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. 

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.

My story about selling commodities

A few years ago, I wrote about our worst investment of all time—commodities.

I think this is a classic case of deviating from the tried and true rules that you only need three investments in an effort to get creative and get higher returns.  In general you should always resist that siren song.  It cost us well over $100,000; that’s an expensive lesson.

After a few years of crapping performance, I finally bit the bullet, admitted defeat, took a huge loss, and sold my commodities.

 

Examining the wreckage

We starting buying commodities ETFs (ticker symbol DJP) in 2010 in small increments, and continued that through the end of 2014.  When all was said and done, we had invested a total of about $100,000.  By the time we sold, those ETFs were worth about $65,000, so we lost $35,000.  Ouch!!!

But that’s only a small part of the loss.  I knew, I KNEW, that we should invest that money in stocks but we didn’t.  Had we invested that money in a stock index fund that $100,000 would have grown to nearly $200,000 by the end of 2017.  I just threw up in my mouth.

A picture says a thousand words–the purple line is commodities for the period we owned them; the blue line is US stocks. OUCH!!!

 

This is a boneheaded mistake for the ages.  Of course, as in most things in life, when you realize you made a mistake like that you need to move on.  With stocks that’s tough psychologically to do because not only is it admitting failure, but it’s also locking in those losses.  So long as you keep the investment you can always tell yourself there’s a chance that things will turn around.

Finally at the end of 2017, to take advantage of a little tax loss harvesting, I sold all our commodities investments.  That horrendous chapter of our investing history was over.

 

Investing gods decide to humble me further

What unfolded was a story similar to one of those stories from the Bible where God continues to test someone’s faith.  I sold all our commodities investments and invested them in US stock investments.

By the end of April 2018 commodities were up about 2% for the year while stocks were down 2%.  ARE YOU KIDDING ME?  After 7 years of stocks drastically outperforming commodities, the trend reversed right after I sold out my commodities.  As you might guess, I was feeling picked on by some power beyond my understanding.

I kept to my guns and my faith was rewarded.  By the end of August 2018, stocks had a big rally (up 8% for the year) while commodities were crushed (down 7% for the year).  When all is said and done, stocks are up about 2% while commodities are down 5%.  That difference equates to about $4000 in my favor.

 

There are a couple things I took away from this:

First, as an investor, you have to focus on the present and future, and not cling to the past.  Second, sometimes your investments work out and sometimes they don’t, and you can’t get paralyzed by your investing failures.  Third, exotic investments generally don’t work out over time.

All these really combine to illustrate all the things I did wrong with commodities.  I should have just stuck to investing in stocks as I always preach on this blog.  Once it started going bad, I should have cut and run instead of clinging to something in the hope that it would “come around.”

Better late than never.  While I definitely left over $100,000 on the table, at least I didn’t leave that last $4000.  That’s what I tell myself anyway.

Top 5—investing moves when you’re just getting started

My neighbor’s son, Rhino, just got engaged (I dubbed him rhino because the rhinoceros beetle is the strongest animal in the world pound-for-pound, and this kid is really strong).  We’ve gotten to Rhino over the years.  He was Mini and ‘Lil Fox’s first babysitter when we moved into the neighborhood, so of course he has a special place in our hearts.

We were talking about his engagement, starting out life, and obviously since it’s a conversation with me, how to do the right things financially.

It got me to thinking about what are the most important things to do in the world of personal finance when you are just getting started.  For the soon-to-be newlyweds, here is my Top 5 list:

 

5. Figure out your debt situation: If you’re lucky, you won’t have a lot (or any) debt.  For most of us there is some out there, and that isn’t necessarily a bad thing.  List out every debt you have (student loan, mortgage, credit card, car payment, etc.), the balance, and the interest rate.

On a spreadsheet (see #4) rank them in order of interest rate.  As a general rule I use a cutoff of about 6%.  If your interest rate is above that pay those off right away, starting with the highest interest rate debt first.  If your interest rate is below that, that might be okay to keep that debt and just make the normal monthly payments.

If you have any debt (especially credit card debt) at any rate higher than 10%, that’s a “debt emergency”.  Really look at every purchase you make—if it’s not critical to your survival (food, shelter) then pass that up until your debt is paid off.  The only exception to this is #1—funding your 401k.

You can get creative with your debt by consolidating high interest rate cards onto a lower rate card or one that offers a low teaser rate.  That could save you a ton of money, and you should probably look into that, but ultimately, you’ll need to pay that sucker off.  So just hitting the grindstone of paying off your credit cards is a must.

 

4. Make a budget on a spreadsheet: Take a spreadsheet and put a quick budget together that includes your income, your expenses, and the difference between those two.  This can be simple at first (and it should be simple at first).  Over time, you’ll add more and more sheets to the spreadsheet for things like your mortgage, investments, kids’ education, and other things.

But at the beginning, you need to get a sense of where your money is going.  The budget will give you an aspirational view of this.  After your budget is done, you can track your spending with a website like mint.com.  This two-step process lets you figure where you want to spend your money, and then also look at where you actually spend it.

Of course, this is an iterative process, and as you close a month and look at your expenses, you can see if you’re spending more than what you budgeted.  This isn’t a time to beat yourself up (being too hard on yourself is a sure way to stop looking at your finances closely, and that’s a REALLY bad thing), but a time to ask yourself why you spent more and if it was worth it.

As an aside, using a spreadsheet is a really good skill in general.  I was really good at spreadsheets and it’s hard to overstate the incredible impact it had on my career, as well as the incredible wealth those skills gave me and my family.  And really, my experience with spreadsheets started in college when I was creating a financial budget.

 

3. Educate yourself on investing: At a young age, educate yourself on investing.  Obviously, this blog is the universally acknowledged best place to learn about investing, but I have heard rumors there are others.

www.mrmoneymustache.com is a great website that looks at personal spending and his early posts had a tremendous impact on my outlook.  A Random Walk Down Wall Street is a book on investing that really defined my investing strategy; I read that as a 19-year-old and still think about its insights today.

