THE BLOG

Smart Advice for the HuffPost Investor

05/25/2011 12:15 pm ET
  • Dan Solin Author of the Smartest series of books

Is my enthusiasm for Vanguard index funds influenced by undisclosed payments?

Should an investor give up 28% returns for a boring index fund portfolio?

Are Target Funds an intelligent option for Smart Investors?

Why buy index funds without charge when you can pay a broker a hefty fee for the privilege?

And (my personal favorite), should you buy individual stocks recommended by your broker based on his or her intuitive feelings that there is a "bump coming"?

You asked these excellent questions. I pulled no punches with my answers.

Please keep your questions coming. Just add a comment to this blog.

Question From Chris:

Does Vanguard pay you to promote their funds? I think this is an important question since you are giving out financial advice and constantly mention Vanguard.

Also most financial advisors disclose their holdings. So are you invested in any of the funds you name?

All of this goes toward bias and is important for all people to know when reading your columns.

This is a very fair question. Thanks for asking it.

I receive no compensation from Vanguard, directly or indirectly. I recommend their index funds, as well as those of Fidelity, T. Rowe Price and Charles Schwab & Co, based solely on merit. Historically, Vanguard has been the lowest cost provider of index funds, although the competition is heating up. Since low costs are directly related to higher returns, I believe that this is an important factor for all Smart Investors to consider.

I am not invested in any Vanguard funds. I am invested in portfolio #60 through Index Funds Advisors, with whom I am affiliated. All of the mutual funds in my portfolio are managed by Dimensional Fund Advisors (DFA). DFA passively manages all its funds. It does not engage in stock picking or market timing.

DFA funds are only available through designated Registered Investment Advisors.

Question From miguelpakalns:

Mr. Solin --

I am a 26-yr-old 401(k) investor currently saving money to open a prospective online trading account, in which I had planned either to: A. Buy-and-hold equities of low-debt companies with strong earnings growth and positive cash flow, or B. Buy socially responsible Funds, or most likely C. Both.

My 401(k) does not meet your standards. I currently hold about 60% emerging markets (FEMKX, reduced contributions from 50 to 33 a few months back but the % remains at ~60 due to NAV growth), 30% domestic (Fid Contrafund FCNTX and FDSCX) and roughly 10% junk bonds (FAGIX).

As you can see, I am an investor willing to gamble, and so far it has payed off very handsomedly (FEMKX!! ; Began buying FAGIX when it was 8.60-8.70 two months ago, saw it was generic junk corporate debt with few direct ties to mortgages or subprime and I figured it was being panic-sold, now it's back toward NAV 9.00 plus the monthly dividend).

Would your advice be for me to switch my 401(k) to Index Funds, and take my gambles with the online trading instead? To switch everything to Index Funds?

I hate to admit it, but advice to dump my YTD-28% earning portfolio for 8-11% earners will not please me nor most investors my age, even if I/we know it is "the most sound" advice (with young colleagues we snicker about "index investors").

Should I jump out of Emerging Markets before the "inevitable" crash? (note again, I felt "bubble" in June/July and started cutting back contributions, but FEMKX keeps on chugging with only the occasional blip)

Any special advice for online buy-and-hold investing? Or is the recommendation Index Funds uber alles?

Trying to make sense of all this, much appreciated,

Your questions raise some excellent issues.

My views on intelligent investing, supported by reams of academic data, are set forth in my blog entitled: It's So Easy, Your Broker Could Do It!

There is no evidence that anyone has the ability, over the long term, to predict what segment of the market will outperform other segments. This applies to geographic areas as well. For example, as you note, emerging market funds (dominated this year by China funds) are having a great year. However, that does not necessarily mean that those funds will repeat their stellar performance next year.

In 1999, Japan funds were all the rage, just like China funds are today. The Warburg Pincus Japan Small Company Fund was up 328.7% for the year.

In 2000, these funds nosedived. The Warburg Pincus Japan Small Company Fund lost 71.6% of its value!

One study of mutual funds over an 11 year period validated the lack of consistency of performance by mutual fund managers. The study concluded that only about 14% of the top 100 managers in one year repeated their top 100 performance in the second year. Over the long term, this percentage would decline drastically.

The securities industry wants you to believe that market returns are "average". They do this so that you will use their services to try to "beat the markets." However, studies of the returns of mutual fund investors indicate that market returns are superior returns.

Dalbar, a financial research firm, studied the returns of mutual fund investors from January, 1984 through December, 2000. During that time, the S&P 500 index returned an average of 16.3% per year.

How did investors do? A pathetic 5.3% per year for the same period.

Your 28% returns this year are impressive. But the data tells us that, if you continue to time the market and attempt to pick outperforming mutual funds, you are likely to underperform the markets.

Therefore, my advice remains unchanged: Smart Investors should determine their asset allocation and invest in a globally diversified portfolio of low cost index funds.

Dan,

What do you think about target age funds? I am fascinated by them, but they own a lot of financial funds and bonds. The closer you get to your retirement date, the more they buy of the financial funds and bonds.

Would it be better to buy them 20 years earlier than your actual retirement?

Target funds can be an excellent option, but only if the underlying funds are low cost index funds (like the Target Retirement Funds offered by Vanguard) and not hyperactively managed funds. Reputable target funds are not overweighted in any particular sector or asset class. They should consist of a globally diversified portfolio that is rebalanced to become more conservative at the "target date" gets closer.

Question From Halsey:

Dan...you cannot just tout the S & P...the performance "quilt"...clearly indicates that it is few years, indeed, that the S & P is the top performing..one year it will be emerging marking, the next, small cap grown, the next, managed futures, the next Large Cap Value.

I too recommend index funds over mutual funds IF the investor has more than $25,000...as you cannot properly diversify with less...except to go the mutual fund route..and there ARE ways a broker can buy them at NAV..then just charge 85 bps a year..(we do have to make some money for our effort..but don't have to gouge!)

I remain solid in my knowledge that at "good" broker" will properly diversity even the smaller investor...and NEVER put all the eggs in the s & P basket...

By they way..did YOU buy Microsoft on Monday? I did... just "felt/knew"... it had a bump coming.

I do not recommend that anyone hold a portfolio consisting only of the S & P 500 index. I agree that this would be far too volatile for investors. My views on asset allocation and the composition of an appropriate portfolio of globally diversified, low cost index funds for both stocks and bonds are set forth in my blog entitled: It's So Easy Your Broker Could Do It!

I don't understand why anyone would pay a broker 0.85% per year to purchase index funds that they could buy directly from the major fund families (Vanguard, Fidelity, T. Rowe Price, and Charles Schwab & Co) and pay zero for the privilege.

Finally, I did not buy Microsoft on Monday, or on any other day. I believe investors should make decisions based on hard data and not on emotion.

Investing in Microsoft may, or may not, prove to be a wise decision over the long term. However, what few investors (and brokers) understand, is the risk inherent in buying individual stocks. When you hold individual stocks, you take on what is called "uncompensated risk", which means that you could obtain the same expected returns with far less risk, by holding a more diversified portfolio.

One study demonstrated that, from 1997 to 2003, an investor in a single S & P 500 stock had the same expected return as an investor who held an S & P 500 index fund. However, the single stock investor was exposed to nearly twice as much risk!

Investors are, of course, free to use brokers who charge fees for putting them in index funds, or hyperactively managed mutual funds, and who recommend individual stocks, without regard to uncompensated risk. However, well informed investors would be well advised to take charge of their own finances and avoid these "investment professionals."



The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein.