Why the Dow is a bad indicator of stock market performance

NPR’s Planet Money did a great segment on why the Dow is a terrible indicator of stock market performance.  It is a price index where higher priced stocks count more than lower ones regardless of the company’s market cap.  On top of that it is only 30 companies out of more than 5,000 that are traded.  The only thing it has going for it is that it has been around for a very long time.  Read more here http://www.npr.org/blogs/money/2013/03/05/173515767/the-dow-isnt-really-at-a-record-high-and-it-wouldnt-matter-if-it-were

Or listen to the podcast:  http://www.npr.org/blogs/money/2013/03/12/174139347/episode-443-dont-believe-the-hype

Creating a More Tax Efficient Portfolio

Here are some simple tips to create a more tax efficient portfolio:

Invest in Index Funds

Index funds generate lower short-term capital gains and higher long-term capital gains due to much less frequent buying and selling.  Short-term gains are taxed every year as ordinary income.  Long-term gains are taxed at lower capital gains rates, and most are only realized when you sell your shares.

The idea here is to place assets that produce higher income (e.g. bonds) in tax advantaged investments (IRA, 401k) that will allow you to not to have to pay taxes annually on the income.

Then putting assets that generally produce less income (e.g. stocks) in taxable accounts.  You will have lower taxes each year, and when you sell your shares you will pay the lower long-term capital gains rate on your profits.

What about Roth IRAs and Roth 401k Accounts?

Since any gains in these accounts are tax free when withdrawn, it does make sense to put assets that will have the highest long-term growth in these accounts as well (e.g. stocks) as an exception to the rule above.


It will often not be possible to execute this perfectly with all of your income producing assets neatly tucked away in your Traditional IRA and your growth assets in your Roth IRA and taxable accounts.

Also please do not let the desire for tax efficiency overwhelm having the right asset allocation for your long-term needs.  Tax efficiency is really a tactic not a strategy.


Why Low Cost Index Fund Investing Makes Sense

There are two basic types of mutual funds:

Actively Managed Mutual Fund

In this type of mutual fund the fund manager attempts to pick investments which he or she feels will outperform the overall market.  Typically this type of fund does a lot of buying and selling of individual investments, turning over its portfolio about three times per year.  The average charge for a actively managed stock mutual fund is about 1.35%.  This means that every year the investors in the fund are charged about $13.50 per $1,000 invested.

Passive (Index) Mutual Fund

In this type of mutual fund the manager follows a published index (e.g. the S&P 500).  They buy and hold the stocks in the index only selling or buying new stock when the index changes.  The turnover in an index fund is usually very low, less than 10%. A low cost index fund has a management fee of roughly 0.15% or $1.50 per $1000 invested.

Why are Passive Funds a Better Choice?

Lower Management Fees

In order to just equal the index fund performance the active fund must out perform it by 1.2% per year (1.35%-0.15%).  That may sound easy, but the number of actively managed funds that manage to do this is quite low.  On average actively managed and passive index funds perform about the same before fees are considered.  Once fees are added in then the actively managed funds underperform passive index funds.  The longer the time period the fewer actively managed funds outperform low cost index funds.

Tax efficiency

Because actively managed mutual funds turnover their portfolio much more frequently than passive index funds they generate much higher short-term capital gains on stocks they held less than a year.  Even if the investor does not sell their shares in the mutual fund, and reinvests all capital gains, they still will have a tax bill for the capital gains their mutual fund generates.  The short term capital gains are taxed as ordinary income.  These taxes can significantly reduce long-term performance.

A low cost passive index fund, generates much lower capital gains.  Most of the gains for an investor are only realized when she sells her shares in the fund.  Those gains are much more likely to be long-term capital gains which are taxed at a lower rate.


Actively managed mutual funds only disclose their holdings a couple of times per year.  This means that a fund that is considered “Large Cap” may have significant holdings in “Small Cap” companies without disclosing it.  This means that the investor has a different risk/return profile that he realizes.

A passive index fund is almost always invested in line with it’s published index meaning that the investor’s risk return/profile is in alignment with what she thinks it is.

So who is pushing actively managed funds?

Often actively managed funds are pushed by brokers who earn a commission from selling them, or a told to sell them by their firms.

Most independent experts agree that investing in low-cost passive index funds is a great strategy for most investors.

Yale’s Swensen: Index Funds Best Plan for Most

Long-term investing: Keep it simple

Vanguard Changing the Indicies Used

Vanguard announced they are changing the incidicies they use to construct some of their most widely held funds including the Vanguard Total Stock Market Index, The Vanguard International Stock Market Index, and the Vanguard Total Bond Market Index.  Instead of following the Morgan Stanley Capital Indicies (MSCI), domestic funds will follow the University of Chicago’s Center for Research in Security Prices (CRSP), and international funds Financial Times and Stock Exchange (FTSE) index.  The reason for the shift is to lower the ongoing fund fees.  The new indicies charge a lower licensing fee then than the current MSCI ones do.  Vanguard does not anticipate a major change in the composition of most of their broad based index funds.  They also do not anticipate signficiant capital gains distributions from the switchover.

The only possible hiccup involves South Korea.  Right now it is in the MSCI emerging market index.  FTSE has it in the developed market index.  If you own the Vanguard Total Stock Market Index or both the Vanguard Developed and

This is not the first time the Vanguard has shifted indicies, for example the Vanguard Total Stock Market Index moved from following the Wilshire 5000 to the MSCI index in 2005.

