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How to Rebalance Your Investment Portfolio – Part 2 of 3

29 Wednesday Jul 2015

Posted by wmosconi in asset allocation, bond market, bonds, Consumer Finance, financial advice, financial goals, financial markets, financial planning, investing, investing advice, investing information, investing tips, investment advice, investment advisory fees, personal finance, rebalancing, rebalancing investment portfolio, stock market, stocks

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asset allocation, bond market, bonds, consumer finance, finance, financial advice, financial markets, financial planning, financial services, investing, investment advice, investment advisory, investment advisory fees, investment fees, investments, personal finance, portfolio, portfolio allocation, portfolio management, rebalancing, stock market, stocks

In the first part of the discussion on rebalancing your investment portfolio, I outlined its definition and the most common method to do so. The web link to that particular post is listed below:

https://latticeworkwealth.com/2015/07/16/how-to-rebalance-your-investment-portfolio-part-1-of-3/

As a reminder, the definition of rebalancing is the periodic adjustment of one’s investment portfolio back to the original allocation percentagewise to the various asset classes. Over the course of time, the financial markets will vary up and down and one’s investment portfolio will change. However, the individual investor will normally have a plan on how to invest in order to reach his or her financial goals while being comfortable with the amount of risk taken by investing in the various asset classes (i.e. stocks, bonds, cash, etc.). Thus, rebalancing is simply ensuring that the investment portfolio is back in line with the original parameters of asset allocation.

In this second part of the discussion on rebalancing your investment portfolio, I will show you a different way to rebalance your investment portfolio. The same general concept applies, but, using this method, one can rely on actual published financial advice. The nice thing about this particular method is that the financial advice is free and from the most and trusted asset managers in the financial services industry. Does that sound too good to be true? Well, I invite your skepticism. That is always a healthy trait whenever someone discusses investing. Let’s delve into this a bit deeper and see if I can’t assuage your fears.

Many of the asset managers in the financial services industry offer something called target date mutual funds or life cycle mutual funds. The naming convention depends on the mutual fund company, but the financial product is the same. The idea behind these mutual funds is that they invest in a certain combination of stocks and bonds depending on when the money is needed. The mutual fund will invest more of the investment portfolio in stocks in the beginning and gradually shift that percentage to bonds and cash as the target date approaches. For example, someone who is forty years old now (2015) and wants to retire at age sixty-five would invest in a target date 2040 mutual fund. Some of the asset managers offering these financial products include Vanguard, Fidelity, and T Rowe Price. The web link to each of these mutual fund families’ offerings are listed below:

Vanguard – https://investor.vanguard.com/mutual-funds/target-retirement/#/

Fidelity – https://www.fidelity.com/mutual-funds/fidelity-fund-portfolios/freedom-funds

T Rowe Price – http://individual.troweprice.com/public/Retail/Mutual-Funds/Target-Date-Funds

Now I will not personally recommend any specific financial product; however, all these mutual fund families have excellent reputations and long track records. The benefit of this rebalancing method is that you can choose a particular target date or life cycle mutual fund that lines up with your financial goal and timeline. Each of these mutual fund offerings must periodically report their investment holdings to investors and are displayed on the mutual fund family’s website. As an individual investor, you need only replicate the recommended investments in that mutual fund. Adjusting your investment portfolio either semiannually or annually is normally sufficient. The added bonus is that you can alter the target date or life cycle mutual fund you select if your risk tolerance is different than what is offered in that portfolio. If you want to take on more risk for potential added rewards in performance returns, you can select a mutual fund with a target date later than your age would indicate. For instance, assume it is 2015 and you want to retire in 30 years, you might opt for the target date 2050 instead of 2045. Conversely, if you want to take on less risk because you are more sensitive to financial market volatility, you can select a target date closer than your age would indicate. In this case, assume it is 2015 and you want to retire in 30 years, you might opt for the target date 2040 instead of 2045. Let’s take a closer look at how this works in terms of the nuts and bolts.

For purposes of illustration only, I will utilize the product offerings of the Vanguard family of mutual funds. Assume that it is 2015 and you have 20 years until retirement (2035). Furthermore, assume that you have a normal risk tolerance for financial market volatility. If that is the case, you would select the Vanguard Target Retirement 2035 Fund (Ticker Symbol: VTTHX). The asset allocation of that target date mutual fund as of June 30, 2015 is as follows:

Asset Allocation as of June 30, 2015
Mutual Fund Percentage
Vanguard Total Stock Market Index Fund 53.9%
Vanguard Total International Stock Market Index Fund 28.1%
Vanguard Total Bond Market II Index Fund 12.7%
Vanguard Total International Bond Market Index Fund 5.3%
Total 100.0%

Essentially you now have an investment portfolio that selects investments for your investment portfolio to achieve your financial goals without paying a Financial Advisor. Those investment advisory fees may be 1% to 2% (or higher) of your total investment portfolio each year. Using this rebalancing approach those fees are avoided, but you are still able to see what professional money managers are recommending for free. Now there are two courses of action at this point. First, it is possible to simply invest in this particular fund through the Vanguard mutual fund family. However, you will incur additional expenses for the fund family to manage the money and make the periodic percentage allocation adjustments. Those expenses do vary by fund family and are normally somewhat reasonable but are higher at some companies than others. Second, it is possible to invest monies into ETFs or index mutual funds that match the percentage allocations to the various asset classes. Admittedly, there are times when the commissions incurred to do so are higher than simply having the mutual fund family invest in the various funds for your investment portfolio. With that being said, there is a way to invest in ETFs for free.

One of the nicest offerings that not enough people know about is that Fidelity Investments offers the BlackRock iShares ETFs free of commission. While not all of the iShares are offered, there are currently 70 ETFs registered in the program. These ETFs have some of the lowest expense ratios (percentage fee charged on assets; normally 0.20% or less per year) in the business, and the range of ETFs should cover most any recommended target date or life cycle mutual fund investment pieces you might choose to use. The current list of the iShares ETFs from Fidelity that are free from commissions are as follows:

Commission-Free iShares ETFs at Fidelity Investments – https://www.fidelity.com/etfs/ishares-view-all

The reason one would use this method to build an investment portfolio and rebalance along the way is that expenses are minimized throughout the investing process. Many investors are not aware how much “seemingly small” expenses add up and compound over time. Decades and/or years worth of fees as small as 0.50% or 1.00% annually can erode thousands, tens of thousands, or more from your investment portfolio. Which makes it harder for you to reach your investment goals or necessitates taking on more risk in order to reach the goal than you might be comfortable within your investment portfolio. (For more information on that topic, you can view one of my earliest blog posts via this web link: https://latticeworkwealth.com/2013/07/11/is-learning-about-investing-worth-it-how-about-224000-or-320000-worth/).

Here’s a summary of the usefulness of this particular rebalancing approach for your investment portfolio. You may know when your financial goal is going to come due to pay or provide for, have a general idea of the risks you are willing to take, and know a bit about the types of asset classes for investment available. However, you may lack the confidence or specific expertise to know how to create an investment portfolio and allocate percentages of money to the various asset classes. The nice thing about this method is that you can “piggyback” off of the investment ideas of some of the best money management firms in the financial services industry. You initially invest the money in your investment portfolio as is indicated on the mutual fund family’s website. Then every six or twelve months (preferably mid-year or end of the year; the most common interval is twelve months) the investment portfolio is rebalanced to exactly match the way the target date or life cycle mutual fund is currently invested in.

Book Promotion on Amazon.com – A New Paradigm for Investing: Can Your Financial Advisor Answer These Questions?

14 Thursday May 2015

Posted by wmosconi in book deals, books, business books, finance, finance books, finance theory, financial advice, Financial Advisor, financial advisor fees, financial markets, financial planning, financial services industry, investing, investing advice, investment advice, investment advisory fees, investment books, investments, personal finance, reasonable fees for financial advisor, stock market, stocks

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book deals, books, business, business books, finance, finance books, financial advice, Financial Advisor, financial markets, financial planning, financial services, financial services industry, investing, investing books, investment advisory, investment advisory fees, investment books, investment fees, investments, personal finance, reasonableness of finance advice, stock market, stocks

Greetings to all my loyal readers of this blog.  How would you like to learn a better way to seek investment advice?  I list and thoroughly discuss questions you can ask prospective Financial Advisors when interviewing them.  Selecting someone to assist you with the process, which is so incredibly important for you, can be a nightmare of complexity.  By reading this book, you will be in the 95th percentile of individual investors in terms of the knowledge necessary to have the tools and information to walk into those Financial Advisor meetings and understand the discussion/jargon and feel confident.  This book on Amazon.com is available for download onto a Kindle.  Additionally, there is a Kindle app for iPhones and Android devices which is free to download.  Please feel free to check out the title below.  I have provided a link to make it easier.   My email address is latticeworkwealth@gmail.com should you have any questions/comments/feedback.

The link to the book is as follows:

A New Paradigm for Investing:  Can Your Financial Advisor Answer These Questions?

 

http://www.amazon.com/New-Paradigm-Investing-Financial-Questions-ebook/dp/B00F3BDTHW/ref=sr_1_3?s=books&ie=UTF8&qid=1388595896&sr=1-3&keywords=a+new+paradigm+for+investing+by+william+nelson

The book listed is normally $9.99 but I am offering it for a lower price over the course of the week (May 14, 2015 through May 18, 2015).  For most of the day today, the book is $1.99 which is 81% off.  The price of the book will be gradually increasing during the course of that period.

I would like to thank my international viewers of my blog as well.  The blog can be located at http://www.latticework.com.  I also wanted to especially thank some selected followers of my @NelsonThought and @LatticeworkWlth Twitter accounts (each of whom I would recommend following for the content and insight):

Followers on @NelsonThought:

  • The Wall Street Journal Wealth Report @WSJwealthreport – #wsjexperts
  • The Wall Street Journal Central Banks @WSJCentralBanks – Coverage of the Federal Reserve and other international central banks by @WSJ reporters
  • The Royce Funds @RoyceFunds – Small Cap value investing asset manager
  • Research Magazine @Research_Mag – Latest industry information for wirehouses and ETFs
  • Barron’s Online @BarronsOnline – Weekly financial news magazine of Dow Jones
  • Cleveland Fed Research @ClevFedResearch
  • Pedro da Costa @pdacosta – Central banking and economics reporter at The Wall Street Journal
  • Muriel Siebert & Co. @SiebertCo
  • Roger Wohlner, CFP® @rwohlner – Fee-only Financial Planner for individuals
  • Ed Moldaver @emoldaver – #1 ranked Financial Advisor in New Jersey by Barron’s 2012
  • Muni Credit @MuniCredit – Noted municipal credit arbiter
  • Berni Xiong (shUNG) @BerniXiong – Author, writing coach, and national speaker

Followers on @LatticeworkWlth:

  • Tracy Alloway @tracyalloway – US Financial Correspondent at Financial Times
  • Vanguard FA @Vanguard_FA – Vanguard’s ETF research and education
  • EU External Action @eu_eeas – Latest news from the European External Action Service (EEAS)
  • Charlie Wells @charliewwells – Reporter and Editor at The Wall Street Journal
  • Sri Jegarajah @CNBCSri – CNBC anchor and correspondent for CNBC World
  • Jesse Colombo @TheBubbleBubble – Columnist at Forbes
  • Alastair Winter @AlastairWinter – Chief Economist at Daniel Stewart & Company
  • Investment Advisor @InvestAdvMag – Financial magazine for Financial Advisors
  • Gary Oneil @GaryONeil2 – Noted expert in creating brands for start-ups
  • MJ Gottlieb @MJGottlieb – Co-Founder of hustlebranding.com
  • Bob Burg @BobBurg – Bestselling author of business books
  • Phil Gerbyshak @PhilGerbyshak – Expert in the use of social media for sales

The Two Numbers the Financial Services Industry Does NOT Want You to Know Available on Amazon.com

11 Monday Nov 2013

Posted by wmosconi in asset allocation, bonds, business, Charity, Consumer Finance, Education, Fed Taper, Federal Income Taxes, Federal Reserve, finance, financial planning, Income Taxes, Individual Investing, interest rates, investing, investing, investments, stocks, bonds, asset allocation, portfolio, investments, math, personal finance, portfolio, risk, State Income Taxes, stocks

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bonds, consumer finance, economics, expense ratios, finance, finance books, financial advice, Financial Advisor, financial planning, financial services, financial services industry, investing, investing books, investment advisory, investment advisory fees, investment fees, investments, retirement, saving for retirement, selecting a Financial Advisor, stocks

I wanted to pass along the latest installment of my book series, A New Paradigm for Investing that I have published on Amazon.com.  The subtitle is The Two Numbers the Financial Services Industry Does NOT Want You to Know.  Have you ever struggled with trying to determine how much value you get for the investment advice you are paying for?  It can seem like everyone has the same “pitch” and the same fees.  Since you are entrusting a Financial Advisor or other financial professional with a large part of your net worth and financial future, you deserve to know exactly how fees work in general.  I am by no means advocating dumping the individual you have developed a relationship with.  Rather, I would like to provide some insight into investment fees and how much they actually are when compared to your annual income.  I assure you that, if you are utilizing a full service brokerage firm or other advisory services, these figures will astound you.

Note that this book is available for download onto a Kindle.  Additionally, there is a Kindle app for iPhones and Android devices which is free to download.  Amazon.com prime members can borrow the book for FREE. I have provided a link below to make it easier.   My email address is latticeworkwealth@gmail.com should you have any questions/comments/feedback.

The link to the book is:

A New Paradigm for Investing:  The Two Numbers the Financial Services Industry Does NOT Want You to Know:

 

http://www.amazon.com/New-Paradigm-Investing-Financial-Services-ebook/dp/B00GCQACF4/ref=sr_1_1?s=books&ie=UTF8&qid=1384183129&sr=1-1&keywords=a+new+paradigm+for+investing+by+william+nelson

I would like to thank my international viewers as well.  I also wanted to especially thank some selected followers of my @NelsonThought and @LatticeworkWlth Twitter accounts (each of whom I would recommend following for the content and insight):

Followers on @NelsonThought:

The Wall Street Journal Wealth Report @wsjexperts – #wsjexperts

The Royce Funds @RoyceFunds

Research Magazine @Research_Mag

Barron’s Online @BarronsOnline

Vanguard FA @Vanguard_FA

Cleveland Fed Research @ClevFedResearch

Pedro da Costa @pdacosta – Reporter for Reuters covering economics and the Federal Reserve

Muriel Siebert & Co. @SiebertCo

Roger Wohlner, CFP® @rwohlner

Ed Moldaver @emoldaver

Sylvia Maxfield @sylviamaxfield

The Shut Up Show @theshutupshow

Berni Xiong (shUNG) @BerniXiong

Followers on @LatticeworkWlth:

Euro-banks @EuroBanks

Direxion Alts @DirexionAlts

Charlie Wells @charliewwells – Editor of the Wall Street Journal Wealth Experts

AbsoluteVerification @GIPStips

Investment Advisor @InvestAdvMag

Gary Oneil @GaryONeil2

MJ Gottlieb @MJGottlieb

Bob Burg @BobBurg

Melody Campbell @SmBizGuru

TheMichaelBrown @TheMichaelBrown

Phil Gerbyshak @PhilGerbyshak

MuniCredit @MuniCredit

D.J. Rob-Ski @DJRobSki

Are Your Financial Advisor’s Fees Reasonable? Are You Actually Adding More Risk to Your Ability to Reach Your Long-Term Financial Goals? Here is a Unique Way to Look at What Clients Pay For

