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How to Create an Investment Portfolio and Properly Measure your Performance: Part 1 of 2

16 Tuesday Jul 2013

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One of the age-old questions when it comes to investing is how to actually construct a portfolio.  Part of the difficulty relates to the fact that there is so much “noise”.  By “noise”, I mean information that comes out on a daily basis which might change your opinion on what to invest in, how to adjust your portfolio, and whether or not you should sell all your stocks and bonds.  It can be quite confusing.  If you watch business TV shows, you will likely see several guests with different opinions.  I usually find that one guest will say that the stock market is poised for a big increase, another money manager will point out why the stock market might fall quite a bit, and we might have a technical  trader say that the stock market is likely to consolidate (i.e. not really move up or down too much).  Well, if you think about things from that vantage point, you are really not getting much information that should affect your risk tolerance and your decision on what investments are best for you.  The guests on business TV shows are telling you this:  on any given day, the stock market might go up, it might go down, or it may be unchanged.  Everyone knows this to begin with!  Today’s big news becomes a backburner item quite quickly.  For example, do you remember the fiscal cliff, sequestration, and Portugal/Italy/Greece/Spain  downgrades on sovereign debt?  It used to be news that was so important that it dominated TV coverage, financial newspaper articles, and even mainstream nightly news.  Long story short, if you have a long-term time horizon, everyday news is not really important to you.  In fact, when you are beginning to invest, I would recommend not trying to keep up with financial news.  The best course of action would be to read a book or two about asset allocation and how the financial markets work in general.

Setting up an investment portfolio is intimidating.  The financial services industry has done its best to drill it into your head that the process is so difficult you have to come to them for advice.  Now that advice comes at a price.  You will usually have to pay a fee based upon your total assets that they management which is referred to assets under management (AUM).  An AUM fee is normally around 1% per year.  Therefore, if you have $1 million, you will pay your Financial Advisor $10,000.  As an aside, whenever you do seek out advice from financial professionals, you should always ask about the fee in percentage and absolute terms.  Why?  Well, 1% does not sound like too much, but writing a check for $10,000 is a different story in terms of how you view the benefit of going to that financial professional.

In reality, setting up a diversified portfolio is easier than you might think.  There was a recent story in the Wall Street Journal which really elucidates my point.  See this link:  http://online.wsj.com/article/SB10001424127887323566804578551793835572924.html?mod=rss_mobile_uber_feed.  Now if we start things off without looking at your risk tolerance (how comfortable you are investing in stock, bonds, or other financial instruments), you can create a simple portfolio.  I will not pitch any particular investment.  To start things off, I strongly recommend that you start off with passive investment vehicles.  Passive investment vehicles would be Exchange Traded Funds (ETF) or index mutual funds.  An ETF is simply a stock traded on a stock exchange that represents a basket of stocks tied to an index like the S&P 500.  You are able to buy/sell the ETF during market hours.  An index mutual fund is a pooling vehicle.  The mutual fund manager combines your investment dollars with other investors and buys stocks and/or bonds in an index on your behalf.  You are buying shares in the mutual fund, and you can buy/sell once a day when the financial markets close.  Your share amount is based upon the mutual fund’s Net Asset Value (NAV) which is a fancy way to say the “stock” price of the mutual fund.  ETFs and index mutual funds have the advantage of extremely low expenses.  Most passive investment vehicles have an expense ratio (annual fees) of 0.20%.  If you went to a Financial Advisor, you would still have to pay his/her 1% AUM fee and your investment return would be lower by that same expense ratio if your financial professional suggests an ETF or index mutual fund.

You can set up a portfolio with just ETFs.  As in the aforementioned WSJ article, you might decide that you have 30 years to retirement, so you are fine with owning 80% stocks and 20% bonds in your portfolio.  How do you actually implement this?  One example would be to purchase the Vanguard Total Stock Market ETF (55% Ticker Symbol VTI), Vanguard Total International Stock ETF (25% Ticker Symbol VXUS), and Vanguard Total Bond Market (20% Ticker Symbol BND).  Their expense ratios are 0.05%, 0.16%, and 0.10%, respectively.  As I have mentioned in previous posts, you will never earn an investment return better than any of those indexes.  However, it is extremely difficult for money managers to beat those indexes over the long-term (five or ten years) as well.  Refer to http://t.co/nlz2h1WDkG.  At this point your financial professional will be up in arms and chomping at the bit to tell you that this type of advice is way too simplistic.

