Jonathan Clements's Blog, page 441

Value for Money?

WHAT’S THE BIGGEST CHALLENGE facing investors? Forget politics, low interest rates or high stock market valuations. I would argue there’s an even bigger challenge: How do you find financial advisors who are worth their fee?

On offer are brokerage firms, insurance companies, banks, mutual funds, accountants and independent advisory firms, all of them employing charming people who would love to help you. Problem is, there isn’t a lot of uniformity in the products and services they offer, and their fee schemes range from reasonable to outrageous.

Depending on who you ask for help, you might face layers of sales commissions, transaction fees and product expenses. Indeed, the same investment product can be offered with different pricing schemes. Often, smaller purchases trigger higher costs, while larger buyers can enjoy substantial discounts.

What do you get in return for those costs? A 2017 study by Russell Investments pegged the value of a top-notch advisor at some four percentage points a year. The study looked at five areas where advisors can add value. The potential value added is shown in parentheses:

Selecting investments (0.33%)
Financial planning (0.75%)
Tax planning (0.8%)
Portfolio rebalancing (0.2%)
Helping clients avoid behavioral mistakes (2%)

As the above numbers suggest, many clients and advisors wrongly focus on good investment choices as the sole measure of value, and yet softer skills are more important. Identifying special needs or making smart tax choices can help the bottom line far more than choosing a good mutual fund—and that good mutual fund isn’t much help if the next market dip scares you out of the stock market.

Four percent is a substantial annual reward for hiring quality help. But will you get that much value from your advisor? The Russell study focuses on advisors who are held to a fiduciary standard—with good reason. Fiduciary rules discourage advisors from accepting sales commissions and require they provide ongoing attention to clients.

Among providers, you’re most likely to find a fiduciary advisor in a bank’s trust department or at a so-called RIA, or registered investment advisor. Fiduciary advisors typically charge fees for specific services or an annual percentage of a portfolio’s assets, often around 1%.

Non-fiduciary advisors can also add value in the five areas identified by Russell. But will they? Portfolio rebalancing and monitoring client behavior depend on ongoing contact. But a commission-charging broker or insurance agent may not monitor a client’s portfolio or stay in touch during turbulent times.

Similarly, custom financial and tax planning advice requires deep client knowledge, expertise and considerable time. But the necessary time may not be productive for a commissioned advisor. Spending hours studying tax returns and trade confirmations doesn’t put food on their table.

An additional issue with non-fiduciary advisors: Some offer “proprietary” investments or mutual funds—products “manufactured” by the financial firm that employs them. Sometimes, those products impose high costs. If the costs are too high, they may more than offset the value of the advice you receive. On top of that, with any proprietary product, you have to ask, “Is this really the best product for me to buy—or is it the best product for the advisor to sell?”

Dan Danford is a Certified Financial Planner with the Family Investment Center in Kansas City, Mo. He learned early on about money from his late father, Thad Danford, who charged rent on the family lawn mower when Dan cut neighborhood lawns. Dan is the author of Stuck in the Middle: The Mistakes That Jeopardize Your Financial Success and How to Fix Them. His previous blog was Fake News.

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Truly Taxing

IN 1934, WHEN I WAS ONE year old, a federal income tax return was one page, and came with two pages of instructions. It was hand carried to the house by a live postman. The IRS regulations were 200 pages—though some say it was 400—all of which were memorized by the tax author J. K. Lasser.

When I was a young man in the workforce, we still got the several-page income tax form by mail, accompanied by a booklet of instructions that ran about 20 pages, as I recall. If you had a rental property or something more complex, you could buy J. K. Lasser’s tax guide, which was about 3/8 inch thick.

Almost everything that was added to modern tax forms and instructions since then was for social engineering. Now there are a stack of forms, many of which you have to download from the internet. If you want the 106 pages of instructions for the basic 1040 return, you can get them on the internet—or a copy will be mailed to you, but you’ll likely have to wait 10 days for delivery.