26 Saturday Oct 2013

Posted by wmosconi in asset allocation, bonds, business, Consumer Finance, finance, financial advisor fees, financial planning, Individual Investing, interest rates, investing, investments, math, Modern Portfolio Theory, personal finance, portfolio, reasonable financial advisor fees, statistics, stock prices, stocks, volatility

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asset allocation, bonds, conflict of interest, finance, financial advisor fees, Financial Advisors, financial planning, FINRA, gross fees, investing, investment advisory, investment advisory fees, investments, net fees, performance, portfolio, reasonable financial advisory fees, retirement, stocks, total returns

More and more financial professionals are charging clients based upon assets under management (AUM).  A common fee is 1%.  The fee for a $1 million portfolio would be $10,000 ($1,000,000 * 1%). Now you have heard me talk about the importance of keeping fees as low as possible.  Essentially you are trying to maximize your investment returns each year.  If you have quite a few needs, a Financial Advisor usually can provide a number of different services and advice.  For example, you also may need assistance with legal and tax advice.  Additionally, you may have more complex financial planning needs.  Financial professionals will assist you with portfolio allocation always.  Now I am going to look at AUM fees in a way that you may not be familiar with.  I can tell you already that the financial services industry will not be happy or agree with this presentation.  However, my goal is to help you and provide you with an argument that may finally give you the impetus to manage your own investments or think seriously about working with a financial planner that charges fees on an hourly basis.

I also encourage you to read the Wall Street Journal’s Weekend edition for October 26, 2013.  On the bottom of the Business & Finance section, Jason Zweig discusses the many conflicts of interest that Financial Advisors have.  FINRA (a Self-Regulatory Organization comprised of all brokerage firms) issued a 22,000-word report about fees, conflicts, and compensation of Financial Advisors.  Oddly enough, the words “advice” and “investing” showed up less than 10 times.  The financial services industry is concerned about this matter, so you should definitely take note and learn much more about what you are actually paying for.

Example for Retirees:

I will start out with an example for retirees because they tend to be working with financial professionals already.  If you are retired and not independently wealthy, you are in the wealth distribution phase of your life.  There are some retirees that are permanently in the wealth preservation phase.  Wealth preservation simply means that an investor has enough money to live comfortably, but he/she does not need to deplete his/her investment portfolio.  Furthermore, this investor does not really try to increase the value of his or her investment portfolio.  A retiree in the wealth distribution phase of life is the most common example.  This investor is gradual depleting his/her investment portfolio to pay for living expenses on an annual basis.  Due to the fact that this person is not working anymore and, thus has no income from work, and longevity keeps getting longer, he/she needs have an investment portfolio that is somewhat conservative in nature.  Therefore, it is not reasonable to expect to earn 8% per year.  A more common target return might be 5.5-6.0%.  If you are working with a financial professional who charges you 1.0%, you need to earn 6.5-7.0% on a gross basis in order to get to that target net return.  Now the long-term historical average of stocks is about 8.0%, so the higher your AUM fees are, the more weighting you will need to have in stocks and away from bonds and cash.  Well, we have already gone over that, and most individuals that present information will stop there.  I want to take this even further though.

Let’s say you are a current retiree with $1 million that you are living off of in additional to Social Security income.  You have a target return of 5.5% to fund your desired retirement lifestyle, and your Financial Advisor charges you a 1.0% AUM fee.  Thus, you will need to earn a 6.5% return gross to reach your bogey.  Now I would like to put in the twist, and I want to do a thought experiment with you.  Your Financial Advisor will sit down with you and assess your risk tolerance and ensure that the investment recommendations made are not too aggressive for you.  If you cannot take too much volatility (fluctuation in asset prices up and down over the short term), your financial professional will reduce your exposure to equities.  Well, I like to present information using economic principles as well.  If you just retired and are 65, you have one option right away.  You can simply invest all your retirement money in 10-year Treasury notes issued by the Department of the Treasury.  Treasury notes are free to buy.  All you need to do is to participate in one of the Treasury auctions and put an indirect bid in.  What is an indirect bid?  An indirect bid is simply saying that you would like to buy a set dollar amount of notes, and you are willing to accept whatever the market interest rate set by the auction is.  What is the yield on the 10-year Treasury right now?  The 10-year Treasury closed at 2.51% on October 25, 2013.  When you go to a financial professional, he/she is selecting investments in lieu of you simply purchasing the 10-year Treasury.  Keep in mind that US Treasuries are among the safest investments in the world.  They are backed by the full faith and credit of the US government.  Stocks, bonds, real estate, gold, and other investment options all have an added degree of risk.  With the additional risk, there is a possibility for higher returns though.  How does this relate to your 1.0% AUM fee?

Think about it this way:  why are you paying your Financial Advisor?  You are paying him/her to select investments that can earn you more than simply buying a US Treasury bill, note, or bond.  As an investor, you do not want to just settle for that return in most cases.  With that being said though, you can just start out there and forget it.  You do not need to engage a Financial Advisor to simply buy a 10-year US Treasury note.  This means that you are paying the Financial Advisor to get you incremental returns.  In our example above for a retiree, your target investment return is 5.5%.  If you are able to earn 5.5% during the year, the incremental return is 2.99% (5.50%-2.51%).  Remember that you are paying the Financial Advisor 1.0% in an AUM fee.  Therefore, you are paying the Financial Advisor 1.0% of your assets in order to get you an extra 2.99% in investment returns.  Well, 1.0% is 33.4% of 2.99%.  Thus, you are essentially paying a fee of 33.4% in reality.  Now your financial professional would flip if the information was presented in this way.  He/she would say that it is flawed.  The mathematics cannot be argued with; however, I will admit that many folks in the financial services industry would disagree with this type of presentation.

Remember that you started out with $1 million.  You could have gone to the bank and gotten cash and hid it in a safe within your residence.  AUM fees are always presented by using your investment portfolio as the denominator.  In our example, your investment fee is 1.0% ($10,000 / $1,000,000).  I urge you to think about this though.  Does that really matter?  Of course, the fee you pay to your Financial Advisor will be calculated in this manner.  But what are you paying for in terms of incremental returns?  If you want to calculate what you are paying for (the value that your Financial Advisor provides), the reference to the starting balance in your brokerage account is really moot.  It is yours to begin with.  Therefore, it should be removed from the equation when trying to quantify the value your Financial Advisor provides in terms of investment returns on your portfolio.

Now remember that I said your target investment return was 5.5%.  The long-term historical average of stocks is approximately 8.0%.  If you choose to simply allocate only enough of your investment portfolio in stocks and the rest in cash to reach that 5.5% target, you will select an allocation of 68.8% stocks and 31.2% cash (5.5% = 68.8% * 8.0% + 31.2% * 0.0%).  Note that I am assuming that cash earns no interest at all and that you can select an ETF or index mutual fund to capture the long-term historical average for stocks.  Now your financial professional is working with you to select an investment portfolio that achieves the 5.5% target return, and their investment recommendations will be different than this hypothetical allocation.  With that being said, the hypothetical allocation achieves your target return with a simple choice of two assets (an ETF or index mutual fund and hard currency).  Keep in mind that you will normally have a portion of your portfolio allocated to fixed income.  The 10-Year US Treasury note is trading around 2.50% as of October 25, 2013.  If you allocate your portfolio to 60% stocks, 30% 10-Year, and 10% cash, your expected return would be 5.6%  (60% * 8.0% + 30% * 2.5% + 10% * 0.0%).

Whatever your Financial Advisor is charging you in terms of fees, you need to make that percentage more in your total return on a gross basis such that your net return equals your target return.  In our example above, the assumed AUM fee was 1.0%.  That investment fee means that you have to earn 6.5% on a gross basis because you need to pay your Financial Advisor 1.0% for his/her services.  After the fee is paid, the return on your portfolio would be 5.5% on a net basis.  If we keep the allocation at 30% 10-Year and 10% cash, how much weighting do stocks need to be in your portfolio to ensure that your overall returns is 5.5% after paying your AUM fee?  The answer is 72.7%.  Why?  The expected return of your portfolio is 6.5% (72.7% * 8.0% + 27.3% * 2.5% + 0.0% * 0.0%) before fees.  Given the average retiree’s risk tolerance at age 65 or older, most people do not desire to have a portfolio with 65% or larger allocated to stocks.  Plus, the historical, long-term average of stocks is just that.  It is an average and rarely is 8.0% in any given year.  For example the S&P 500 Index has not had a single down year since 2008.  The returns for 2009, 2010, 2011, and 2012 were 26.5%, 15.1%, 2.1%, and 16.0%, respectively.  The average return over that span was 14.9%.  As of September 30, 2013, the S&P 500 Index was up 19.8%.  Now I am by no means making a prediction for the remainder of 2013 or 2014 for that matter.  However, I wanted to drive home the fact that, if your Financial Advisor sets up your financial plan with the assumption that your stock allocation will earn 8.0% on average, any actual return lower than that estimate will cause you to not reach your target return.  What is the effect?  You will not be able to maintain the lifestyle you had planned on, even more so if there are negative returns experienced in stocks over the coming years.

Essential/Important Lesson:

Let’s look at the next five years starting in 2014.  A five-year period covers 2014-2018.  If you start out with $1,000,000 invested in stocks and plan on earning 8.0% per year, you are expecting to have $1,469,328 at the end of five years.  Let’s say that the return of stocks is actually only 4.0% per year over the next five years.  You will only have $1,216,653 as of December 31, 2018.  The difference is $252,675 less than you were expecting.  The analysis gets worse at this point though.  How can it get any worse?  Well, if you were planning on 8.0% returns from stocks per year, the next five-year period 2019-2023 needs an excess return to catch up.  Thus, if your starting point on January 1, 2014 is $1,000,000, your financial plan is set up to have $2,158,925 as of December 31, 2023.  If you are starting behind your estimate in 2019, the only way you can make up the difference is to have stocks earn 12.2% over that five-year period which is 4+% higher than the historical average.  As you can see underperformance can really hurt financial planning.  The extremely important point here is that a 1% AUM fee will cause you to be even further behind your goals.  Remember that the illustration above is gross returns.  You only care about net returns and what your terminal value is.  Terminal value is simply a fancy way to say how much money is actually in your brokerage account.

