The Index Card: Why Personal Finance Doesn't Have to Be Complicated

by Helaine Olen

They use computer programs to adjust the investment to stay even with the index. As a result, while the average annual fee for a managed stock mutual fund is 0.89 percent, the average fee for an equity index fund is a much more reasonable 0.12 percent. Those numbers sure don’t sound like much. It’s only a 0.77 percent difference. Well, when it comes to investing expenses, remember a corny early 1960s love song: Little things mean a lot.

The actively managed fund is Strawberry, and it charges the average fee of 0.89 percent. Orange, the index fund, charges 0.12 percent. That’s a difference of more than $5,000. And this is by no means an extreme comparison.

NOT ALL INDEX FUND FAMILIES ARE CREATED EQUAL So put your money in an index fund and all will be fine? Not exactly. It would be nice if we could assume that any index fund comes with the lowest and best expense ratio. Unfortunately, this isn’t true. Take Vanguard’s flagship fund, the Vanguard 500 Index Fund. It has a lovely and low expense ratio of 0.17 percent. On the other hand, many index funds charge 0.7 percent, and some even more. Sometimes they soar to more than 1 percent.

MUTUAL FUNDS VERSUS EXCHANGE-TRADED FUNDS There are two ways to invest in index funds. The first is via a mutual fund. The second is what is called an exchange-traded fund (ETF). What’s the difference? Mutual funds are not always index funds. Exchange-traded funds are almost always pegged to an index or other benchmark. Exchange-traded funds can be traded like stocks. Mutual funds can be bought and sold only at the end of the business day. Exchange-traded funds almost always have lower expense ratios but higher trading costs than mutual funds.

We diversify to spread risk. The idea is that not everything in your investment portfolio rises and falls by the same amount at the same time.

you quickly scan the Internet, you will see that there are people out there who say if you go this route, you need at least ten funds to achieve proper diversification. There are mid-caps and real estate investment trusts and international small caps, and maybe you should do one or two managed funds to hedge against downturns and . . . MAKE IT STOP. If you are reading this book, you are almost certainly in search of simplicity.

So how do you sort all this out? Portfolios are traditionally organized by age, what you need the money for, and whether your risk tolerance is high, low, or somewhere in between. They are also—for the most part—divided between stocks and bonds.

As a result, many people consider a bond a more stable investment than a stock, which can go up and down in value, with no guaranteed return. On the other hand, stocks tend to do better over time than bonds.

The sooner you think you need the money, the less risk you should assume. If you have a pot of money put aside to buy a house, and you are planning to purchase it this year, you should probably move it into a short-term bond fund. The same is true for your emergency money.

Conversely, if you are twenty-five years old and this is your retirement savings, an aggressive growth strategy is likely better. The healthier and wealthier you are, the more risks you can reasonably take.

Finally, you can be saving and investing money for any number of reasons. You could be investing for your retirement or saving up to buy your first home. It could be college savings or a dream vacation. It might be your emergency savings. It might be something to help your kids.

Well, conventional advice goes something like this: 1. What’s your age? 2. Subtract that number from 100. 3. The answer is the percentage of your assets that should be invested in stocks.

There are now financial sages out there who say you should up the base number from 100 to 110. That’s what Harold is doing. This advice, needless to say, comes with the assumption that all this money is targeted for your retirement. Something else worth noting: This formula assumes stocks will perform better than bonds over the long haul. That is indeed the conventional wisdom. Since 1928, the S&P stock index has returned a premium of about 6 percent above what one could receive from safe government bonds.

For your stock investments, we suggest: Seventy percent: A good S&P 500 index fund. This fund will provide domestic and international (more on that later) exposure to large-cap companies based in the United States. The S&P 500 represents industries that include technology, banking, and health care so you are assured quick diversification.

Fifteen percent: A small-cap index fund such as the Russell 2000 Index. While large-cap companies tend to drive headlines, you also want to make sure your portfolio contains exposure to small-cap funds. Why? Small-cap funds have generally outperformed large-cap funds. Before we get too excited about outperformance, remember that it comes with greater risk. Think of small-cap companies as small and agile. Some companies will be poised for growth and may even evolve into large-cap companies, while others may go bust. You will see this in the slightly more volatile returns of small-cap companies. Fifteen percent: A broad-based international fund like Vanguard’s Total International Stock Index Fund. You will want an international fund that has access to both developed—think Europe and parts of Asia—and emerging—think South America, Africa, and other parts of Asia—markets. Make sure that you choose an international fund and not a “global” fund. An international fund will have little to no holdings in U.S.-based companies, whereas a global

TARGET-DATE FUNDS ARE NOT GUARANTEES Then there is the life-cycle fund, often better known as a target-date fund. They come with names like Total Retirement 2030.

Moreover, surveys show that a majority of investors in target-date funds are under the impression that the fund is a guarantee—that, at a minimum, they will receive their initial investment back at all times. This is simply untrue.

This word is “fiduciary.” THE FIDUCIARY STANDARD VERSUS THE SUITABILITY STANDARD A fiduciary is a financial advisor who has a legal and regulatory duty to put your interests ahead of his or her own.

A financial advisor working to the fiduciary standard 1. has a legal duty to act in your best interests; and 2. is not getting paid to steer you into buying overpriced investment products you don’t want or need.

THE ONLY CREDENTIAL THAT MATTERS: FIDUCIARY At last count, there were more than two hundred titles would-be financial consiglieri can use to convey knowledge, integrity, and expertise to their customers.