I will admit that the concept is simple.  However, there is another way to approach your investment portfolio.  Within the last decade, mutual fund families have developed what are
referred to as life-stage funds.  A life stage fund is a mutual fund that has a year associated with it and is meant to coincide with when you retire.  An example would be that, if you are 50 years old and would like to retire when you are 65, you might buy a fund that has a 2025 year associated with it.  Let’s take a look at this concept a little closer.  Vanguard has a Target Retirement 2025 (Ticker Symbol VTTVX).  When you look at the underlying components of this mutual fund, it has 70% stocks and 30% bonds.  More specifically, it owns 49% US Stocks, 21% International Stocks, 24% US Bonds, and 6% International Bonds via Vanguard ETFs.  There are also two competing mutual fund complexes (among others) that offer similar products.  They are Fidelity and T Rowe Price.  The corollary mutual funds would be Fidelity Freedom 2025 (Ticker Symbol FFTWX) and T Rowe Price Retirement 2025 (Ticker Symbol TRRHX).  These funds work well for investors who wish to “set it and forget it”, but you must realize that the mutual fund family will charge you a fee for this service.  Using my example above the Vanguard expense ratio is 0.17%, the Fidelity expense ratio is 0.72%, and the T Rowe Price expense ratio is 0.73%.  I personally believe that those expense ratios are too expensive, especially the Fidelity and T Rowe Price offerings.  Remember that you will pay the expense ratio and also the expense ratio of the underlying ETFs and/or mutual funds.  There is a way to get around that though.

All the mutual fund families have to report their underlying components on a quarterly basis.  If you go on their respective websites, it is possible to see their holdings.  When you look at the Vanguard Target Retirement 2025 fund, you can just buy the four ETFs yourself.  You will pay a commission to your broker; however, you will avoid the expense ratio of the mutual fund which is 0.17% in this case.  Now if you have $100,000, you would save $170 per year.  On an annual basis, you can look at the holdings and adjust your personal portfolio accordingly.  There is even a way to avoid brokerage fees altogether.  Fidelity offers a plan where you can buy iShares ETFs with no commission.  The list is as follows: https://www.fidelity.com/etfs/ishares-view-all.  Now your broker will not particularly like it, but it is in your best interest to keep your expenses as low as possible.  There are iShares that will mirror the components in the Vanguard Target Retirement 2025 mutual fund.  The expense ratios are similar, plus you get the bonus of being able to invest additional funds on a monthly basis in small increments.  For example, if you only have $150 to add to your portfolio on a monthly basis, you can purchase small numbers of shares for free.  Well, your financial professional will be steaming at this point and tell you that your risk tolerance must be analyzed closer.

It is very true that investors are risk averse or risk takers.  How can you account for differences in your risk tolerance?  Well, let’s say that you are just starting off investing and just want to wade in.  You do not have to purchase the target date fund that matches your retirement date.  You can simply choose to purchase the 2020 fund.  The 2020 fund will be more conservative and have less exposure to stocks.  Now the corollary would be to invest in the 2030 fund or later if you would like to take on more risk.  Measuring your risk tolerance is quite difficult.  Your financial professional will usually have you fill out a questionnaire in order to assess it.  Always remember that your answers on paper should be converted to absolute dollars.  I mean this in terms of any questions that ask if you are fine if the stock market might go down 20% in any one year.  You might be fine with this.  Think about it this way though.  If you have $1 million and want to retire in a couple of years, what if your portfolio went down to $800,000 to start the next year?  How do you feel about that?  Actual numbers make it more real and provide context.

I cannot stress enough that participating in monthly buying programs of shares offered by brokerage firms is a horrible idea.  For example, you might find a firm that will allow you to purchase more shares for $4 per trade on a monthly basis.  This commission is very low, but what if you only have $100 to invest monthly?  The $4 commission really is a 4% fee.  Furthermore, the stock or ETF has to go up 4% before you can sell it to break even.  Thus, the stock needs to increase 8% for you to have $100 after you pay commissions.  The long-term, historical return on stocks is roughly 7.25%, so in the case above, you are sacrificing one year’s return to invest on a monthly basis.  You are much better off searching for an index mutual fund.  An index mutual fund will allow you to purchase more shares at the current NAV at no additional charge.  It is a great way to hold down expenses.

In the next part of this discussion, I will talk about measuring your investment performance.  Your financial professional will tell you that he/she can help you navigate the troubled waters and confusing developments taking place currently in the financial markets.  That financial professional is definitely correct and will have financial advice ready from his/her firm.  With that being said though, you are going to pay for that advice.  In the example first used, if you have $1 million, you are going to pay $10,000 if the AUM is 1%.  You may decide though that it is worth your time to learn about investing to avoid the fee.  At the very least, learning how to properly construct a performance benchmark will allow you to see the benefit (or lack thereof) of your financial professional.

If you would like more information regarding possible portfolios, here are a couple of links:

http://www.kiplinger.com/tool/investing/T052-S001-investment-portfolio-finder/index.php

http://etfdb.com/wp-content/uploads/2012/04/Free-Report-1.pdf

http://www.etftrends.com/etf-model-portfolios.php

Why Learning About Investing is Worth $225,000 or $320,000?