Example for Those Saving for Retirement:

For those of you that are saving for retirement, you should use a different bogey than the 10-year US Treasury.  If you are 35 years old, you can simply invest in the 30-year Treasury bond (the jargon on Wall Street is “the long bond”).  The closing yield on the 30-year Treasury on October 26, 2013 was 3.60%.  Thus, I would suggest that you use this benchmark to calculate your incremental return.  If your financial professional tells you that this analysis does not apply to you because you are 45 years old and your timeframe to retirement is 20 years, I would agree.  With that being said though, you can find the current yield on a US Treasury bond with 20 years to maturity.  Most people are familiar with the Treasury yields quoted in the financial media and on financial websites.  Those yields are calculated based upon on-the-run Treasuries.  On-the-run simply refers to the most recently Treasuries sold at auction.  Once the Department of the Treasury sells new bills, notes, or bonds, those last financial instruments are referred to as off-the-run.  Keep in mind that the off-the-run Treasuries still trade on the bond market.  You always can get a current yield for them.  It is harder to find, but it is available on the Internet.  You can find out more information directly on the Department of the Treasury’s website:  http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/yieldmethod.aspx if you wanted to learn about this concept in more detail.  I would never recommend using a bogey less than the 10-year Treasury note though even if you have fewer than 10 years to retirement.  The aforementioned analysis for the calculation of incremental returns and the value-added from your financial professional will apply as in the example for retirees.

I will admit that this is a novel way to look at fees on investment portfolios.  However, there are a number of financial professionals that are using this approach now.  Keep in mind that one of the hardest questions to answer is in regard to the measurement of how much value your Financial Advisor provides.  How do you know if he/she is doing a good job for you?  The more common approach is to look solely at investment returns and compare it to a standard index return(s).  This analysis is meant to supplement the discussion.  I am hoping that this presentation will give you added incentive to seriously consider managing your own investments.  Or at the very least maybe try to find a financial planner that charges an hourly fee or flat fee.  You can pay a financial planner an hourly fee to sit with you and decide if your life situation and the current state of the financial markets warrant a change to your portfolio allocation among asset classes.  That financial planner also can work with you on your emotional intelligence and the urge to sell all your stocks and/or bonds because of current negative news and events.

Of course, I will not dissuade you from seeing a Financial Advisor.  On the other hand, I encourage you to have them walk through the value that they provide for you.  What can he/she do for you that you cannot do for yourself by buying an index mutual fund and US Treasury notes absolutely free?  You can use this analysis as a template for your discussion.  Most financial services firms essentially bundle financial advice.  Even if you do not need legal, tax, and complicated financial planning advice, you are still paying for it.  Now it is nice to have it available to you at any given time, but, if you do not use it or never use it, do you really want to pay for it?  It is very difficult to find financial services firms that can separate out those higher level services and provide advice on portfolio allocation and distribution of income to supplement retirement income only.  The vast majority of investors do not need complex advice though.  For example, the current exemption for estate taxes is $5.25 million.  Thus, if you do not have a net worth more than this, estate planning will not be a major concern.  Furthermore, if you are not planning on setting up a charitable trust for giving, legal advice is not necessary either.  In terms of tax advice, most investors simply have to record capital gains and dividends.  There are some techniques to “harvest” capital losses to reduce capital gains, but that is pretty simple to do on your own.  In terms of sophisticated financial planning, most investors do not have life situations that necessitate the advice (e.g. providing for the long-term needs of a special needs child, concentrated wealth in a family-owned business, significant stock options, etc.).  If your financial services firm offers that advice and you do not use it, you cannot just tell your financial services firm that you do not want to pay for it.  There really is not an ala carte option.  You will pay your 1.0% (or whatever it may be) AUM fee.  The ironic thing is that, if you have a large enough investment portfolio where this advice comes into play, your AUM fee will almost certainly be significantly less than 1.0%.  Doesn’t this make you want to learn more about investments and if you can take more of an active role?  I sure hope so.

I welcome comments/feedback and constructive criticism.  If there are Financial Advisors that totally disagree with my logic and presentation, I would love to hear from you.  I can be contacted at latticeworkwealth@gmail.com.  As I mentioned in a previous post, I wanted to hear from you.  I appreciate the topics selected.  In my next few posts, I will devote some time to discussing the issues that were suggested by you.  I will get back to my normal selections in a week or so.

