Friday, February 25, 2011

Costs Matter - Stick With Index Funds!

Mutual fund giant Vanguard announced that they're slashing some of their industry-low expense ratios on several index funds, including many of their international offerings. This is welcome news for Gen Y investors because it means that those of us who invest in index funds (and we all should!) get to keep more of the return that our funds generate.

Consider this: You invest in an actively managed mutual fund that charges a total of 7%; a 5% front end load is paid upon purchase of the fund and an additional 2% in management/other fees get tacked on as well. To make up for that immediate hit, your fund has to return 7% just to break even. Even worse, it's quite difficult for portfolio managers to consistently beat the market and even harder for investors to pick those managers who will!

Alas, it's not all bad news. Index fund purveyors like low-cost leader Vanguard, Fidelity and TIAA-CREF all offer index funds that passively track a market index and earn the return of the market, minus a very small fee. Whereas an actively managed fund may charge you 5%+, an arm and a leg indeed, index funds typically charge very minimal fees. In Vanguard's case, the expense ratio on their Total Stock Market Index (VTSMX) is only 0.17% - now that's cheap!

Thursday, February 17, 2011

The Power of Compounding

It's amazing to me that the simplest principles in the world of finance are often the most overlooked. Granted, I don't expect CNBC and other financial news outlets to offer lessons on the basic concepts of finance but I can dream!

Vanguard, the massive mutual fund management firm that pioneered the index fund for individual investors, has a great article on the power of compounding on its website. Basically, compounding is the effect that you get when your earnings grow on top of prior earnings. These earnings can be in the form of interest, dividends, capital gains distributions or the like.

For example, if you have 1,000 shares of an index fund with a NAV of $10 which pays out a quarterly dividend of 0.25 in the 1st quarter, you will have $250 in dividend income. If you decide to reinvest that, come the next quarter, you will have 1,025 shares (holding the price of the fund constant). As the fund pays out its dividend of 0.25 in the 2nd quarter, you will subsequently receive $256.25 in dividend income. Imagine the results if you keep adding to this by investing systematically. All of this highlights a key principle that is proved true due to compounding: its easier to make money when you already have it.

That adage shouldn't discourage you - in fact, it should inspire you. After all, by starting at a age young like I hope members of Generation WISE are, you will begin to realize the full benefits of compounding investment returns. As your investments and savings grow from a young age, compounding will work its magic. Vanguard says that for compounding to work, you need to "start now, invest regularly and be patient." I couldn't have said it better myself.

Thursday, February 10, 2011

"There's Plenty of Time To Save"

Perhaps you're like me, 22 years old and excited about graduating from college and starting in the proverbial "real world". The prospect can be exciting and frightening at the same time, but also full of misconceptions. A recent article on highlights "8 Misconceptions College Students Have About Money". These misconceptions run the gamut from fear over credit, seeing no need to budget and other general financial pitfalls. Yet, the worst misconception to me is the idea that there's "plenty of time to save."

While retirement may seem far away - 40+ years is likely for a worker just getting into the workforce - the day where you will begin to seriously consider it will come faster than you think. As a result, the planning and saving that we do today will affect both when we retire and how we retire. By that, I mean that how much money we have saved and invested will dictate the terms of our retirement - will we retire at 62, collect Social Security (if it's still around) and live comfortably off a lifetime of savings - or will we "retire" at 70, collect Social Security yet be forced to take a part-time job to cover rising living expenses? The former should be our goal, yet the latter is an unfortunate reality for many people.

By saving and investing more money early on, you will have less of a return differential to make up for as you get closer to retirement age. Ideally, your portfolio will grow and compound enough with the additional contributions that you make during your working years to negate the need for any makeup return as you get closer to retirement. The FOX article quotes a 2009 Vanguard report which states, "
only 31% of employees under age 25 save for retirement, compared to 61% for those between 25 and 34.”

Those are harrowing statistics because it means that we are forgoing the best years of our life to save - when we have limited obligations such as a house payment or raising a family - and wasting precious time. Sure, a dollar today is worth more than a dollar in the future. However, a dollar today is not worth more than a dollar invested today for 40 years earning a 7% average annual return.

Thursday, February 3, 2011

Brokerage Advice Can Be Hazardous to Your Wealth

I have a confession to make. As a young investor in the late 1990s, I was naive and quite taken by the Internet euphoria. At the time, I owned a single stock - PepsiCo (PEP) - which I still own to this day. However, I couldn't help but watch stock prices explode without feeling like I should be a part of the game. Granted, I didn't have much spare cash to work with, but when I did, I was advised by my broker to buy Munder NetNet - one of the pioneering Internet-focused funds that grew to a whopping $8.5 billion in asset size in April of 2000. I should have been smarter, but as an 11 year old investor, I believed in the transformative power of technology and the "new paradigm". Didn't you?

When all was said and done, my small investment in Munder was wiped out to the tune of 90% or so. And while our broker was confident that it would rebound all the way down, it was only then that I realized investing works best when you:

1). Keep it simple and index
2). Buy what you know

Contrary to what Wall Street tells you, it's OK to be conservative as a young investor. And by conservative, I mean that it's OK to invest in index funds. Interestingly, former bond trader and famous author Michael Lewis of Liar's Poker, Money Ball and The Blind Side fame, notes in a recent interview that he took advice from a broker and in 2008 purchased Lehman Bros. preferred stock and auction-rate securities - both investments were wiped out by the financial crisis and Lehman's bankruptcy. So, after this gut-check experience, what does Lewis advocate for individual investors? Surprise, surprise! He says, "
be conservative, don’t listen to brokerage advice, and index."

I couldn't agree more. Ultimately, Wall Street is all about sales and brokers are at the forefront of making sure products - investments in this case - get sold. Unfortunately, the first place they often look to unload their worst products are to unwitting individual investors. It's best to keep it simple by indexing and to avoid listening to brokerage advice!