There are a lot of websites written by millennials about spending and personal finance that might resonate even more.  A few are: millennialmoneyman.com, moneypeach.com, and brokemillennial.com.  Most are about reducing spending and budgets and that sort of thing, but there are some on the nitty gritty of making investing choices.  You’ll want perspectives on both.

The whole point is that you need to know what you are doing here.  Spending 20 hours early in your life to figure out basics like asset allocation, tax avoidance, and fee minimization as well as a general attitude towards saving early can easily lead to hundreds of thousands or millions of dollars.  That comes to about $50,000 per hour—not bad.

 

2. Start an IRA with $1,000: This is as much about the experience gained as it is about actually investing your money.  Vanguard lets you start an IRA with $1,000 as the minimum amount.

You’ll navigate through their website, figure out how to make choices (like Roth or Traditional IRA—go traditional).  You’ll pick your investments, and then you’ll have something to look at every once in a while to see how it’s doing.

So many people are just at a total loss when it comes to setting up accounts for their investments.  That becomes a real problem once you hit 30 or 40 and you’re starting to get behind the 8-ball; you know you need to do something but are kind of clueless on where to start.  Doing it now lets you get your toes wet in this world and makes the next accounts you need to set up (529, 401k, brokerage, etc.) all the less daunting.

 

1. Get the company match on your 401k: #2 was more for experience than for investment.  Here is where you should start walking down the path for investments.  At a minimum, contribute the match and take the free money.

This is so important for a couple reasons.  First, you’re getting that free money.  Second, you’re making your first “asset allocation” decision.  When it comes time to pick which fund to invest in, unless you have very unique circumstances for an early-20s person, I would definitely go with a 100% equity index fund.

Third, your 401k is a really powerful tool.  If you had no other investing tool, you could still grow a 401k to well over a $1 million during your working career.  That is enough to fully fund your retirement.

 

BONUS—Stay poor:  Too many young adults make a huge mistake of trying to mimic the lifestyle their parents provided, once they (the young adults) get out of school.  That first paycheck of $2,000 is going to seem like a ton of money (and it is).  It’s really tempting to decide to buy a new car or go on a kickin’ vacation or upgrade the furniture.  Resist the urge.

Your parents took 25 or more years of working (with pay increases and investment returns) to provide the house and cars and vacations you enjoyed your senior year of high school.  It’s not realistic to think you can have stuff at that level of niceness so early.

A car is a really good example.  In general, automobiles are horrible investments.  To the degree you have a car that can get you from point A to point B, keep it.  A new car will be nice and cool and make your friends gawk, but it’s a horrible use of money.  A couple hundred dollars a month for a car, plus insurance, and maybe $50 for a gym membership, $50 for cable, and $80 for four dinners at a restaurant—those numbers add up.  Those alone could fund your savings in the early years.

Your early 20s are a time when it’s still okay not to have the best and nicest of everything.  If you can embrace that, even when you do have the money, and put that extra money to work in investments you’ll build a very strong financial foundation that will afford you many more opportunities are you reach your 30s and 40s (remember, I did that and I retired at 36).

Tax loss harvesting

The US has a complex tax code.  That means people are always looking for ways (hopefully legal) to reduce the amount they owe in taxes.

Tax loss harvesting is one way you can do just that.  The option isn’t always available; you need to have investment losses which means you can only do it in years the market is down.  Through November, US stocks were slightly down for the year while International stocks were down significantly.  That created the situation where you might be able to do some harvesting.

There are some intricacies with the tax law here.  Remember that I am not an expert, so if you do this, you may want to consult a tax professional.

 

What it is

We all know that when you make money in the stock market (sell stock for more than what you bought it for), you are taxed on that gain.  That’s called a capital gain.  The opposite is true for losses; when you have a loss (sell for less than what you bought it for), you can reduce your taxes.  Wait for it . . . those are called capital losses.

Tax loss harvesting is selling some of your investments at a loss, and then using that capital loss to reduce what you owe to the government in taxes.

 

How to do it

The strategy is pretty simple.  When markets are down you can sell some of your investments at a loss.

Then at the end of the year, you can claim that loss on your taxes.  The loss will offset any stock gains you have (either capital gains or distributions/dividends).  If you still have losses after those have been offset, you can reduce your taxable income by up to $3000.  That last part is a pretty sweet deal, especially if you are in a higher tax bracket.

Tactically, you just go to the website with your accounts (www.vanguard.com or www.fidelity.com or where ever) and sell those investments which have a loss.  The in April when you pay your taxes, you get the tax forms from your brokerage house, and put those in your tax forms.  Easy.

 

Why it’s important

The major benefit is that you are reducing your tax bill . . . now.  Notice how I said that.  Ultimately, you’re doing all this to lower your tax bill now and have it increase at some point in the future.  Make no mistake, at some point or another you will need to pay taxes on your gains, it’s just a matter of when.

Obviously, having more money now instead of giving it to the government is a good thing, even if you’ll have to give it up later.  Beyond that, there is the potential to create real dollar savings instead of just delaying when you pay taxes.

Capital gains and qualified dividends are taxed at three different rates, depending on your income.

Income (for married couple) Tax rate
$0 to $77k 0%
$77k to $600k 15%
$600k+ 20%

 

If you can use tax loss harvesting to influence when you pay taxes on those capital gains, there is the potential to recognize them when you’re in a lower tax bracket.

For Foxy Lady and me, we are in that middle tax bracket, so we would pay 15% on any capital gains and qualified dividends.  However, if we did harvesting now and then recognized those gains in a year when our income was lower (below that $77k threshold), it’s possible that we could lower our rate from 15% to 0%.  That’s real savings.

 

Doesn’t that defeat the purpose of investing

When you tax loss harvest you’re selling your investments, obviously.  That could lead to another problem that you’re pulling your money out of the market, and you’re pulling your money out when stocks are down which seems like the absolute worst time.  Likely you don’t want to do that; certainly, all other things being equal, pulling your money out at a loss isn’t what we’re going for with investing.

Actually, you can just trade your investments.  So you can sell mutual fund ABC at a loss and simultaneously use those proceeds to buy mutual fund XYZ.  You get the benefit of the tax loss but stay in the market.

The IRS understands this and has rules.  You can’t sell ABC, recognize the loss, and then immediately buy back ABC.  You have to wait 30 days to do that round trip.

However, you can buy something similar.  The IRS says it can’t be too similar, but they don’t strictly define that so it’s a gray area.  I personally, think it’s fair game to sell a broad mutual fund and buy another that is similar but still different (maybe a total international mutual fund gets sold and a total world mutual fund gets bought).  You are still fully invested and largely have similar exposure, but you get that tax loss which is the whole point.

 

I don’t think this is something that is going to make you rich (like asset allocation or lowering fees—those strategies will make you rich).  But it could net you a couple hundred or maybe even a couple thousand dollars.  Who says “no” to that?

Kids investing in real stocks

For those of you who have been following the Summerfield Open, you know that those tests for 4th and 5th graders had a major focus on applying mathematical principals to personal finance.  Many of the kids got interested in investing because of those questions which led parents to ask me how their kids can start investing in stocks.  Here is how I would approach it.

Of course, remember this is just friendly advice.  I am not an expert and you should call the broker (I suggest Vanguard) or work with a paid advisor.  With that out of the way, here’s what you can do:

 

Fun or boring

We’ve talked ad nauseum on this blog about the best investing strategy being buy and hold index mutual funds.  This is a tried and true approach, but it’s boring.  When you’re thinking about how to get kids excited about and engaged in investing, that’s a conundrum.

You want investing to be exciting for the ankle-biters to hold their attention.  If you’re an ankle-biter who is looking to start investing, the point may be less to make a lot of money.  Rather, it might be to gain experience investing.  Yet, you want them to develop good investing habits that will pay dividends (haha, do you see what I just did?) for the rest of their lives.

With all that, I think you want to have a foundation of correct investing principals (boring), and then try to mix in some fun into that.  Let’s look at those investing principles and see which should apply to the padawans:

  • Diversification—This is a critical concept that you want to have early on. Investing in individual stocks might make it a bit more tangible for the munchkin (you’re investing in Apple which is the type of phone mom has), but I think you can do something similar with a mutual fund or more likely ETF (more on that in a minute).  Individual stocks will be more volatile which will translate to more exciting for a munchkin, but ETFs will definitely have plenty of action.
  • More diversification—As you look to diversify an important concept is “total coverage”. You want to have investments everywhere.  That might be a bit harder for individual stocks because it’s not always easy to know the exposure that a company has geographically (you’re investing in Ford because that’s the car dad drives, but how much of their business is in the Middle East?).  With ETFs you can overtly pick US funds or European funds or Pacific, etc.  That gives a bit of a built in geography lesson too, so there you go.
  • Minimize costs—We’ll have a whole section on this, but costs are especially important for the half-fries. They probably don’t have a lot of money to invest (remember, investing is probably more for the experience than the wealth creation).  With a smaller portfolio a $5 or god-forbid $15 transaction fee to buy some shares of stock would have an outsized negative effect on a $100 portfolio compared to a $100,000 “adult-sized” one (but even adults shouldn’t pay transaction fees).
  • Hold investments for long term—This is critical for wealth creation, but I think we sacrifice that for the tadpoles. Trading is “exciting” and keeps them engaged.  Fortunately, because of the Random Walk there’s no reason to believe that more active trading will negatively impact the portfolio beyond the transaction costs (mentioned above, and again below).  So here I say have a lot of fun and dip your toe in and out of the different investments somewhat frequently to keep it exciting.
  • Track your investments—This is probably even more important for the spuds. As an adult it’s actually a bad thing to be looking at your portfolio all the time.  However, here I think it’s good.  Everyday something will happen with the investments—it’ll go up a lot or down some or something.  There are amazingly great math lesson here—calculating returns, making graphs of what’s going on.  If you want, as a parent you could really dig in and make this a huge adjunct math course.

 

Setting things up

Fair warning, the advice I am giving here might be illegal.  I strongly recommend you talk to an investment professional as you do this.

Unfortunately, to set up a brokerage account that allows you to trade in stocks or ETFs or what ever, you need to be 18.  So that’s a problem for the half-pints.  As a parent you would need to take said half-pint’s money and invest it in your (adult’s) account.  Technically, the money will belong to the adult, but perhaps you can make a deal with your half-pint to “promise” it will go back to them.  Seriously, the IRS does allow gifts between people (I think the limit is $10,000 per year), so I don’t think it should be too big a deal, but do understand the technicalities.

All our investments are at Vanguard, and that is where I would go.  You can go to www.vanguard.com, select “Open an account”, say you’ll fund it with a check, and then pick a “general savings account”.

There will be a lot of questions that you’ll need to fill out and then with things like your social security number, a username and password, and other stuff.  Get all that done, and then you can call them up and ask for deposit slips so you can send them a check to fund your account.

 

Minimize costs

Once everything is set up and the money is in your account, you will get to the fun part which is picking your investments.  Here I would suggest ETFs, which basically act like stocks—you buy them in whole shares and they trade throughout the day—but they are really like a mutual fund in that they invest in hundreds of companies.

This is where Vanguard really shines.  You can open your account for no minimum and then invest as little as one share (each share is typically between $50 and $150).  If you invest in a Vanguard ETF (they have a ton of high quality ones—here) they don’t charge any transaction fee.  So you can trade and out of them as much as you want.  Obviously, you don’t want to be silly, but that works well for juniors who want to experience the trades.

If you want to invest in individual stocks or non-Vanguard mutual funds there is a fee (I think $7 per trade), but I don’t really think there’s any reason to do that.

There are ETFs for everything.  For a little dude, I would suggest equities, and here are a few that you might consider:

  • VTI—all US companies
  • VB—small US companies
  • VT—all companies in the world
  • VXUS—all international companies
  • VDE—energy companies (industry specific)
  • VHT—healthcare companies (industry specific)

 

As you know, I have a huge passion for investing and helping kids.  If you’re doing this and need some help navigating things, please let me know.

Top 5—Financial moves when the stork is coming

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A lot of our readers are starting their families or have younger kids.  Foxy Lady and I have been so blessed to bring two wonderful little cubs into the world.  As you embark on parenthood and rearing little ones, what are the financial considerations you need to make?  Surprisingly, I don’t think there are all that many:

 

5. Set up your health insurance. Depending on when you find out your pregnant, the chances are you will have an enrollment period with your health insurance.  Foxy Lady and I screwed this up twice since both of our boys were born in October (we found out we were pregnant in February so we missed the open enrollment while pregnant), but let’s imagine that found out that we were pregnant in October and the baby was due in June.

When open enrollment comes around every December and goes in effect in January, we would have bought the primo policy that gives the best coverage.  Normally, we don’t pick the Cadillac policy that our work offers because we’re relatively healthy and don’t go to the doctor a lot.  Under normal circumstances we get a middle-of-the-road policy.  If we happen to have a medical issue (like with ‘Lil Fox in 2014) we know we’ll spend a little more in out of pocket, but that doesn’t happen very often so we generally come out ahead.

However, when you’re expecting you know for sure you’re going to spend a lot of time in the hospital and you’re going to have a lot of doctor’s visits, and that gets expensive.  If you know this is coming, get the insurance policy that has the higher premium every paycheck but then covers most or all of those expenses.  Had we done this with our boys, we probably would have saved $3000-4000 on each little guy.  As it is, I’ve told both boys they owe us that money and it should be treated as a loan accruing interest, but neither has acknowledged the righteousness of my claim.

 

4. Set up your flex spending account. Similar to #5, if you’re having a baby you know you’re going to have some medical expenses. Make sure at open enrollment you set up your flex spending account to pay for those.  With flex spending accounts you can pay for medical expenses using before-tax dollars.  So that $2000 you had to pay with pre-tax dollars only feels like $1300.

Also, once you have kids, you can use a flex spending account to pay for childcare.  The government allows up to $5000 per child to be tax deductible (I’m not a tax expert, but that’s my understanding) if you use a flex spending account.  Spending $5000 in pre-tax dollars instead of after-tax dollars is pretty sweet.  And for childcare it seems like a no-brainer that amounts to about $1500 per year.  Most of us know for sure that we’re going to have childcare expenses.  Why not spend the hour it takes to save that money (if $1500 isn’t worth an hour of your time, then I’d like for you to help me with my finances).

 

3. Steel yourself against crazy “baby” spending. Definitely when you are going to have a baby there is a lot of stuff that you need, and this is especially true for your first child.  But for everything item that you do need there are probably 5 that you don’t need.  Baby stuff has become a big business and the people who market this stuff are smart.  They know you want the best for your child, and they aren’t above pulling on your heart strings to let you think that you “need this to be a good, loving parent.”

We did get the diaper genie and are glad we did.  We never got the bottle warmer, and never missed it for a second.  We got a pee tent (when you’re changing your son’s diaper and keeping him from peeing everywhere between diapers) and never used them.  We got three strollers with our first—a regular that the car seat fits into, a jogger, and an umbrella stroller—and used all three but we never have really used the tandem stroller once Mini Fox joined his brother.  There are a million more examples but you get my point.

This isn’t a baby blog, so I’ll stop there.  Just understand my point is that you can spend hundreds and thousands and tens of thousands of dollars on baby stuff, much of which you won’t need and none of which will make you love your baby any more.

 

2. Start a 529 account. If you are planning on paying for some or all of your child’s education (that’s a big “if” and one I covered here), a 529 is a no-brainer.  Basically, a 529 allows you to take after-tax money and invest it for your kid’s education.  That money can grow tax free so when you take it out you won’t pay any taxes on it.  In that way it’s very similar to a Roth IRA.

Doing back of the envelop math, if you saved $500 per month for your child’s education that would give you about $200,000 after 18 years.  Of that $200k, about $110k would be what you put in and $90k would be what you gained on your investments.  Without a 529 you would be taxed on that $90k gain; depending on your tax bracket that could be $30-40k you would owe Uncle Sam.  With a 529 you get to keep that.  Think about that for a second—basically the tax advantages of a 529 buy you another year of college.  It’s like buy three years, get the fourth year for free.

 

1. Love. This is a finance and investing blog so I always focus on money, but with your baby your love is a million times more important than anything you can do that has a dollar sign attached to it.  There will be some costs, a few of which we discussed above, but not as many as you’d think.  You’ll spend some on diapers and formula, as much or as little on clothes as your fashion sense (or lack thereof) allows, and you’re pretty much set.

Very often, somewhat to your chagrin, they’ll find more joy in the box that expensive toy comes in than the toy itself.  Library books are free, and children’s books in general are pretty inexpensive, so reading to your kids (one of the best things you can do according to child development experts) is pretty cheap and really rewarding.  And walks to the park and rides on the swings are still free.  As is keeping your cool when your kid puts one of his rubber balls under the treadmill, having it sucked into the motor so now it makes a funny noise.

As you embark on parenthood it’s a crazy rollercoaster.  Sure there are a couple financial bows you have to tie, but I don’t believe near as many as a lot of people would have you believe.

 

Happy parenting.  For those parents out there, what were the major financial items you had to take care of when your bundle of joy arrived?

Thinking about your home equity in retirement

Sometimes my logic just doesn’t add up.  When ever I think about the Fox family’s retirement, or when ever I work with clients and discuss their retirement, I never consider the value of our/their home.  That seems crazy, especially when you look at national statistics.  The average American has a net worth of $80k, of which about $55k is their home equity!!!  That means that for the average American 70% of their net worth is in their home, yet that’s something I don’t incorporate when I think about retirement.  What gives?

 

Your home as an investment

To start, it’s worth thinking about your house as an investment.  As investments go, especially over the long-term, houses don’t perform nearly as well as other types of investments like stocks (I did a whole blog on this point).

