So asked E.M., a Houston reader, immediately after my Thursday (February 27) column about investment expenses (URL below).
Good question. Several answers.
All three answers share a common theme: keep things simple. Recognize that complexity costs money but seldom delivers improvement. All three paths are simple and prudent. Whatever route you choose, stay close to a basic pension fund asset allocation. The traditional pension fund allocation is 60 percent stocks, 40 percent bonds. Studies of portfolio survival rates have shown that portfolios that are 50 to 75 percent equities have the best long-term survival odds at reasonable rates of withdrawal.
The No-Load Balanced Fund Way
Vanguard Balanced Index Fund has no load and an annual expense ratio of 22 basis points (that's 0.22 percent). It has done better than 70 percent of its managed peers over the last 10 years. No, it will not keep you from losing money if the market turns bad. You will, however, lose less because of its bond diversification.
Don't believe in indexing? Then you can invest in the handful of no-load managed funds with low expenses and superior very long-term records. Last November, for instance, an examination of 20-year track records for domestic equity funds found that the Vanguard 500 Index was near the top of the list. It also found a handful of managed balanced funds that provided competitive returns at lower risk. (The URL for the column is below.)
The managed balanced funds: Dodge and Cox Balanced, Vanguard Wellington, and Fidelity Puritan. Their annual expense ratios are 0.53 percent, 0.36 percent, and 0.64 percent, respectively.
The No-Load Index Fund Way
A slightly more difficult approach is to build your own Couch Potato Portfolio using low cost no-load index funds. This portfolio has been a regular feature of my column for years, with regular performance reports. The easiest version--- the one best for retirees--- is a 50/50 mix of Vanguard Total Bond Fund and Vanguard 500 Index or Vanguard Total Market Index. Younger people can increase their equity exposure for an "Aggressive" Couch Potato, which is 75 percent stocks, 25 percent bonds.
Why do the extra work of owning two funds? You can make your withdrawals from the bond fund when the stock market is swooning. This will allow you to avoid selling stocks when they are down. Similarly, you can make your withdrawals from the stock fund when stocks are soaring.
The Commission Compensated Advisor Way
Sadly, the first two methods don't include the reassurances of a financial advisor. Many people need those reassurances. Unfortunately, the basic goal of most (not all, most) of the financial services industry is to make 2 percent a year on our money.
That doesn't mean there aren't some wonderful advisors out there. As I have pointed out many times, it is possible to be well compensated in commissions and still direct investors to low cost funds with superior long term performance.
Over the 20 years ending January 31, for instance, an investment in American Funds American Balanced A shares would have provided a return of 11.77 percent annually, ranking in the top 10 percent of all balanced funds and trailing the S&P 500 index by only 0.57 percent a year. An investment in American Funds Income Fund A shares would have provided a return of 11.69 percent annually. That's superior performance with less risk.
The advising broker would have received a 5.75 percent (gross) commission for his service and your annual expense would have been about 0.68 percent, including a small 12b-1 fee.
Many people never hear about these funds because they are not on their broker-dealers' list of "preferred funds." In some cases there is a de-facto reduction in compensation for the selling broker compared to what the brokerage house wants sold. Brokers who work in this sort of environment are primarily salesmen, not advisors, because they are putting their commissions and their employer before the long-term interest of their clients.
Where would you be if you had invested in these funds through a commission compensated advisor?
Better off. If you had made an investment of $100,000 (before commission) in American Funds American Balanced A shares on February 1, 2000 (close to the market peak) and you had made monthly withdrawals at the rate of $333.33 (that's 4 percent a year), you would have had $99, 765 as of January 31, 2003. Do the same with American Funds Income Fund A shares and you'd have $94,240 left.
Either way, few "wrap accounts" or "select manager" accounts can get in the ring with that performance.
How do you find the brokers and financial advisors who follow this path?
I don't know. Every major brokerage house is pushing its sales force to sell wrap accounts and related plans, generally with annual costs in the range of 2 percent. They will continue doing this because they don't know how to do anything else.
Tuesday: Waiting for the Southwest Airlines of financial services.
Thursday, February 27, 2003 Q&A column on advisory fees
Columns on Couch Potato Investing
Columns on Couch Potato Portfolio Performance
November 3, 2002 column on very long term performance of equity funds
This article contains the opinions of the author but not necessarily the opinions of AssetBuilder Inc. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational puposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.
Performance data shown represents past performance. Past performance is no guarantee of future results and current performance may be higher or lower than the performance shown.
AssetBuilder Inc. is an investment advisor registered with the Securities and Exchange Commission. Consider the investment objectives, risks, and expenses carefully before investing.