Having a high income does not guarantee wealth

The recent debates over tax policy and the “fiscal cliff” have raised a pet peeve of mine.  My peeve is when people, use the word “wealthy” interchangeably with “high income”.  I do agree that there is a correlation between the two, but there are people with high incomes, with much lower wealth than people with significantly lower incomes.

I will draw a couple of examples based on a composite of my clients.

High Income/Lower Wealth

John and Mary Smith both age 42, work at high paying jobs and have a combined income of $400,000.  They have two children, ages 6 and 2.  They have high housing expenses, child care expenses, retirement savings, and college savings.  They also spend money on home improvements, eating out and vacations.  They have a net worth of $200,000 equal to a half a year of their income.

Lower Income/Higher Wealth

Doris and Boris Johnson, retired, are 67 and 65.  They both collect pensions and Social Security which total $90,000 which provide enough income for them to live the lifestyle they wish.  They spend time on volunteering, visiting friends and family, and some travel.  They have lower housing costs than the Smiths, even though they have a second home, and do not have to worry about saving for retirement or college for their children.  They have not spent any of their retirement nest egg of $1.8million, and plan to help their grandchildren with college expenses with some of it. Their total net worth is $2.3million or 25.5 times their annual income.

Factors that I have seen that are associated with a higher net worth besides income include.

  1. Age, the older you are the more time your investments have had a chance to grow.  In early retirement expenses may also be lower if you are in good health then they were if you were saving for retirement of college educations for children.
  2. A strong ability to delay gratification.  People who find it easy to delay gratification tend to spend a lot less.  They spend less both on shorter-term expenses (vacations, eating out, ‘stuff’), and longer-term expenses (housing, cars).  This is also manifested in a “pay yourself first” attitude when it comes to their income.
  3. Think about their future often and though generally optimistic, know that financial reversals do occur and want to prepare for them.

Personal Finance Magazines — Bad Advice?

I often read Personal Finance magazines because I know my clients do.  In a big picture way they give solid advice about investing — not timing the market, setting up a long-term asset allocation, etc.  At the same time many of their articles and columnists are advocating just the opposite.  The January 2013 cover story for Kiplinger’s title story is “Where to Invest Now” quoting Katerine Nixon of Northern Trust saying “It’s going to be a pretty good year for stocks.”  I have two issues with this cover.  First, it implies that market timing can be a successful strategy even when research implies that for most people it isn’t.  Second, what the heck does a “pretty good year for stocks mean?”

Opening the magazine we see that they feature a mutual fund manager in a red tie and socks (Cardinals Fan, were told — is that baseball or football?)  who only holds about 20 stocks.  Why don’t they feature the guy that bet on red at the casino and doubled his money in a few seconds.  Arguably a much better result that this guy achieved.  When a magazine features the mutual fund manager “winners” they imply that more than luck is involved in their winning ways, when in reality a long-term statistical analysis implies that it’s all luck.

There are two reasons why many people have a hard time buying this.

1. When it’s something we perceive as complicated and don’t fully understand how it works we give greater deference to those who seem to do well.  Since we do not understand how the stock market really works those who do well are perceived to have have special skills.   Such deference is usually not accorded to someone who flips heads 10 times in a row, a much rarer feat.

2. The mutual fund industry spends vast amounts of money to support this model. If you can make a lot of money convincing investors that you have a winning strategy for the long-term they will give you more money to invest.  If you do well in the short-term you can tout your performance to gather more assets and fees.  When you do poorly, blame it on the market or shut down that fund and start over again.

I understand that Kiplinger’s and the others have to sell magazines and web views but it would be great if they included a disclaimer by every article recommending individual stocks or actively managed mutual funds that “there is no empirical evidence that pursuing this strategy will be more effective than a buy/hold/re-balance asset allocation strategy using low-cost index funds.”

You want a mechanic not a used car salesman

We’ve all heard the story of someone who buys a used car and then takes it to a mechanic and finds out there are all kinds of problems which are really expensive to fix.  The car looked great and the salesman was really sincere. . .

Sound familiar?  I often see people make big financial decisions the same way that and end up with buyer’s remorse because the did not want to take the time or spend the money to get an unbiased opinion.  In many of these situations they have received the advice of a “financial advisor” but unfortunately, he was really a salesperson in disguise, just like the guy at the car dealer.  All he really cared about was selling you the product (annuity, life insurance policy, mutual fund, etc.)

What you want is the mechanic, someone who can give you objective advice, that is not selling you anything, and whom you pay directly, not through the purchase of a product.  Sure the advice is not free, but it’s definitely worth it.

Drive safe.


Are you on track for retirement?

Here is a ‘quick and dirty’ tool that I found in Money Magazine (Feb 2011), that gives you a quick assessment to see if your retirement savings are on track.

For each age there is a savings factor (e.g. at age 30 the savings factor is 0.3).  This means that if you want to retire at age 65 you need to have 30% of your salary saved by age 30.  If you earn $100,000 this means that you would need to have $30,000 saved for retirement.  At age 50 the factor is 4.5 which means that if you earn $100,000 you would need to have $450,000 in retirement savings.

Age        Savings Factor

30               0.3

35               1.1

40               2.0

45               3.2

50               4.5

55               6.2

60               8.2

65              10.6

This table is a better estimate for younger ages when retirement is far off and you want a quick reality check. As you get closer to retirement so many other specific factors could affect your number (e.g. will you have a mortgage, will you move, will your lifestyle change, etc.) that it may be worth doing a more specific sophisticated analysis, or even seeing a Fee-Only(tm) Financial Planner.