As for the popular and common term “financial advisor,” it means precisely nothing. Whether “advisor” is spelled with an e or an o, it still doesn’t matter.

THERE IS NO SUCH THING AS A FREE LUNCH—OR DINNER Unfortunately, it’s not that easy to meet an advisor working to the fiduciary standard. Why? They are often not the ones glad-handing, looking to meet clients. Take the popular financial information lunches and dinners sponsored by those seeking to sell their financial 411. If you are over the age of fifty-five, you most certainly are familiar with this game.

Another study found that more than half the sales pitches reviewed by the surveyors contained exaggerations, false information, or other misleading statements. That doesn’t count the 13 percent that could be described succinctly by the word “fraud.”

problems, and to address our entirely legitimate fears. Often, the first item in the playbook is to prey upon our mistrust of the government. Since writing and doing the reporting for Pound Foolish, Helaine has sat through many such meals over the years and has been repeatedly told that Social Security and Medicare are doomed—or at least bound to be drastically cut. Taxes are going to rise. She’s in immediate danger of not being able to pay for her children’s college. She will outlive her retirement savings. The solution? Whatever financial vehicle the broker making the presentation is pitching.

It doesn’t matter. Your friendly neighborhood brokerage or bank is not a place to go for nonconflicted, fiduciary financial advice, any more than an appliance store is the best place to ask whether you really need a 3-D TV.

frontline people and brokers are under intense pressure to meet sales quotas for various financial products. From “alternative investments” to “structured products” and simple mutual funds, most of what they have to offer will cost more, might well come with more risk than you realize, and will underperform a simple index fund.

less than 10 percent of the brokers tested without their knowledge told their would-be clients to put their money in low-cost index funds.

Take it from Melissa. She’d wisely put her funds in a low-cost group of index funds. But when her grandmother died and she received a small inheritance, she planned to move the money over to her main account.

IF YOU WANT GOOD ADVICE, PAY FOR IT Do you work for free? Neither do financial advisors. If you want unconflicted financial advice, you almost certainly have to pay for it.

Then all too many will receive a commission for pushing one financial product over another.

Then there are trailing fees. That means the advisor selling the financial investment receives a commission

Altogether, the Obama administration estimated in 2015 that what it called “backdoor payments and hidden fees” in the retirement savings industry are costing Americans up to $17 billion annually.

HOW DO YOU FIND A FIDUCIARY? So what is a fiduciary?

These are credentials that indicate someone is almost certainly working to the fiduciary standard: certified financial planner (CFP) registered investment advisor (RIA) fee-only advisor

They include the following: CFP: CFP Board, http://www.cfp.net fee-only advisor: National Association of Personal Financial Advisors (NAPFA), http://www.napfa.org

And how do you make certain someone is a fiduciary? You need to ask and ask quite specifically: Do you work to the fiduciary standard at all times? This last part, “at all times,” is important. As the fine print on brokerage forms indicates, the fact that an advisor commits to a fiduciary standard for some of her dealings with you does not hold her to this standard in others, even if she is providing detailed information and guidance.

Tara Siegel Bernard, a personal financial writer for the New York Times, recommends taking this even a step further. Never mind asking about the fiduciary standard. “Ask them to sign an oath stating they will act as fiduciaries,” she writes. She suggests one put together by the advocacy group the Committee for the Fiduciary Standard. Putting Your Interests First I believe in placing your best interests first. Therefore, I am proud to commit to the following five fiduciary principles: I will always put your best interests first. I will act with prudence; that is, with the skill, care, diligence, and good judgment of a professional.

I will not mislead you, and I will provide conspicuous, full and fair disclosure of all important facts. I will avoid conflicts of interest. I will fully disclose and fairly manage, in your favor, any unavoidable conflicts. ADVISOR FIRM AFFILIATION DATE

CONSIDER USING ROBO-ADVISORS Robo-advisors are the newest advisors on the block. Less than ten years old, these companies use computers in place of the human touch.

There was only one problem. They were nowhere close to having the traditional 20 percent down payment.

OWNING A HOME IS NOT SOMETHING WE’VE ALWAYS DONE Prior to the Great Depression, Americans were much more likely to be renters than homeowners. Why? Well, for starters, mortgages were limited. Home buyers needed to put up half the purchase price in cash, then pay off the remainder in five to ten years.

The Great Depression changed things. The sudden economic collapse meant that many couldn’t pay off their loans. Foreclosures soared. Real estate prices plummeted. In an effort to stabilize the situation, the federal government introduced the 20 percent down mortgage that could be paid off over thirty years.

The newfangled concept got a huge boost after World War II, when low-rate, low-down-payment federally subsidized mortgages turned millions of...

HOME PRICES DON’T ALWAYS GO UP Home prices can go up, or they can go down. Yet many people don’t quite believe it.

For the majority of Americans, their home is their largest financial asset. The National Association of Home Builders claims a primary residence makes up 62 percent of a median homeowner’s total assets. More Americans own a home than possess a retirement or brokerage account.

Owning a home is almost always what experts call a highly leveraged investment. That makes it a risky investment, even if it is hard to see risk in bricks. How does this work? Well, suppose you have a $200,000 home with a $180,000 mortgage on it. A 10 percent drop in your local housing market all but wipes out all of your home equity. If for some reason you can’t make your monthly payments, you might lose the house you were counting on for your retirement, along with everything you invested in it.