Tag Archives: investment fees

Individual Investors Should Treat Obtaining Financial Advice Like Buying a New Car

29 Tuesday Oct 2019

Posted by in asset allocation, behavioral finance, Consumer Finance, financial advice, financial advisor fees, financial advisory fees, financial goals, financial markets, financial planning, financial planning books, financial services industry, Income Taxes, Individual Investing, individual investors, investing, investing advice, investing information, investing tips, investment advice, investment advisory fees, investments, personal finance, reasonable fees, reasonable fees for financial advisor, reasonable fees for investment advice, reasonable financial advisor fees, risk tolerance, stock market, Stock Market Returns, stock prices

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I had a long conversation with a friend and business associate about how I think individual investors approach obtaining financial advice.  We went back and forth for almost 30 minutes.  However, I found myself stumbling upon the analogy of purchasing a new vehicle.  This analogy encapsulates how individual investors might want to think about building their investment portfolios, setting financial goals and how to obtain them, establishing their risk tolerance, and addressing any special situations that might pertain to their specific situation (e.g. caring for an elderly parent in their house).  I should state at the outset that, if you have more than $1 million in investable assets (i.e. an accredited investor), the size of your portfolio demands special attention.  If you have not amassed $1 million, please read on to the rest of this article.

First, I would like to lay out the typical new vehicle purchase scenario and then turn to its applicability in the case of financial advice.  Most people start off the process by doing a good deal of research on the available options.  After considering his/her situation, the individual will go to the vehicle dealership.  For the purposes of this particular example, let’s suppose that the vehicle dealership offers a number of different car manufacturers as options and then the various models associated with them.  Luckily today, there is a lot less haggling (well at least upfront in the process) and the vehicles’ prices are normally right around the MSRP.  However, you as a consumer need to select the car make and also the specific model.

Usually a salesperson will assist you with the process.  Even though you can do a lot of homework prior to picking out a new vehicle, it still does not fully capture actually looking at the vehicle.  Of course, you also need to sit in it and take a test drive.  The salesperson is able to translate what your needs are to try to select the best option.  For example, do you need to transport the kids to basketball practice?  What if you take turns carpooling and pick up an extra 3-6 kids?  How big should your SUV be?  What if you drive a lot of highway miles and a lease option may not work for you?  Do you like to have a decent amount of horsepower to be able to merge onto highway traffic?  What about the manufacturer’s warranty?  Does the dealership service the vehicles onsite?  What about financing options (i.e. buy or lease)?  The list of questions could go on and on.

Given the entire list of questions you might ask, the salesperson is an integral part of the vehicle buying, or leasing, process.  After the salesperson has finally answered all of your questions, let’s say you decide on a price, the financing options, and the color/options/model.  If you make the purchase, the salesperson will earn a commission.  Once you leave the dealership’s parking lot, you are then responsible for the maintenance of the vehicle.  Fingers crossed, you should only need to take car of oil changes and normal maintenance (e.g. changing the air filter, flushing the transmission fluid, etc.).  What would you do if the salesperson came over to your house and wanted to check if you were still pleased with the vehicle you selected in the second year?  Does it fit your needs and perform as expected?  Wow, that experience would be one of pretty good customer services.  But now, the salesperson’s next utterance is that you own him/her $500.  What?  Well, he/she responds that he/she helped you out and things are going according to plan.  My guess is that you would be dumbfounded and refuse to pay another commission to the salesperson in year two of ownership.

What in the world does this have to do with financial advice?  I would argue that the analogy fits quite well with the normal way financial advice is given to individual investors.  When you first sit down with a Financial Planner, Financial Advisor, or Registered Investment Advisor, he or she really walks through your entire life situation.  Additionally, that person will assess your tolerance for risk which is not always as easy as it sounds.  Usually most financial professionals will include questions that relate to your behavior under certain instances of financial market conditions.  So, you cannot simply ask only objective yes/no questions.  Other big thing that may come up are any insurance, tax planning, or estate planning needs that you have.  Another significant area is trying to find out if you might have any special circumstances.  The caring of an elderly parent was provided above.  But there are myriad other situations that might require special planning considerations unique to your family.

The vast majority of financial professionals no longer charge commissions.  Rather, they will charge a fee based upon the total asset in your portfolio of stocks, bonds, other assets, and cash.  The financial services industry calls this an AUM (assets under management) fee in the jargon, and a very typical fee that one will see is 1%.  What does that mean?  Well, to use round numbers, let’s say you have $1 million dollars in your account of financial assets.  You would then pay a fee of $10,000 ($1 million * 1%).  To be technical though, the fee is normally prorated over four quarters throughout the year and not in one lump sum.  Given all the assistance that I listed in the previous paragraph, there is no doubt that the financial professional earns his or his AUM fee.  But what happens when year two of your financial relationship begins?