The federal tax code now totals 74,608 pages. The Constitution fits on three pages with single spaced typing or only four sheets of the original handwritten 28 3/4 inches by 23 5/8 sheets. The 27 amendments amount to only three additional typed pages.

Congress was less wordy in 1787, used more noble language and lawyers weren’t paid by the hours they booked. Their objective wasn’t to parse who got government money because people had to be self-sufficient. And there was no IRS. Must have been refreshing by comparison.

Henry “Bud” Hebeler is the retired president of Boeing Aerospace Company and the author of Getting Started in a Financially Secure Retirement. His previous blog was Unhealthy Increases. To read more from Bud, visit his website at AnalyzeNow.com.

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This Week/May 7-13

SNATCH THE MATCH. Are you on track to contribute enough to your 401(k) to get this year’s full matching employer contribution? If not, crank up your contribution now, so you can spread the required sum over this year’s remaining paychecks. In 2017, the maximum 401(k) contribution is $18,000, or $24,000 if you’re age 50 or older.

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May’s Newsletter

INDEX FUNDS were initially designed to match the performance of the broad stock market. But today, they’re just as likely to be built to capture a subset of stocks, especially those that reflect a particularly investment style or factor. Welcome to the world of smart beta. But is smart beta truly smarter and better? That’s the topic I tackle in May’s newsletter.

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Risky Business

Is “smart beta” truly smarter and better?

The world of smart beta, sometimes called factor investing, used to be fairly easy to grasp. In 1981, academic Rolf Banz noted that small-company stocks didn’t just outperform their larger brethren. Rather, they outperformed by more than could be explained by their extra risk, as reflected in greater share price volatility. Similarly, in 1992, finance professors Eugene Fama and Kenneth French documented the strong performance of bargain-priced value stocks—and noted that this couldn’t be explained by volatility, either.

Those two insights prompted many investors to overweight both smaller-company stocks and value stocks. For everyday investors, the typical tack was to give their portfolios a tilt toward small and value stocks, by purchasing index funds that focused on these two areas. Some quantitatively driven money managers went a step further: They added a momentum overlay, favoring small stocks and value stocks that had recently outperformed, because there was also evidence that short-term winners continued to shine.

“This isn’t just some interesting academic exercise. Rather, it’s big business. Wall Street has been quick to exploit these insights.”

In the years since, researchers have documented a slew of additional factors. For instance, historically, you could have notched surprisingly good results by favoring securities characterized by lower price volatility, higher yields and higher quality (as reflected in, say, higher gross profitability or lower debt).

Researchers have found that favoring these factors can goose performance in the U.S. and foreign markets—and can help in picking stocks, bonds and currencies. But this isn’t just some interesting academic exercise. Rather, it’s big business. Wall Street has been quick to exploit these insights, most notably through a tidal wave of new exchange-traded index funds.

Has all this been overdone? Critics have noted that the funds often don’t fare as well as the research suggests. A recent Bloomberg Businessweek article questioned whether some of the factors identified reflected not disinterested research, but data mining. Even Vanguard Group founder Jack Bogle has chimed in against smart beta funds.

Are the critics right? For those of us without finance PhDs, this debate can be tough to sort out.

Back in the 1990s, I was more skeptical about factor investing, but I’ve slowly warmed to the idea. With factor investing, you’re taking human judgment out of the mix—and with it the potential taint of emotion—and replacing it with systematic investing based on historical evidence and academic theory. That seems like a far more promising approach than old school methods, such as trying to uncover market-beating stocks by reading SEC filings, interviewing company management and making financial projections.

Four Doubts. Today, in my portfolio, I own index funds that overweight value stocks and smaller-company stocks, both in the U.S. and abroad. I’m not 100% convinced this will boost my portfolio’s return. But I figure that, if I suffer a patch of underperformance, I’ll have the patience to sit tight, and the long-term damage, if any, will be modest. Why do I have doubts? There are four reasons.