11 Thursday Jul 2013

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Learning about investing is very important in terms of the amount of fees you can save if you manage your own investments, or you see an expert financial planner annually.  I will provide three different examples.  The examples will apply to both workers and retirees.  The key is to notice that being able to avoid asset management fees, which can be 1% or more of your total assets, will exponentially affect your portfolio value over the long term.  Let’s take a look at the specifics.

I will cover topics related to younger investors later.  However, I will start with an example focusing on retirees.  The first example will be basic to lay the groundwork.  Most Financial Advisors (FAs) will charge a fee based upon the total assets under management you have.  Although your fee will vary, we will use 1% for purposes of discussion.  (In reality, most fees will be greater than this per annum.  Additionally, even if your FA charges you 1%, the fee will be collected quarterly at 0.25%.  Thus, the APR is 1.0%, but the fee you actually pay is slightly higher on an APY basis).  Let’s build a scenario to illustrate how fees affect your long-term balance in your portfolio.  Here is the illustration to elucidate my point:  assume that you have $1 million to start with, your FA charges you 1% on the total assets under management, your portfolio only grows 1% per year, assumed inflation is 3%, the long-term historical investment return on the S&P 500 index is 7.25%, and you have a 20-year relationship with your FA.  When it comes to the end of the year, your FA will charge you 1% of assets under management which is $10,000.  At the end of the second year, your FA will charge you 1% of assets under management so you will pay another $10,000 (remember we are assuming that your portfolio only grows enough to pay the FA’s annual fee).  Over the course of your 20-year relationship with that FA, you will pay $200,000 in fees ($10,000 * 20).  I am using a 20-year relationship because, when you retire at age 65, actuarial table say that most people will live to 85 which is 20 years after retirement.  What could you have done with that $10,000 annual fee if you did not need financial advice?  Well, there is an opportunity cost of paying your FA.  You could have taken that $10,000 and simply invested it each year in an S&P 500 index ETF or mutual fund earning 7.25% per year.  If you had chosen that route, you would have approximately $421,300 at the end of 20 years.  Now that amount in 20 years is a future value, we need to discount that future amount back to present day dollars by using an expected inflation rate which was defined above as 3%.  That future sum is worth $233,275 in today’s dollars ($421,300/(1+3%)^20).  That is how much money you are choosing to forgo, as an opportunity cost, to let an FA manage your investments.  Think of it in these terms.  You are paying your FA a 23.3% fee ($233,375/$1,000,000) once you shake his/her hand to assist you in retirement.  Not a bad deal for the FA, but it represents your choice of not learning how to invest and/or not trusting yourself to make investment decisions.

The second example is still devoted to retirees but more realistic.  Here is the illustration:  assume you retire now and are 65 years old, you have $1.5 million, you need to withdraw $75,000 in year one for expenses, your FA charges 1% per year on total assets under management, your gross investment return is 6% per year which is 5% net, the long-term historical investment return on the S&P 500 index is still 7.25%, the assumed rate of inflation is 3%, and you need to increase your annual withdrawals by the rise in inflation each year.  Okay, now that we have laid down the groundwork, how does the example work?  Your investment portfolio will earn $90,000 with the 6% gross return but your FA will charge you $15,150 as an annual fee and you need to withdraw $75,000.  Thus, at the beginning of the next year, you will start off with $1,499,850.  The next year you earn 6% or $89,991, withdraw $77,250, and your FA will charge you $15,126.  Therefore, you end that next year with $1,497,465.  That process will repeat each year until age 85 when you sadly depart this earth.  This scenario is related to the first example because you could have taken the annual 1% fee from your FA and invested it in an S&P 500 index fund earning 7.25%.  At the end of the 20-year period, you would have $577,960 as a future sum.  In order to think about things in today’s dollars, we need to discount that future sum back to the present.  If one does that calculation, it equates to $320,000 in today’s dollars ($577,960/(1+3%)^20).  In this scenario, you are forgoing that amount by having a 20-year advisory relationship with your FA.

Now you may not feel comfortable learning about investing.  However, you can think about things in a different way.  In the scenario I laid out for you above, your ending portfolio would be $807,680 if you choose to pay a 1% annual fee to an FA.  When you die and pass away with an inheritance, your beneficiaries and charitable organizations will get that money.  The $807,680 is equivalent to $447,200 ($807,680/(1+.03)^20).  The $320,000 present value savings by taking charge of your own investments will add that amount to your ability to give away from your estate.  Your estate is 71% bigger.