For illustrative purposes, I am going to assume that your life situation does not change at all.  In the first year of your relationship with the financial professional, he or she is likely to have prepared an asset allocation for at least the next five years.  One would expect a long-term investing plan.  Of course, he or she may recommend that based, upon the price movement in the financial markets, you should reallocate your investments to either the same target allocation in year one or slightly different percentages.  He or she may even recommend that you sell a particular investment and replace it with what he or she deems to be a better performing investment vehicle for the future.  Well, to keep using round numbers, if your investment portfolio stays constant, you would pay another $10,000 (again $1 million * 1%).

The year two situation is akin to car maintenance in year two of your ownership of that vehicle from my car vehicle purchase analogy.  Now, if you blew a head gasket in your car’s engine, you would want to take the vehicle back to the dealership or go to a trusted mechanic.  The latter represents a major change in your life situation, financial goals, income tax ramifications, and other major events.  Otherwise, we have a situation where you are paying the car salesperson another commission in year two.  Now my analogy may not be entirely “apples to apples” (as my business associate said during our discussion).  However, it is close enough to get to the point that I am trying to make in terms of financial advice.  You need to be very cautious with how much money you pay in expenses for financial advice.  Why?  It really eats into the investment performance returns you will realize.  I am all for paying for financial advice when there is a complicated situation, but, if nothing of import changes, it can be hard to justify.

So, what can you do if my analogy resonates with you?  Well, there are two options that I will provide.  However, there are other avenues to proceed down.  I will discuss each in turn.

First, you can select a financial professional that charges a fee-only amount or one that charges by the hour.  The fee-only financial professional will charge you a set amount per year for financial advice, and, in almost all cases, it is significantly lower than the $10,000 in our example.  The hourly financial professional is just as it sounds.  In the second year, you might require 10 hours of financial advice throughout the year, some of which might include just coaching you through the inevitable volatility in financial markets.  Depending on the area that you reside in, you can expect to pay anywhere between $250 to $500 per hour.  Using the 10-hour amount, you would be paying anywhere from $2,500 ($250 * 10 hours) and $5,000 ($500 * 10 hours).  Using either type of financial professional with a different fee structure will lower your overall investment fees.  Note that the quality of financial advice usually does not decrease in most cases.  And yes, there are certain cases where the quality will increase markedly.

Second, you can use an external investment account at the beginning of your relationship with a financial professional that charges a percentage of assets under management (AUM).  What does this mean?  The vast majority of asset managers are large and sophisticated enough to handle this arrangement at the outset.  For example, you would establish an investment account where your financial professional is located.  Next, you would establish an investment account with another brokerage firm and allow your financial professional to have access to the investment portfolio you maintain.  Note that the access is only for purposes of preparing reports for you and not to execute actual trades of stocks, bonds, mutual funds, or any other financial asset.  For instance, you might keep 50% with the financial professional’s firm and another 50% in the external account.  You would just maintain the portfolio allocation that your financial professional would like you to have in the external account.  In order to ensure that you do not deviate from his or her investment recommendations, your monthly or quarterly investment performance reports would lump together the assets at the financial professional’s firm and your external account.

In regard to the second option, just because asset managers can easily do this reporting for you, does not mean that they will not push back.  Some asset managers and financial professionals get even confrontational.  It is understandable since the more assets you maintain at their firm the larger the investment advice fee.  But this response can be very informative for you.  If your financial professional does not handle your request of this potential option diplomatically, this may be a cue to seek financial advice elsewhere.

So, have I successfully convinced you that buying investment advice is just like buying or leasing a new vehicle?  My guess would be that you think the analogy is not a perfect one.  I will readily admit that it is not and really is not meant to be.  Rather, I wanted to get you thinking about the financial advice you receive and investment fees from another viewpoint.  Investment fees have an outsized effect on the returns that you will experience over time.

Their impact is even greater if you take into account the “opportunity cost” of investment fees.  However, that is another topic entirely that I will not delve into.  If you would like more information on the idea of “opportunity cost” and investment fees, you can refer to a previous article that I wrote.  Here is the link:

https://latticeworkwealth.com/2014/02/26/what-is-the-800-pound-gorilla-in-the-room-for-retirees-it-is-12-5/

How to Rebalance Your Investment Portfolio – Part 2 of 3

29 Wednesday Jul 2015

Posted by 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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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 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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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

Does it even matter if your Financial Advisor adheres to suitability requirement or acts as a fiduciary? Resounding YES!