First, by owning a portfolio that looks different from the broad market, I’m making a market bet—and I could be wrong. Don’t want to take that risk? My advice: Purchase a total U.S. stock market index fund, a total international stock index fund and a total bond market fund. With that combo, you’re guaranteed to outperform most other investors with a similar asset allocation, because their results will be dragged down by their higher investment costs.

That brings me to my second reason: These broad-based index funds are cheaper than factor-tilted index funds. That means that factor funds need to deliver not just superior performance, but performance that’s sufficiently superior to overcome their cost disadvantage. That cost disadvantage has lately looked slightly more daunting, as major index-fund providers engage in a price-cutting war to promote their flagship funds that track broad market indexes. In essence, many index-fund providers are using these broad-based index funds as loss leaders to attract new customers, who they hope will then buy more expensive factor-tilted index funds.

Third, we should never forget that we have only one history of capitalism. That history may be a rotten guide to the future. Perhaps the factors that have been identified are an historical quirk, not an enduring advantage.

“If there’s no added risk, it’s an easy choice for investors: They’ll realize there’s a free investment lunch to be had and flock to buy the stocks involved.”

Finally, markets are made up of humans—and humans learn. If a chance to beat the market is uncovered, folks rush to take advantage and the opportunity can quickly disappear. For instance, since Rolf Banz’s paper on the small-stock effect appeared in 1981, small stocks have outperformed blue chips, but the margin of victory has been modest. Could it be that the large historical outperformance by small stocks reflected not massively greater risk, but rather a mispricing—and that mispricing has now been rectified, as investors have learned about the small-cap effect and moved to take advantage?

That, in a nutshell, is the dilemma that all factors face. For a factor—whether it’s the small-cap effect, value, momentum or something else—to continue to deliver superior returns, it must involve added risk, for which investors are then rewarded. If that isn’t the case and there’s no added risk, it’s an easy choice for investors: They’ll realize there’s a free investment lunch to be had, they’ll flock to buy the stocks involved, the share prices will be bid up and future performance will be no better than the rest of the market.

So do these factors involve added risk? Again, go back to the small-cap effect. When modern portfolio theory was first formulated, it was assumed that risk was captured by volatility—and the surprise with small stocks was that their outperformance was larger than could be explained by volatility alone. The assumption: Something else must be going on, but nobody was quite sure what it was.

We have the same problem with the other factors that appear to deliver outperformance. Their outperformance can’t be explained by their greater volatility, so either there’s some risk involved that we don’t really understand—or there isn’t any greater risk involved, in which case the performance advantage probably won’t persist.

Embracing Risk. So where does that leave us? If something is obviously riskier, there should be a return advantage. That’s the case with stocks relative to bonds. Those who have a larger allocation to stocks can reasonably expect somewhat higher returns over the long haul. Similarly, within stocks, it’s pretty clear that smaller companies and emerging markets are dicier propositions than blue chip companies, so it seems reasonable to expect some extra return—even if the extra return from small stocks isn’t as great as history suggests.

But what about everything else? I’m not convinced there’s greater risk involved with, say, value stocks or stocks with short-term momentum. Instead, if there’s any reason these factors work, it strikes me that it’s probably behavioral.

Investors get too excited about growth companies, and pay too much for their stocks, and they’re too pessimistic about the prospects for value stocks, so there are bargains to be had. Similarly, momentum may reflect an excess of caution among investors, who are slow to change their minds when faced with a corporate turnaround, so it takes a while for good news to get fully reflected in a company’s share price. That doesn’t mean that value and momentum strategies won’t outperform over the long haul, but investors could overcome their behavioral biases—and the performance advantage may disappear.

Because of that risk, I wouldn’t bet the ranch on any factor. Instead, you might anchor your portfolio with a total U.S. stock market index fund, a total international stock index fund and a total bond market index fund. Want to be a tad more clever? Go ahead and add a few factor-tilted index funds—but realize you’re taking a risk that may not get rewarded.