Are Your Financial Advisor’s Fees Reasonable? Here is a Unique Way to Look at What Clients Pay For

07 Wednesday Aug 2013

Posted by wmosconi in asset allocation, bonds, business, finance, financial advice, financial advisory fees, investing, investment advice, investments, reasonable fees for financial advisor, reasonable financial advisor fees, stocks

≈ 12 Comments

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bonds, business, finance, financial advisor fees, financial markets, investing, investment advice, investment advisory, investment advisory fees, investment fees, investments, reasonable fees for financial advisor, reasonable financial advisor fees, retirement, stocks

More and more financial professionals are charging clients based upon assets under management (AUM). A common fee is 1%. The fee for a $1 million portfolio would be $10,000 ($1,000,000 * 1%). In practice though, the fee is normally charged on a quarterly basis. Thus, you will pay 0.25% in fees based upon your AUM at the end of every quarter: March 31, June 30, September 30, and December 31. Now you have heard me talk about the importance of keeping fees as low as possible. Essentially you are trying to maximize your investment returns each year. If you have quite a few needs, a financial advisor usually can provide a number of different services and advice. For example, you also may need assistance with legal and tax advice. Additionally, you may have more complex financial planning needs. Financial professionals will assist you with portfolio allocation always. Now I am going to look at AUM fees in a way that you may not be familiar with. I can tell you already that the financial services industry will not be happy or agree with this presentation. However, my goal is to help you and provide you with an argument that may finally give you the impetus to manage your own investments or think seriously about working with a financial planner that charges fees on an hourly basis.

I will start out with an example for retirees because they tend to be working with financial professionals already. If you are retired and not independently wealthy, you are in the wealth distribution phase of your life. There are some retirees that are permanently in the wealth preservation phase. Wealth preservation simply means that an investor has enough money to live comfortably, but he/she does not need to deplete his/her investment portfolio. Furthermore, this investor does not really try to increase his or her investment portfolio. A retiree in the wealth distribution phase of life is the most common example. This investor is gradual depleting his/her investment portfolio to pay for living expenses on an annual basis. Due to the fact that this person is not working anymore and, thus has no income from work, and longevity keeps getting longer, he/she needs to have an investment portfolio that is somewhat conservative in nature. Therefore, it is not reasonable to expect to earn 8% per year. A more common target return might be 5.5-6.0%. If you are working with a financial professional who charges you 1.0%, you need to earn 6.5-7.0% on a gross basis in order to get to that target net return. Now the long-term historical average of stocks is between 7.0-8.0%, so the higher your AUM fees are, the more weighting you will need to have in stocks and away from bonds and cash. Well, we have already gone over that, and most individuals that present information will stop there. I want to take this one step further though.

Let’s say you are a current retiree with $1 million that you are living off of in additional to Social Security income. You have a target return of 5.5%, and your Financial Advisor charges you a 1.0% AUM fee. Thus, you will need to earn a 6.5% return gross to reach your bogey. Now I would like to put in the twist, and I want to do a thought experiment with you. Your Financial Advisor will sit down with you and assess your risk tolerance and ensure that the investment recommendations made are not too aggressive for you. If you cannot take too much volatility (fluctuation in asset prices up and down over the short term), your financial professional will reduce your exposure to equities. Well, I like to present information using economic principles as well. If you just retired and are 65, you have one option right away. You can simply invest all your retirement money in 10-year Treasury notes issued by the Department of the Treasury. Treasury notes are free to buy. All you need to do is to participate in one of the Treasury auctions and put an indirect bid in. What is an indirect bid? An indirect bid is simply saying that you would like to buy a set dollar amount of notes, and you are willing to accept whatever the market interest rate set by the auction is. What is the yield on the 10-year Treasury right now? The 10-year Treasury closed at 2.67% on August 6, 2013. When you go to a financial professional, he/she is selecting investments in lieu of you simply purchasing the 10-year Treasury. Keep in mind that US Treasuries are among the safest investments in the world. They are backed by the full faith and credit of the US government. Stocks, bonds, real estate, gold, and other investment options all have an added degree of risk. With the additional risk, there is a possibility for higher returns though. How does this relate to your 1.0% AUM fee?

Think about it this way: why are you paying your Financial Advisor? You are paying him/her to select investments that can earn you more than simply buying a US Treasury bill, note, or bond. As an investor, you do not want to just settle for that return in most cases. With that being said though, you can just start out there and forget it. You do not need to engage a Financial Advisor to simply buy a 10-year US Treasury note. This means that you are paying the Financial Advisor to get you incremental returns. In our example above for a retiree, your target investment return is 5.5%. If you are able to earn 5.5% during the year, the incremental return is 2.83% (5.50%-2.67%). Remember that you are paying the Financial Advisor 1.0% in an AUM fee. Therefore, you are paying the Financial Advisor 1.0% of your assets in order to get you an extra 2.83% in investment returns. Well, 1.0% is 35.3% of 2.83%. Thus, you are essentially paying a fee of 35.3% in reality. Now your financial professional would flip if the information was presented in this way. He/she would say that it is flawed. The mathematics cannot be argued with; however, I will admit that many folks in the financial services industry would disagree with this type of presentation. Remember that you started out with $1 million. You could have gone to the bank and gotten cash and hid it in a safe within your residence. AUM fees are always presented by using your investment portfolio as the denominator. In our example, your investment fee is 1.0% ($10,000 / $1,000,000). I urge you to think about this though. Does that really matter? Of course, the fee you pay to your Financial Advisor will be calculated in this manner. But what are you paying for in terms of incremental returns? If you want to calculate what you are paying for (the value that your Financial Advisor provides), the reference to the starting balance in your brokerage account is really moot. It is yours to begin with. Therefore, it should be removed from the equation when trying to quantify the value your Financial Advisor provides in terms of investment returns on your portfolio.

