace look like a Burger King.”  Many offer gourmet lunches to their staffs every day, limos, in-house massage therapists, and the list goes on, but you get the point.  And where does all this money come from?  It comes from the extra 1.4% difference in management fees between an actively managed fund and an index fund.

Where can you find the information?

This fancy thing called the internet actually makes this pretty easy to look at. Pretty much every finance website (Google,Yahoo!,etc.) lists every mutual fund’s expense ratio. This allows comparison shopping to be really easy.  In about 5 minutes you could look up and compare the management fees of any of the mutual funds you are considering.

You can see the expense ratio circled in red on the left.

That’s not to say this is the only factor you should consider when choosing a mutual fund. That’s some deep water which would be a great topic for another post,but it is a really important one.  Some would even argue that it is the single most important factor.  Sadly it’s one that very, very few people are knowledgeable of.  As you look to build your nest egg, it’s something you should absolutely know when you start making your investment decisions.

For our money, the Fox family is a believer in index mutual funds.  In fact, 100% of all our money is in index mutual funds, so this is no joke to us.  The management fee varies for each fund,management fees for US funds tend to be a little higher than international funds, but the range is about 0.05% to 0.20%, with the average coming in around 0.08%.  So we are paying 0.08% of our total nestegg each year in management fees.

That’s what I do, but that doesn’t mean you have to do the same.  There are many vocal proponents of actively managed mutual funds (by buddy Mike from Boston).  Their points become especially compelling at times like this when the market is going down.

Believe what you will, but if what ever type of mutual fund you invest in you should always know what you are paying.  After all, you aren’t JP Morgan.  If you are paying a high management fee, just make sure you are getting your money’s worth.