Greatest Hits

These were April’s five most popular blogs:

Next to Nothing
Nothing Better
Ten Commandments
Retire to What?
Three Steps to Seven Figures

This newsletter continues to grow in popularity, with a 56.5% open rate for the email version of April’s newsletter, versus a 17.3% industry average for comparable newsletters. Know friends and family who might enjoy HumbleDollar’s free newsletter? Please forward the link for this page and encourage them to subscribe, so they receive the newsletter directly each month.

Meanwhile, please also continue to support HumbleDollar. Got something you want to buy from Amazon? You can subsidize our efforts by clicking through to Amazon and our other referral partners from HumbleDollar.

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Trust Issues

LIKE MOST PEOPLE, I’ve made my fair share of financial blunders. I’ve also had some successes. But I definitely spend more time beating myself up over my errors than celebrating my successes.

Undoubtedly, my biggest mistake fits into the relatively obscure category of asset location. If you aren’t familiar with the term, I can explain it by way of an example. Suppose you have two investment accounts: a retirement account and a standard, taxable account. In these accounts, you want to buy some stocks and some bonds, and you also want to hold some cash for a rainy day. The question: How much of which assets should you buy in each of your accounts? The answer hinges largely on taxes, but also reflects other factors. This is the heart of asset location.

My asset location error was straightforward: About five years ago, I had some money to invest and was thinking through various alternatives. At the time, my children were all under 10 years old, so I thought it would make sense to establish 529 college savings accounts for them. When I asked an estate planning lawyer, however, he steered me in a different direction. Don’t focus on college costs, he said. Instead, if you want to help your family, establish a trust that’ll protect your money from estate taxes. And that’s what I did.

There were at least four things wrong with this decision:

I gave up one of the greatest tax gifts the government offers. With 529 accounts, all gains are completely tax-free if used for qualified education costs. Suppose I had put $100 into an S&P 500 fund at the time. With the market’s gains, it would be worth about $160 today. If it were in a 529, I could withdraw those funds entirely tax-free. Without the benefit of the 529, though, those $60 of gains would be subject to taxes, leaving me with perhaps $145.


I prioritized a lower-probability occurrence over a higher one. Sure, estate taxes are real, but there are many unknowns. Among them: What will the tax rate be in the year that I die and, by that time, will I even have enough money left for the government to tax? By contrast, my children’s likelihood of going to college is (hopefully) very high, and it’s right around the corner. That should have been my priority.


I took one person’s advice without considering the context. To a hammer, everything looks like a nail. And to an estate planning lawyer, everything looks like an opportunity to save on estate taxes. He wasn’t wrong, but it was my job to consider the alternatives.


Trusts can be expensive. As their name suggests, trusts require trustees, and oftentimes they want to be paid. Meanwhile, 529 accounts are relatively cheap.

Asset location isn’t the most exciting topic in the personal finance world. But a little bit of attention to this seemingly dull topic could yield big benefits.

Adam M. Grossman’s previous blogs were Contain Yourself and Take It Slow. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning and investment firm in Boston.  He’s an advocate for evidence-based investing and is on a mission to lower the cost of investment advice for consumers.

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Talkin’ ‘Bout My Generation

YOU CAN TELL THE STORY of my generation in myriad ways—including through our evolution as investors. I entered the world of stock investing with the purchase of shares in Twentieth Century (now American Century) Select Fund. It was the summer of 1987 and I was 26 years old. By autumn, the stock market had crashed and the value of my shares along with it. It was the first of three major market declines that my generation would face. If there were ever a scenario for wanting to bail out of stocks, and avoid the turbulence of investing, this was it. But I stayed with it.

Back then, there was already a dizzying array of mutual funds. For a novice investor, it was overwhelming. Without the internet, fund research involved reading through personal finance magazines and checking the newspaper’s mutual fund results. You had to determine which had the best long-term record, what the investment style was and what was the minimum dollar investment required.