Remember that I said your target investment return was 5.5%. The long-term historical average of stocks is 7.0-8.0%. (I use a range for the long-term historical average because the average will change based upon the universe of stocks you include and your chosen timeframe. In other words, you will see different people tell you that the long-term historical average is various figures). Let’s pick the midpoint of 7.5%. If you choose to simply allocate only enough of your investment portfolio in stocks and the rest in cash to reach that 5.5% target, you will select an allocation of 73.3% stocks and 26.7% cash (5.5% = 73.3% * 7.5% + 26.7% * 0.0%). Note that I am assuming that cash earns no interest at all and that you can select an ETF or index mutual fund to capture the long-term historical average for stocks. Now your financial professional is working with you to select an investment portfolio that achieves the 5.5% target return, and their investment recommendations will be different than this hypothetical allocation. With that being said, the hypothetical allocation achieves your target return with a simple choice of two assets (an ETF or index mutual fund and hard currency).

For those of you that are saving for retirement, you should use a different bogey than the 10-year US Treasury. If you are 35 years old, you can simply invest in the 30-year Treasury bond (the jargon on Wall Street is “the long bond”). The closing yield on the 30-year Treasury on August 6, 2013 was 3.73%. Thus, I would suggest that you use this benchmark to calculate your incremental return. If your financial professional tells you that this analysis does not apply to you because you are 45 years old and your timeframe to retirement is 20 years, I would agree. With that being said though, you can find the current yield on a US Treasury bond with 20 years to maturity. Most people are familiar with the Treasury yields quoted in the financial media and on financial websites. Those yields are calculated based upon on-the-run Treasuries. On-the-run simply refers to the most recently Treasuries sold at auction. Once the Department of the Treasury sells new bills, notes, or bonds, those last financial instruments are referred to as off-the-run. Keep in mind that the off-the-run Treasuries still trade on the bond market. You always can get a current yield for them. It is harder to find, but it is available on the Internet. You can find out more information directly on the Department of the Treasury’s website: http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/yieldmethod.aspx if you wanted to learn about this concept in more detail. I would never recommend using a bogey less than the 10-year Treasury note though even if you have fewer than 10 years to retirement. The aforementioned analysis for the calculation of incremental returns and the value-added from your financial professional will apply as in the example for retirees.

I will admit that this is a novel way to look at fees on investment portfolios. There are a number of financial professionals that are using this approach now. Keep in mind that one of the hardest questions to answer is in regard to the measurement of how much value your Financial Advisor provides. How do you know if he/she is doing a good job for you? The more common approach is to look solely at investment returns and compare it to a standard index return(s). This analysis is meant to supplement the discussion. I am hoping that this presentation will give you added incentive to seriously consider managing your own investments. Or at least maybe try to find a financial planner that charges an hourly fee. You can pay a financial planner an hourly fee to sit with you and decide if your life situation and the current state of the financial markets warrant a change to your portfolio allocation among asset classes. That financial planner also can work with you on your emotional intelligence and the urge to sell all your stocks and/or bonds because of current news and events. I will not dissuade you from seeing a Financial Advisor. On the other hand, I encourage you to have them walk through the value that they provide for you. You can use this analysis as a template for your discussion. Most financial services firms essentially bundle financial advice. Even if you do not need legal, tax, and complicated financial planning advice, you are still paying for it. Now it is nice to have it available to you at any given time, but, if you do not use it or never use it, do you really want to pay for it? It is very difficult to find financial services firms that can separate out those higher level services and provide advice on portfolio allocation and distribution of income to supplement retirement income only. The vast majority of investors do not need complex advice though. For example, the current exemption for estate taxes is $5.12 million. Thus, if you do not have a net worth more than this, estate planning will not be a major concern. Furthermore, if you are not planning on setting on a charitable trust for giving, legal advice is not necessary either. In terms of tax advice, most investors simply have to record capital gains and dividends. There are some techniques to “harvest” capital losses to reduce capital gains, but that is pretty simple to do on your own. In terms of sophisticated financial planning, most investors do not have life situations that necessitate the advice (e.g. providing for the long-term needs of a special needs child, concentrated wealth in a family-owned business, significant stock options, etc.). If your financial services firm offers that advice and you do not use it, you cannot just tell your Financial Services firm that you do not want to pay for it. There really is not an ala carte option. You will simply pay your 1.0% (or whatever it may be) AUM fee. The ironic thing is that, if you have a large enough investment portfolio where this advice comes into play, your AUM fee will usually be significantly less than 1.0%. Does this make you want to learn more about investments and if you can take more of an active role? I sure hope so.

I welcome comments/feedback and constructive criticism. If there are Financial Advisors that totally disagree with my logic and presentation, I would love to hear from you. I can be contacted at latticeworkwealth@gmail.com. As I mentioned in a previous post, I wanted to hear from you. I appreciate the topics selected. In my next few posts, I will devote some time to discussing the issues that were suggested by you. I will get back to my normal selections in a week or so.

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