You’re always going to hear stories about people who made a killing when they sold their house.  Like fish stories, you only hear about the “wins” and not from the people who didn’t do that well.  Also, a lot of people think about the “gain” of the sale, comparing what they originally bought the house for and what they sold it for, yet they don’t factor in all the maintenance and home improvements they put in.

The point is that I think most people and certainly the mass media tend to romanticize the idea of houses as an investment.  I think the performance is much more modest.

 

Your home as a shelter

Obviously, your home serves a very practical purpose as a shelter.  It keeps the rain off your head, protects you from the bad guys (as Mini Fox would say), provides storage for your crap, etc.  That’s the rub, and makes your home fundamentally different from other, more traditional investments like mutual funds or other securities.

Even in retirement you need that shelter, so it’s not like you can sell your home and use the proceeds to fund your lifestyle (actually, maybe you can, but there’s some deep water there that we’ll talk about in a few minutes).  So you’re stuck in the middle—you need the shelter your home provides, but your home represents a large portion of your savings nest egg.  What to do?

 

Options (and why they are problematic)

As we’ve discussed, you’ll probably need about $5000 to $10k per month in retirement to support a moderate, middle-class lifestyle.  That will go to food, vacations, healthcare, and all the other stuff you’ll need.  Oh, by the way, you’ll also need shelter—a roof over your head—so let’s think about how that would go.

Option 1—At some point, maybe when the kids leave the house, you can sell the home you own, take all the equity and put that into your investments, and rent for the rest of your life.  This isn’t a very popular option, yet I think it has a lot of really positive features (see my comparison of renting versus buying).   The proof of the pudding is in the eating, and very, very few retirees with at least a moderate investment portfolio do this.

Option 2—When the kids leave you can downsize, selling your larger family home for a smaller one that accommodates two older people rather than a nuclear family.  This allows you to get a less-expensive home, pocket the equity and put that money in your investment portfolio, and go forward.  This allows people to use that home equity to support their retirement, but the problem is still there, albeit smaller.  You still will own a home that ties up a bunch of your net worth.

Option 3—Do a reverse mortgage.  This is a bit of an obscure strategy with a number of complexities that probably deserves its own post.  Basically, you take your home equity and borrow against it—let’s say taking out $3000 per month to fund your lifestyle.  There are a lot of details here with a lot of fees (that make it less attractive), plus it “forces” you to stay in your home which may be a good thing or a bad thing.  That said, this solves a lot of the problems we discussed.

 

What does it all mean?

It’s clear there are some complexities with this, and I don’t think there’s a clear approach that you should take.  Counting your home equity in your net worth can definitely expose you to not having enough liquid funds to pay for things like food, healthcare, etc.

On the other hand, not counting that money at all seems to be really, really conservative.  After 30 years, our mortgages will be paid off and we’ll have an asset that is potentially worth hundreds of thousands of dollars.  That needs to be incorporated somehow, right?

Basically, I calculate everything as though there is no home equity.  When I look at the Fox family’s financials or those of the clients I help, I know that what ever those numbers (just the investments) say, there’s some upside.  It’s a stupid game we play with ourselves, but that’s how I do it.  If our finances were so close (what I had was right at what I needed), I would definitely start dissecting the home equity value more.

Usually, though, I set the goal for myself and my clients that their investment accounts (brokerage, IRA, 401k, etc) should be enough to fund their retirement.  Then their house can be upside which gives a bit of a cushion for posher retirement or for unexpected expenses which may arise.

Sweet—a really important item in personal finance that defies an easy answer.  That’s how I do it.  How do you think about your home equity?

Problem solved: Race Relations

We are living in a country where race relations are at a multi-generational low.  Despite decades of approaches and policies meant to improve things, up to this point it doesn’t seem to have gotten better (it actually seems to have gotten worse).  Maybe personal finance can move the needle?  Admittedly, personal finance isn’t going to solve every issue, but I think it is uniquely positioned to make a major impact, all the while without redistributing wealth in a way that makes it a dead-on-arrival policy.  Let’s dig in:

 

Income (and net worth) inequality

Data show that there is a huge difference between the haves (whites, Asians) and the have-nots (hispanics, native Americans, and blacks).  Just for simplicity, for the rest of this post we’ll contrast the black/white differences, although this entire post could easily be about black/Asian or hispanic/white or hispanic/Asian and the concepts would be nearly identical.

Race Income (2015) Net worth (2013)
Asian $80,720 $112,250
White $61,349 $132,483
Hispanic $46,882 $12,458
Native American $39,719 N/A
Black $38,555 $9,211
TOTAL $57,617 $80,039

 

The median income for whites is $61k and the median income for blacks is $39k.  That’s a big difference, but the difference becomes even more pronounced when you look at net worth–$130k for whites and $9k for blacks.

The income disparity gets A TON more press than the net worth disparity, and that’s a big miss.  You don’t eat income or use income to buy a house or pay for college: you use net worth for that.  Obviously they are closely related, yet they are different, and the data shows just how uncorrelated they are.

Racial challenges are multi-dimensional, very complex, and nuanced.  There’s no single path to address all of them, but I think you get the biggest bang for your buck by closing the income/net worth gap.  Obviously, by definition, closing the income gap addresses the income gap (incredible insight there, Stocky) and also goes a long way in addressing the net worth gap.

It also addresses a lot of other racial issues: interactions with law enforcement—police have infinitely fewer negative interactions with rich people than poor people. Education—rich people have much better access to high-quality education at every level than poor people.  Healthcare—exact same statement as education.  Political voice—exact same statement as education.  And on and on.

So the challenge is how to increase the income, and more importantly the net worth, of blacks to get it closer to the levels of whites?

 

Net positive, not sum-zero

This becomes a delicate subject.  An obvious solution is wealth distribution based on race.  To address the net worth issues, we as a society could tax white people and give those proceeds to black people.  This actually has a name: Reparations.