I don’t recall ever considering index funds. There were a few around, but they didn’t get the exposure that they do today and, besides, how boring is it to invest in an index fund when you have actively managed funds touting their superior returns? Over time, my savings went into other actively managed funds, ones that had high ratings. I would use dollar-cost averaging, putting in a set amount each month. All of it went into stocks. After all, I was young, with decades before retirement. After a few years, I started to diversify into actively managed international stock funds, large and small cap funds, growth and value funds.

It wasn’t long before I had my own dizzying array of funds that I invested in and had to monitor. There had to be an easier way. It was in the mid-1990s that I started to hear about index funds. Here was salvation: One could invest in funds that covered the broad spectrum of U.S. and international markets. The results would match the appropriate indexes. Nothing flashy. And the expenses were significantly lower than those of actively managed funds.

I joined millions of other investors in making the migration to passive investing. I switched my monthly investments over to index funds and started to rid my portfolio of those actively managed funds that performed poorly, moving the proceeds into index funds. I still own a couple of actively managed funds, which have proven to be winners, but today the great majority of my portfolio consists of index funds.

Bonds entered my portfolio as I entered my 40s and after going through the market crash of 2000-02. I wanted to be more conservative with my investing as I neared early retirement. And the market turbulence was giving me more than a few unsettled sleeps. My bond investments are all in bond index funds. With returns not as lofty as stocks, it’s especially important to be in index funds, with their low management fees.

My bond exposure increased to as much as 45% of my portfolio as I approached my late 40s, putting me in a relatively good position as we plunged into the 2008-09 Great Recession. Yes, the Great Recession was a gut-wrenching time, but I held my own, even investing in stocks as they tumbled in what seemed like an unstoppable downward spiral.

Now that the stock market has recovered and I am retired, I monitor my asset allocation to ensure that I am within range of my targets. The last thing I want is another sharp drop in the market. But having lived through the market turmoil of the past three decades, I’m confident I’ll stay the course, just as I did when I invested my first hard-earned dollars in 1987.

Nicholas Clements is one of Jonathan’s older brothers. An avid cyclist, Nick is retired and lives just outside Washington, DC. His previous blogs include Try This at Home and Retire to What?

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This Week/April 30-May 6

REVIEW THIS YEAR’S SPENDING. Which expenditures do you remember with a smile—and which prompt a shrug of the shoulders and maybe even a wince? To jog your memory, look back through your bank and credit card statements. Lavishing dollars on stuff you don’t enjoy? Maybe it’s time to change the way you spend.

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Playing Favorites

OTHERS ARE LUCKY. But we deserve every penny we have, right? The distinction between “just deserts” and “just plain lucky” strikes me as far messier than we might initially assume. Consider just some of the ways that we can be financially lucky or unlucky:

Birthplace. If we were born in the U.S. or another part of the developed world, we’re pretty much starting the 100-meter sprint within a few strides of the finish line, not only by historical standards, but also compared to the rest of the world. If that wasn’t the case, we wouldn’t be having a national debate over immigration.

Parents. Even within the developed world, some are born with far greater advantages than others. If our parents launch us into the adult world with some cash, a good education and no debt, we start life with a leg up on most of our fellow citizens.

To be sure, this advantage is frequently squandered. Affluence is often the death of financial ambition—and sometimes all ambition. This might fall firmly into the category of “First World problems.” Still, it strikes me that raising children in an affluent household, while still ensuring they have the drive to make the most of their abilities, is a tricky task.

Talents. In HumbleDollar’s April newsletter, I talk about how we’re constrained by the “hand we’ve been dealt.” Some are born with talents that are richly rewarded by today’s society; others aren’t so fortunate. But instead of gazing longingly at the fine cards held by others, we should focus on making the most of the hand we have.

Mentors. Our colleague—who works no harder and seems no better at his or her job—rises rapidly through the corporate ranks, while the rest of us are left behind. What made the difference? It could be as simple as personal chemistry: Maybe someone in senior management took a shine to this one employee and pushed for his or her promotion.