18 Monday Nov 2013

Posted by in asset allocation, bonds, business, Consumer Finance, Education, Fiduciary, finance, financial planning, Individual Investing, investing, investing, investments, stocks, bonds, asset allocation, portfolio, investments, personal finance, portfolio, stock prices, stocks, Suitability

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A great debate is raging on in the financial services industry regarding the concept of suitability and fiduciaries.  In fact, many firms in the financial services industry are lobbying hard with millions of dollars to keep suitability as the “law of the land”.  What is the difference even?  Does it make a difference in the investments and asset allocation strategy recommended to you?  Well, the financial services industry does not want to change the status quo away from suitability; I can assure you of that.  In order to answer that question better, I will provide an analogy below to try to explain the concept more clearly.

Imagine that you have a son or daughter who is finishing up his or her senior year in high school.  He or she has done remarkably well academically and has participated in many extracurricular activities.  Your child is interesting in pursuing a degree in engineering and is not quite sure what school to go to and if mechanical or biological engineering might be the right path.  A sensible and perfectly natural approach would be to consult the high school guidance counselor to get some insight.  The guidance counselor may recommend the local university in town.  The guidance counselor knows that they offer a degree in engineering.  Let’s say your son or daughter report back with excitement at the prospect of going off to college and starting on the path to a career in engineering.

 After you have that conversation, you run into a friend who you “brag” to about the news.  However, that friend is an engineer and mentions that there is a well-respected engineering program only 75 miles away.  That university is known as one of the best in, not only in the state, but in the region.  You are still very proud of your son or daughter but cannot understand why the guidance counselor did not mention that option.  You decide to go to the guidance counselor and ask what his process was when he talked to your son or daughter.  The guidance counselor simply states that your child mentioned that he/she wanted to go into an engineering program.  The local university offers an engineering program, and it is accredited as well.  When you ask why the other university was not mentioned, the guidance counselor replies that his job was only to find a school that had the degree your son or daughter needed.  It was not his job to find the best option.  Needless to say, you would be extremely perturbed or worse.

That little story can serve as the backdrop for the issue of suitability and fiduciaries.  There are some financial professionals that offer advice based upon suitability.  Other financial professionals are considered to be fiduciaries.  Suitability is more akin to the way in which the guidance counselor handled the meeting with your son or daughter.  The job was only to find a school that fit the needs.  Finding a better option was not really thought of or necessary.  The friend actually put you on the path to how a fiduciary approaches things.  A fiduciary would find the best option given all the information about your son and daughter and his/her future plans.

Now the definition of suitability and how a fiduciary must act are really complex from a legal standpoint and the corresponding requirements needed to follow either.  A fiduciary has additional legal responsibilities to you as a client.  In order to be a fiduciary, there are strict rules on compensation, products that meet your financial goals, investment expenses, and conflicts of interest.  What might a conflict of interest be?  Well, a good example is that many financial services firms have proprietary asset management arms and investment products.  If that firm manages your recommended portfolio components, additional revenue goes to that firm.  Another example might be that many mutual fund offerings provide the financial professional with lucrative 12b-1 fees that are referred to in the industry as trails.  A trail simply means that the financial professional receives an annual amount based upon a specified percentage applied to the client accounts that he/she has with the mutual fund company.  Another favorite offering is variable annuities.  These types of products offer extremely high payouts which are applied to the face value of the insurance policy.  It can be very tempting to offer the variable annuity with the highest payout as long as the underlying investments are acceptable (i.e. they invest in large cap stocks that were one portion of your proposed portfolio allocation).

Now I am not saying that anyone who only has to adhere to suitability requirements will automatically place you into investments that have higher fees for you or are better for his/her year-end bonus.  My point is that a fiduciary must adhere to higher standards of conduct and act truly independent.  A fiduciary runs the risk of additional liability if they breach their duty to you as a client.  A financial professional that only has to recommend suitable products has a much lower hurdle to get over.  As long as he or she recommends a mix of stocks, bonds, and alternative investments that meets your financial goals, that is all they have to do.  Of course, that financial professional may suggest the exact same products that a fiduciary would.  However, they are not required to recommend offerings that are the best in terms of investment fees and the best financial product available given your circumstances.

The important thing to remember is to always ask your financial professional whether or not he/she is a fiduciary.  If not, you want to ask them how they come up with solutions that are suitable for you.  You can even ask them if there are other options available.  If you see recommendations that are heavy on the mutual funds of the firm you are dealing with or life insurance products with large amounts of legalize and complicated forms, you should delve deeper into that financial professional’s logic.  You definitely should ask what form of compensation and amount he/she will receive and if any revenue goes to the firm from that financial product.  Additionally, I would ask them why a more low cost, passive approach might achieve the same objective but be less expensive for you.  Some of the responses might surprise you.  If the answers seem to sound more like the guidance counselor, I would urge you to seek a second opinion before you choose that financial professional and start an account with that investment portfolio.