Michigan congressman John Conyers had introduced a reparations bill in every Congress since 1989.  Every single time, the bill never came to a vote and “Died in a previous Congress”.  Given it didn’t even have the support to come to a vote it’s hard to imagine having the support to pass both houses of Congress and get the President’s signature, plus withstand the legal challenges.   I would certainly be opposed to such legislation.

While people can have a lively debate about reparations in particular, they are extremely unlikely.  Broadening that out a bit, I think the idea of punishing/taxing/taking away from one race of people to give to another just isn’t realistic or moral.

That speaks to net worth disparity (give net worth from one race to another), but there is a similar train of thought on income disparity.  We could take certain high paying jobs and force companies to employ blacks but not whites.  This again causes similar challenges.

Actually, this played out in real life recently at Youtube.  Allegedly, they excluded white and Asian men from consideration for some roles.  I’m not certain to the legality or illegality of this, but from a PR perspective this is a practice that Youtube (they are owned by Google) vigorously denied.  They said they hire “candidates based on their merit, not their identity.”  If a private-sector company in an at-will state won’t publicly say they do this, there’s zero chance such a practice would be codified with legislation.

Getting back to the task at hand, that means we can’t address the income and net worth gap by taking from whites and giving to blacks.  We have to find a way to increase the income and net worth of blacks that has no impact (or dare I say a positive impact) on whites.

 

It’s what you do

If you read this blog, you know I am an enormous advocate of personal finance, and “doing the right thing” with your money, whatever that means.  We live in a country with very low financial literacy, which means that people don’t really understand concepts of compound interest, appropriate asset allocation, tax avoidance strategies, and much more.  That applies to all races.

That ignorance comes at a huge cost.  Take two twins, Bill and Jill.  Bill represents your average American who isn’t too financially savvy, while Jill knows the best ways to invest her money.  If they are identical in every way—same job, same salary, same income growth, etc.—Jill will end the game much, much wealthier than Bill.

Just to put numbers to it, let’s assume they each start at 22 with a $50,000 job that grows to $150,000 over time, and they save 10% of their income.  At age 60 Bill would have $630,000 and Jill would have $2,640,000.  Read that again!!!  Jill ends up with a full $2 million more than her twin.

How does such a thing happen?  They both made the same incomes, and they both saved the same amount.  The short answer is Bill wasn’t smart and Jill was.  Bill saved all his money in a brokerage account with a mix of stocks and bonds.  Jill saved her money in a 401k (tax avoidance), got the match (free money), and invested in all stocks (asset allocation).

Those are all fairly simple strategies for personal finance, certainly they are ones we have talked about on this blog quite a bit.  Those couple gems translate to millions of dollars, literally.

But what does this have to do with race?  Unfortunately in our country, personal finance participation is much lower among blacks than whites.  That’s short hand for: blacks tend to act more like Bill than Jill.  “Personal finance participation” is a tricky term that loosely means having investment accounts, having retirement accounts, investing in stocks, and generally doing what personal finance theory says you should.  Make no mistake, it’s an impossible term to define and calculate (which is probably why it’s such a hard problem to tackle).

Certainly you can look at the difference in “personal finance participation” as a function of wealth.  Whites are richer than blacks so of course they are going to have more brokerage accounts and 401k’s and all that other stuff.  That’s true, but even when you control for jobs and income and the other factors like that, black “personal finance participation” is significantly lower, 35% lower by some estimates.

That impact is ENORMOUS and devastating if your broad societal goal is reducing net worth disparity.  If you believe the studies, and use our example of Bill and Jill, the average black person is getting 35% less of the investment gains that Jill got.  That’s could easily be a difference of $600k (in reality is probably even more) and that’s HUGE.

GOAL 1—Increase black “personal finance participation”

 

It’s what you know

Education is a pretty powerful tool, and one that certainly plays a role in the black “personal finance participation” issue as well as the broader income inequality issue.

In college there is a striking disparity between the majors that black students and white students pick.  Statistically, black students tend to pick majors which lead to much lower salaries than their white peers.  That alone can address the income gap in a major way.

However, we’re going to go deeper into the world of finance.  Finance is a pretty good college major, as majors go.  I proudly earned my bachelor’s degree in finance from Pitt.  The average salary for finance majors is $120k.  In a country where the average income for the whole population is $58k, being a finance major seems to be a pretty sweet deal.

Breaking down that by race tells a profound story.  About 14% of all college students are black, in line with the total population—that’s a good thing.  A similar 14% of all business majors are black—so far so good.  However, only 2% of finance majors are black—Houston, we have a problem.  Similar to the issue a couple paragraphs above, finance is a high-paying major and black students are picking it way too infrequently.

That leads to two major problems:  First, those classes for finance majors are a great way to learn the skills critical to “personal finance participation”.  Remember, that accounted to $2 million that Jill had which Bill missed out on.  If you take finance courses, you’re much more likely to be a Jill than a Bill.

Second, finance majors get high paying jobs—remember the average salary is about $120k.  More to the point of this post, finance majors can become investment advisors (much, much more on this in a second).  Data is hard on this, but most estimate that only about 1% of investment advisors are black.  As it is, the decisions black college students are making when choosing a major are cutting them off from all of this.

GOAL 2—Black college students major in finance

 

It’s who you know

Let’s start bringing all this together, shall we?

About 45% of blacks are in the middle class.  Add rich blacks to that as well and you’re talking at least 20 million people.  That’s a lot.

Based on the “personal finance participation” statistics we know a lot of those people aren’t investing the way they should, and they are missing out on a lot of money because of that.  This is true among all races.

I am a financial advisor (I passed my series 65), and my experience tells me that the vast majority of highly-successful professionals, independent of their race, aren’t doing near what they should be doing with their finances.  On a scale from 1 to 10, I see a lot of 3s and 4s among people who are incredibly smart and successful.

Fortunately, those people who would be a 3 or 4 on their own can hire someone, and for a small fee bring them up to a 9 or a 10.  Jill showed us that being a 9 or a 10 can be worth $2 million (and really it’s a much, much larger number), so if you aren’t there on your own hiring someone to help you seems like a good idea.