Health. No matter how careful some people are with their health, they spend their lives struggling with physical and mental ailments. And even if we enjoy good health, we could find ourselves responsible—financially and otherwise—for someone who isn’t so lucky.

Relationships. For those who are coupled up, the earning ability and spending habits of their spouse or partner can make a huge difference to their own financial success, and yet there’s a good chance we won’t have this information when we commit to one another. The reality is, we may not fully grasp our partner’s financial habits until we’ve been together for a few years—and it may be a decade or more before we know whether he or she will have a successful career.

Markets. If you retired in 2000, you would have struggled through a decade of lousy stock market returns, even as your own need for spending money drained your portfolio. By the time the current eight-year bull market kicked in, your savings might have been sadly depleted, thus limiting your dollar gains. None of this was your fault: It was just bad luck.

By contrast, if you had entered the workforce in 2000 and started investing regularly, you would have spent the next decade buying stocks at all kinds of prices, some high, some painfully low. But if you had stuck with it, you would have got your reward: When stocks took off in early 2009, you’d have had a healthy sum invested—and your money would have more than tripled over the next eight years, with any additional savings further padding your portfolio. None of this was due to your brilliance: It was just a lucky sequence of investment returns.

By talking about luck, I’m not denigrating financial success. I like to think that, with a tight grip on the purse strings and a modicum of common sense, everybody can be financially successful. But a little luck can make success a whole lot easier to achieve.

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Lessons Learned

I HAVE MADE SOME glaring investment mistakes over the years. For instance, in my 20s, I was too conservative. I opened an individual retirement account and regularly invested the maximum annual contribution in a mortgage-backed bond fund. I still think about how much further ahead I would have been, if I had invested more of the money in stocks.

In my 30s, I received a $5,000 performance award from my employer. I wanted to invest the money, but wasn’t sure how. A family member told me about a utility called Tucson Electric Power. A few years later, in early 1991, the company was forced into bankruptcy and I lost almost all my money. I learned three important lessons: Never take investment advice from family members or friends, owning individual stocks can be risky, and make sure your investment portfolio is diversified.

In my 40s, I regularly listened to a radio show devoted to investing. The show’s host gave on-air investment advice, and also had a newsletter I subscribed to. I learned a lot from him. For example, I heard for the first time about index funds and the importance of keeping investment costs low. But there was one problem: He was a market timer.

One day, I sat in my living room, listening to people call into the show and thank him for his latest market-timing call. I sat there, with a feeling of envy, wishing I were one of them. The next year, I received an investment newsletter alert in the mail about another market-timing prediction. This time, he gave a major buy signal for the Nasdaq and suggested buying an exchange-traded index fund now known as PowerShares QQQ. I wasn’t going to miss out on this call, so I invested $70,000, with an average cost of around $71 per share.

After I bought the QQQ shares, I couldn’t sleep at night. I realized I was outside my comfort zone. Something inside told me to go ahead, even though deep down I was afraid. Was it greed? Was it the fear of being left out?

This investment didn’t end well, either. The QQQ fell to $20 a share and took many years before it reached my breakeven share price. I learned an important lesson about trying to time the market. I also learned investing can be psychological. Sometimes, it’s hard to stop your emotions from getting in the way of making rational decisions.

With any luck, you will learn from my mistakes, just as I did. Today, I follow these four simple rules:

I make sure my investment portfolio has sufficient stocks for long-term growth, but I avoid taking an excessive amount of risk.
I don’t own any individual stocks. Instead, I invest primarily in index funds that own the broader market.
The only time I make any significant changes is when I rebalance my portfolio every year or so, to get my investments aligned with my desired asset allocation.
I try to control my emotions by tuning out all the noise about investing and instead concentrate on meeting my written financial goals.

Dennis Friedman retired at age 58 from Boeing Aerospace Company. He enjoys reading and writing about personal finance.

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