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

11 Monday Nov 2013

Posted by 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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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 Investment Fees Higher Than Your Taxes? Probably.

22 Tuesday Oct 2013

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

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There are two important ratios that most individuals do not pay enough attention to.  In fact, the financial services industry rarely, if ever, makes mention of them.  They are as follows:

–          The first ratio measures the amount of your investment fees paid versus the total federal, state, and local income taxes you pay.

–          The second ratio measures the amount of investment fees paid versus your total income.

Why are these two ratios so important?  First, they bring to your attention the absolute dollar amount of investment fees paid to your Financial Advisor, your brokerage firm, and other third parties.  Second, you will note that, although you cannot choose to ignore paying your income taxes, you can lower the total amount you spend on financial and investment advice.  Lastly, you can think about what other uses you might have for the money you spend currently on investment fees either in whole or in part.  Let’s talk briefly about how to calculate these ratios and then delve into their usage in more detail.

The ratios are fairly easy to calculate.  The first ratio is investment fees paid versus total federal, state, and local income taxes you pay.  Luckily, most people do not pay local income taxes, and several states have no income tax.  If you do have one or both of these taxes, you simply add the total taxes due together from all three sources.  Note there is a big difference between taxes paid and taxes due.  If you received a federal and/or state tax refund, you still paid taxes into the system.  A refund is simply an adjustment to ensure that you only pay your fair share according to the tax code.  You would add up the taxes due to federal, state, and local agencies on your income tax returns.  Your investment fees come directly from your brokerage statement(s).  The two most common expenses are asset under management (AUM) fees and commissions.  You would add up all the AUM fees and commissions charged to your over the course of the year.  The only other number you need is to take your Adjusted Gross Income (AGI) from your federal tax return.

As I have stated in previous posts, the most common AUM fee is 1%.  So let’s take a common scenario for retirees today.  For illustrative purposes, assume there is a retiree with a $1 million portfolio in a 401(k) account that withdraws $50,000 and is charged a 1% AUM fee.  The total AUM fee would be $10,000 for the year.  If the retiree also has Social Security income of $20,000, the second ratio would be 14.3% ($10,000 / ($50,000 + $20,000)).  What does that percentage mean?  The percentage shows you that your investment fees are equivalent to 14.3% of your annual income.  Now the total taxes paid by each individual will vary greatly.  However, the average taxpayer tends to pay around 10%-15% in federal and state income taxes.  In our assumed scenario above, the total income taxes due would be $7,000-$10,500.  The first ratio is either 142.9% ($10,000 / $7,000) or 95.2% ($10,000 / $10,500).  What does that percentage mean?  The percentage shows that in the higher tax situation you are paying essentially the same amount in income taxes as you are in investment fees.  The lower tax situation shows that your investment fees are 42.9% higher than your income taxes.  No matter which way you slice it, you are in a high “investment fee” bracket.  The investment fees you are paying are yet another drag on the net income you end up having for living expenses and for leisure activities.  To a great extent, your income taxes are fixed in any given year unless you have an unusual income stream occur.  Your investment fees are variable every single year.

Now I am not saying that you should no longer use a Financial Advisor or go to your investment firm.  Please do not mistake that as my message.  However, I am recommending that you calculate those two ratios to bring the investment fees to your attention.  You can then make the choice regarding whether or not you might want to seek out a fee-only or hourly Investment Advisor or Financial Planner.  Or you might want to investigate if you have the knowledge or can acquire the knowledge how to manage your own investments.  What would be the incentive of those two alternatives?  Obviously I am biased, but nothing like these stories inspire me more.  My parents are in the grouping that would be charged roughly $10,000 per year in investment fees.  They are lucky enough to not require a Financial Advisor to whom they would pay a 1% AUM fee or similar level.  I recently found out that they will be taking a two-week cruise in Europe next month for essentially that same amount.  My father is fine with the vacation because he knows my mother deserves a relaxing time after her recent (and successful) battle with breast cancer, and he has listened to my logic in terms of the “savings” that they have each year.  You might debate the term “savings”.  I simply use the term due to the fact that they are taking a cruise rather than paying a Financial Advisor and his/her firm.  It is the same choice that you have when it comes to how you would use your money, if you did not have to pay an AUM fee.