Understandably, if you hire a financial advisor, that needs to be an incredibly trusting relationship.  Personally, all my clients I knew for at least 5 years before I ever started advising them; also, they’re all white and my age, plus or minus a couple years, and live in my time zone.  Once you start working with a client it becomes a very intimate relationship.  You learn all sorts of super personal things about your clients—what they spend money on, what are their goals, what do they try to do but fail at, etc.  I think it’s even more intimate and personal and trusting than a doctor or a lawyer or a minister/rabbi.

The point of all this is: who are those rich and middle-class blacks going to go to for financial advice?  It’s reasonable, and not racist in any way whatsoever, that they would have a preference (possibly unconsciously) for a black financial advisor.  Not because of skin color per se, but because of shared experiences and understandings.  Someone who grew up how you did, had a similar family dynamic, have similar likes and tastes, prioritizes things in a similar way—those are all really good reasons to pick one advisor over another.  Those all correlate strongly with race.

A black person is probably going to have a lot more in common with a black financial advisor.  It’s not that you can’t pick someone from a different race for your financial advisor, but there’s an undeniable level of comfort for many.  Here’s the rub, at least based on my experience, if you don’t find a financial advisor you’re really comfortable with you don’t often pick the “next best thing,” but rather you don’t use anyone.  “Not picking anyone” tends to lead to “not doing anything” and you start to look much more like Bills than Jills.

Let’s be clear, a good financial advisor of any race can help a client of any race.  No question.  But we live in the real world, and here those personal relationship and trust dynamics are powerful.  This isn’t racism, it’s just being comfortable and having a trusting relationship with someone who is dealing with an incredibly personal part of your life.

Clearly the data show this is happening.  Blacks participate in personal finance at much lower rates—they’re closer to Bills.  And that costs them millions.

GOAL 3—Black financial advisors to work with black clients

 

Everyone wins, no one loses

Black college students become finance majors and then financial advisors.  Because they can relate to middle-class and wealthy blacks better, they get those clients and increase their wealth (becoming Jills instead of Bills).

We wanted to close the income gap.  We just found thousands of really high paying investment advisor jobs for blacks.

We wanted to close the net worth gap.  We just converted millions of black families from Bills to Jills by connecting them with highly skilled financial advisors.

Clearly, those are two winning cohorts, but there are no losers.  As blacks become better investors, that really doesn’t impact the investment returns of whites.  The stock market is more like a club with room for everyone, than it is like a high school basketball team where there are only so many spots and if you get a spot that means I don’t.  Also, those black financial advisors aren’t taking clients away from white financial advisors; those black clients weren’t using anyone before so it’s all upside.

 

My local plan

I’ve been trying this with very limited progress so far.  I haven’t gotten past step 1, but I’m not giving up.

  1. Find a couple black college seniors from UNC-Greensboro or North Carolina A&T who are finance majors. Unfortunately, as I mentioned, there aren’t a lot of these and I haven’t had luck so far. But I’m still trying.
  2. Teach the protégés the ins and outs of investing, not necessarily investment advising but just investing. Actually, it would really just be telling them “read all the posts I’ve done in my blog, understand the concepts inside and out, and then come to me with questions.” We’d work together and get them extremely financially literate.
  3. Go to a large gathering of rich and middle-class black people (a church, an NAACP meeting, fraternity alumni meeting, whatever) with my protégés . Tell the audience the story of Bill and Jill, and say I’m here to help.
  4. Work with a couple clients, taking my protégés to every meeting. Legally, the protégés wouldn’t be able to talk or do anything since they aren’t certified, but they could observe and build a non-investment advisor relationship with the client.
  5. Protégés would graduate, then pass their Series 65 or Series 7, and get a job with some investment company. Completely out of left field 😉, the clients I had been working with in the presence of the protégés would leave me for them.
  6. Protégés would take my clients to their new firms. Given most financial advising jobs are meat grinders where getting new clients is the toughest part, my protégés would have a HUGE head start. That would translate to a higher income, faster promotions, and altogether a better career.
  7. Rinse and repeat.

Championship—Asset allocation v. Tax optimization

Basketball hoop

This is what we’ve all been waiting for.  After two weeks of amazing investing tournament challenge action (just indulge me, will you?), in this post we will crown the champion of investing strategies.  Here we have Asset allocation taking on Tax optimization.  In the Final Four, Asset allocation pounded Index mutual funds with higher returns early on and limiting risk as you approach retirement.  Tax optimization made it two thrillers in a row, beating Savings rate on the strength of major tax savings with a little bit of work and education, but not a lot of monetary sacrifice.  As always, see the disclaimer.

bracket-game 6

Obviously both these strategies have tremendous upside, otherwise they wouldn’t be here.  So how do you pick between them?  It’s no easy task, but for you, my loyal readers, I’m ready to take it on.  Let’s see who cuts down the nets.

 

Reasons for picking Asset allocation:

In some ways Asset allocation seems really easy, since all you’re doing is figuring out what percentage of your portfolio goes into stocks, bonds, and cash.  90% Stocks, 10% bonds, and 0% cash; there, I’m done.  That didn’t seem so hard.  Obviously it’s more complicated than that.  We already know that Asset allocation is critically important throughout your investing time horizon.  When you’re younger you probably want to be mostly in stocks (even now the Fox family is 99% in stocks).  As you approach and ultimately enter retirement you want to be more in bonds, but stocks still probably need to be a significant part of your portfolio.

About 10 or so years ago, the mutual fund companies came out with a really cool innovation called target-date funds.  The basic idea is that these handle your Asset allocation for you.  Imagine today you’re 35 and you want to retire when you’re 60, in 2040.  You could invest in a fund like Vanguard’s Target Retirement 2040, and it will automatically shift your Asset allocation from mostly stocks today (currently it’s about 90% stocks, 10% bonds) to gradually less stocks and more bonds as you get closer to retirement.  It’s been a wonderful innovation that has proven extremely popular among investors.