What if you are just starting to save for retirement?  Well, learning about investing applies to you as well.  Let’s lay out a scenario for a 35-year old:  assume you would like a $75,000 annual lifestyle at retirement in today’s dollars, you end up with $3 million at retirement when you are 65 years old, your investment return in retirement is 6% gross, you pay a 1% annual fee to your FA, the long-term historical rate of the S&P 500 index is 7.25%, and assumed rate of inflation is 3%.  Well, if you want that $75,000 lifestyle when you retire, you will actually need roughly $182,000 in 30 years ($75,000 * (1+3%)^30).  When you retire, your $3 million portfolio will grow by $180,000 in the first year, you will withdraw $182,000 for living expenses, and your annual fee to your FA will be $29,980.  Now we are going to stick with the same 20-year relationship with your FA.  If you took that annual fee and invested it in an S&P 500 index ETF, you would have a future sum of $981,880.  If we discount that sum back to the present (meaning when you are 35 years old), the present value in today’s dollars is $223,975 ($981,880/(1+.03)^50).  Therefore, you have 30 years to learn about investing if you are 35 years old in order to save that opportunity cost.  Remember this does not include any attempt to take control of your investments prior to retirement.

Now I know that FAs will be bouncing around and ready to give you the counter arguments.  With that being said though, you should approach your investments as wanting to have an FA help you learn.  It should not be an exercise where he/she tells you how much you don’t understand and can’t control your emotions.  If you look at the first example, your annual fee is $10,000 in the first year.  If your investment does not increase at all and there is no recommendation from your FA to reallocate your portfolio, he/she will get a $10,000 annual fee in year two as well.  Your FA will tell you that you are paying for access to top-notch investment research, extensive financial planning, estate planning advice, and tax advice.  Now this is definitely true, and that FA has a point in terms of what his/her firm provides.  But let’s drill down a bit.  Will your FA provide you with a GIPS-audited composite that shows how his/her portfolio recommendations are beating the financial markets?  (A GIPS-audited composite uses the investment performance returns of an FA’s clients and shows how they perform against proper benchmarks.  When I refer to proper benchmarks, I mean that small-cap mutual funds should be compared to the Russell 2000 or S&P 600 indexes and not the S&P 500 index simply.  Do NOT let your FA compare apples to oranges).  How complicated are your financial planning needs?  If your estate is below $5.12 million, it is not subject to federal taxation right now.  Do you need to give money to charities via a Charitable Remainder Trust or some other legal structure?  Or can you deal with the charity directly?  Could someone at H&R Block do your taxes?

I suggest that you look at the financial advisory landscape as a continuum and not binary.  It is not either manage your own investments or turn it over to an FA.  There are options in between.  Here are the two most important ones.  The first option is to learn about investing yourself but retain an expert Certified Financial Planner to assist you in reviewing your investment portfolio annually and during market turmoil.  You can find an excellent Certified Financial Planner and pay around $250 per hour for a two-hour annual review.  Yes, you pay $500, but you escape paying $10,000+ if you have an FA at a full-service brokerage firm.  Here is the second option.  If you have a more complicated financial situation, you can still manage your own investment portfolio and do even better than using the services from you full-service brokerage firm.  You can set up your investment portfolio in year one with an FA and pay the $15,000 from our second example.  During the second year, you could choose to go to one of the top legal firms in the nation and pay $1,250 per hour for a five-hour estate plan agreement, you could get your taxes done and structured by a Big 4 international accounting firm for $5,000, and you could go to a Certified Financial Planner recommended by Goldman Sachs or Morgan Stanley, or JP Morgan and possibly pay another $5,000.  Using my example and rationale, you would get the best legal, tax, and financial planning advice in the entire nation.  It would cost you $16,250.  Well, your annual asset management fee at a full-service brokerage firm would have been a bit over $15,000.  Would you rather get legal/tax/financial planning advice from your local team of FAs?  Or would you rather go to the best in the nation?  Now chances are you do not really need to go to those lofty outside experts, but I only use that to illustrate the point that you could use your opportunity cost savings from doing your own investing to hire the best in the business for your other needs.  If you look at it in these terms, how does your current FA and firm stack up?  Your FA will tell you that you have the benefit of coming to one centralized location.  I would counter that the observation that your FA and his/her team cannot draft legal documents or fill out tax returns.  They can only advise; you still will have to pay a lawyer and accountant separately.

I just provide this information as food for thought.  If you view the decision of learning how to invest through this paradigm, it shines a different light on the situation.  Now the financial services industry does not present things in this manner.  This paradigm focuses solely on you and your financial interest.  If you do decide to use a FA, ask him/her what their fee is in dollars not percent, what services and advice you get for that annual fee, and whether or not they have a GIPS-audited composite which shows that his/her investment recommendations have done better than you just using a passive investment strategy and just selecting ETFs or index mutual funds.  Remember that, when choosing whether or not to manage your own investments, the pros/cons of fees need to be viewed as it relates to your best interest monetarily aside from the financial services firm.