For many other people, the monies can be used to help family and charities while you are still alive.  For example, you could decide to pay $10,000 toward your grandchild’s college education or add money to your grandchildren’s’ 529 college savings plans.  Or, if you have 15 grandchildren, you might choose to buy all of them an iPad for the holidays.  Conversely, the charitable uses for the money are almost as endless as your imagination.  One particularly interesting idea with Thanksgiving coming around the corner is paying for dinners for disadvantaged families.  The average family spends roughly $50 for a Thanksgiving dinner each year.  That figure sounds quite low to me.  What if you gave 130 families $75 toward their Thanks giving dinner next year?  If you wanted to split the monies between your family and charity, you could buy 65 dinners instead.  Imagine being able to allow an entire square block of families be able to enjoy a great meal or how many more free Thanksgiving meals a homeless shelter could serve with $5,000.    The great thing about this new-found freedom is that you will avoid the $10,000 AUM fee the following year again.  You can choose to do the same thing the following year in whole or in part.  Why not choose to get to know two local families, sponsor them, and pay for their groceries for the entire year?

Note that there is nothing that says you cannot see a fee-only or hourly Investment Advisor or Financial Planner.  You might pay $250 per hour for four hours or a flat fee of $1,000 on an annual basis.  In that scenario, you would be saving $9,000 ($10,000 – $1,000).  Plus, there is another thing that retirees fail to realize most of the time.  There is no rule that says you have to keep all your money at one full service brokerage firm.  There are many individuals that maintain an account at a full service brokerage firm and have another account with most of their funds at a discount brokerage firm.  The full service brokerage firm will want you to transfer the funds over to them, but I worked for years preparing performance reports for high net worth clients.  Many of them had money at other firms, and we simply included that information as data points in a customized report that showed all their assets and returns of their portfolio.  If your firm balks at you moving monies from them and tells you they might drop your account, I would seriously consider why you are at that firm anyway.  You can ask your Financial Advisor what value he/she provides that necessitates your keeping all your assets there.  I would encourage you to show him/her your two ratios and use that to start the discussion.

There may be certain cases where it is difficult to find your investment fees.  If you are not paying any commissions or an AUM fee, I certainly assure you that your Financial Advisor is not managing your money for free and he/she a nice person.  You should ask what fees you are paying.  Did you pay a load to purchase a mutual fund?  What is the expense ratio of your mutual funds or variable annuities?  There is a multitude of ways to charge fees, and it is in the best interest of a financial services firm to not disclose each of them.  Now I will clarify here.  You will most certainly get a financial note that says you are charged x percent, but it is quite rare for that percent to be changed into an actual dollar amount for you to view.  For the aforementioned scenario above, the firm should say that your AUM fee is 1% which is equal to $10,000.  The latter figure is much more impactful.

What are good benchmarks for the ratios discussed above?  The first ratio measures your investment fees versus your total income taxes.  A ratio of 10%-15% is a great target.  The second ratio measures your investment fees versus your total income.  A target of 1%-3% is a great target.  If you are accustomed to dealing with a Financial Advisor, it is quite unlikely that your ratios will approach those levels.  However, as previously mentioned your investment fees are variable and can change.  Your Financial Advisor may make the argument that he/she is needed to ensure your income taxes are strategically planned.  Well, he/she should have been doing that all along, right?  Isn’t that one of the reasons why you are currently working with a Financial Advisor?  If you have a tax plan in place and are not expecting an unusual sum or source of income, the additional cost of having a Financial Advisor as a “tax expert” is usually not a good cost/benefit option.  Why?  Does it make sense to pay a Financial Advisor an extra $9,000 per year over a fee-only Investment Advisor to ensure you do not pay an extra $1,000 in income taxes?  The net cash flow for you is a decline of $8,000; remember you can always consult your tax accountant or financial planner for an hourly consultation whenever a tax situation comes up.  Furthermore, you can arrange to meet with either party for at least one hour per year to speak only about taxes.

Lastly, I strongly encourage each of you to open a checking account at a bank or credit union that you only use to pay investment fees and income taxes.  It is very easy to find a checking account that charges no monthly fee whatsoever, especially at a credit union in your area.  There may be cases where it is inadvisable to pay investment fee via a checking account.  Why?  Well, you would have to withdraw the money, pay federal and state income taxes, and then send the money to your financial services firm.  In that case, I would encourage you to pay your investment fee with a check from your home equity line of credit.  Most of the time, you will be paying 3-5% in interest on a home equity loan.  The tax-equivalent interest rate at today’s levels is approximately 1.95-3.75%.  In order to highlight the level of investment fees paid, it is well worth paying an additional $200 or so in interest on your home equity loan.

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 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

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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.