So there you go.  Problem solved, right?  Well, not so fast.  I actually don’t think these really solve the Asset allocation problem because they figure everyone retiring in 2040 is in the same situation, but that’s definitely not the case.  Let’s say you and your twin retire in 2040, but you will get $1000 from Social Security while she’ll get $3000.  What if she had her house paid off completely while you have always rented?  What if you worked for a company with a 401k and she worked for a company with a pension?

All those scenarios are very real for investors, and require more individualization than knowing you want to retire in 2040 can give.  For all those, conventional wisdom would say that your twin should take on more risk (French for “invest in more stocks”) than you because she has other “assets” that are generating more cash.  Reasonable people can debate that last point, but clearly the idea is that Asset allocation is much more complex than just picking a year and being done with it.

So where does that leave us?  I am a firm believer in investing DIY, and Asset allocation is no different.  But I think this is one of the areas where the degree of difficulty is much higher just because you’re balancing a couple opposing forces and there’s never a clearly “right answer”.  You want to be in stocks but not too much in stocks, and then that changes over time.  Oh yeah, and the stakes are super-high.  Getting it “right” whatever that means could give you an extra few percentage points in return and it could also save your nestegg from catastrophic failure if another 2008 rolls around.  When I work on the Fox’s nestegg, this is probably where I spend the most time.

 

Reasons for picking Tax optimization:

As we’ve said ad nauseam, Tax optimization is important and can lead to enormous savings.  What makes taxes so difficult is that the tax code is constantly changing and the stakes are super-duper high (the stakes for Asset allocation were only “super high”).

Every year there are hundreds of changes to the tax code which keeps accountants employed and programs like Turbo Tax (the Fox family uses Turbo Tax) flying off the shelves.  With the new tax reform bill that just passed, there were major changes to your taxes like the deductibility of mortgage interest and local taxes.  Those changes have massive implications on choices of where to live–both at the level of which state to live in but also whether to buy or rent.  These were huge and made the news.  What about the others that do hit the media’s radar and you never hear about?

There’s always talk about more changes, perhaps profound ones like a wealth tax.  You have to keep up.  Also, it can get really confusing.  I think I’m fairly knowledgeable on these matters but I am still befuddled by the Alternative Minimum Tax, and I know I screw up the foreign interest paid on my international mutual funds.  This stuff definitely isn’t easy.

Also, look at the stakes.  If you screw up on your taxes, theoretically you could go to prison.  If it’s an honest mistake I don’t think the Internal Revenue Service will push it that far, but horizontal stripes are definitely in play as Wesley Snipes can attest.  What is more likely is the IRS will hit you with a fine composed of a penalty plus interest.  Oh, by the way, that interest rate is about 6%; that’s not “Pay-day Loan” high, but it’s still pretty freaking high these days.  That certainly can make someone cautious about how far to push Tax optimization, even when they’re clearly in the right.

However, there is a silver lining.  If you want professional help, there are thousands of Certified Public Accountants who are there to help you out.  For under a few hundred dollars most people can probably have their taxes done by a CPA who can make sure that you stay on the IRS’s good side.  Unfortunately, when it comes to developing creative Tax optimization strategies, my experience says there’s a huge range in quality that you’ll get from CPAs.  Several years back I had a horrible experience with H&R Block and thought they were border-line incompetent.  No way would I trust them to advise me on the finer points of maximizing the tax advantages of investing.  But there are amazing CPAs out there right now (like David Silkman who did our small business’s taxes when we lived in California) who I do think can really help.  But this is a real caveat emptor situation.  Maybe Angie’s List might help.

 

Who wins it all?

It all comes down to this.  In the end, I have Asset allocation pulling it out 76-70.  Obviously both investing strategies are amazingly important and getting them right can have an exponential impact on your portfolio.  For me I gave the nod to Asset allocation over Tax optimization for a couple of reasons:

First, if I met a total train wreck of an investor (he was just stuffing cash in his mattress) and I could only give him one piece of advice, I think it would be to get that money invested in some combination of stocks and bonds.  Tax optimization strategies like an IRA or 401k are nice, but first things first.

Second, I think the big rocks for Tax optimization seem to me better understood and more accessible than for Asset allocation.  Most investors probably know that investing in your 401k or an IRA is a good idea, and probably most could tell you why (at least be able to say “it helps with taxes”).  I think that’s different for Asset allocation where you have a lot of investors who are totally off on what is probably appropriate for their situation (age, income, other assets, etc.).

Third, there’s no real “right” answer for Asset allocation.  I could have a lively debate with my dear friends/loyal readers who work in the financial industry like Jessamyn and Mike, where we argued whether the Fox family should be more in stocks or more in bonds.  But there’s no right answer (other than if stocks go up a year from now, then you know you should have been more in stocks).  It depends on so many variables as well as risk tolerance which are super-hard to quantify.  With Tax optimization you can get closer to a right answer—either the tax code allows you to do that or not.  Of course, you typically sacrifice ease of access to your money for tax benefits, so that does add a complication.

Finally, I think it’s easier and cheaper to get expert advice on Tax optimization.  As I mentioned, a good CPA can probably really help guide you on Tax optimization.  Sure, the quality of CPAs is pretty wide, but good ones are out there, and probably they’ll charge you something with in the three-digit range.  With Asset allocation if you want professional help you typically need a financial adviser.  Unfortunately, and this is just my opinion, it’s a little more Wild West for financial advisers than CPAs.  A really good financial adviser is probably worth her weight in gold (140 pound of gold is worth about $2.6 million, so maybe they aren’t worth quite that much), but the range of quality is staggering; there are some real shysters out there.  Also, they’ll probably charge you in the four- or five-digits range.

So there you go.  Put that all together and I think Asset allocation comes out on top 78-71, finishing the sentence, “if you only do one thing in investing make sure you get Asset allocation right.”

bracket-end

 

I hope you have enjoyed reading all these posts on investing as much as I have enjoyed writing them.  While Asset allocation “won” remember that all eight of these are important and should be definitely be considered as you think about bulking up your portfolio.