Financial Advice for the Younger Daughter - Part 2

One of my best jokes in front of the classroom is to announce that I'm going to "recap" as I make a production of putting  the cap back on the dry erase marker - OK , not that funny,  although it does get a couple of chuckles and plenty of moans.

Anyways....to recap...

Yesterday I was into the "Your Guide to Getting Started" booklet put out by Fidelity for 401k participants. I'm advising my daughter on her participation and trying to look at it from the perspective of a young pastry chef. We had reached the point where we noted there is a wide range of choices, all kinds of classes of funds, and a lack of information. We had reached the white water.

My wild guess is that probably no more than 20% of the people handed this booklet get past skimming the fund descriptions. Furthermore, anyone who wonders why 401k participation is low  has their question answered after looking over the booklet. Imagine a pastry chef reading this for the description of the "PIMCO Total Return Fund" :

"The fund normally invests at least 65% of assets in a diversified portfolio of Fixed Income Instruments of varying maturities, which may be represented by forwards or derivatives such as options, futures contracts, or swap agreements."

Uhh...OK...I guess.

So what do participants need to know to pick appropriate funds? Let's start with how not to do it by putting the choices in table form.

Under the category "Domestic Equity Funds," the following choices are available in the "Your Guide to Getting Started" Fidelity booklet. The data shown in the table comes from Morningstar (just put the ticker symbol in at their site). The data is expected to be reliable but can't be guaranteed.

Source: Morningstar

It is important to note that sometimes there are too many choices. There can be a "deer in the headlights" situation. People back off and can't make a decision and therefore don't participate. (Not true when I have the choice of a lot of desserts, but that's another story!) Also, too many choices can result in an ongoing negative feeling because there will always be choices that do better than the choice you made.

The available funds under this single category offer widely-ranging investment types. They include small companies, large companies, so-called value stocks, and growth stocks as well as blends. The "Rank" shows how they performed relative to their peers.

At first inclination, there could be a tendency to select based on the performance ranking. Unfortunately, that's typically not a good approach. In fact, go to Morningstar and put in the ticker symbols, and you'll find many of the lower ranked funds in the table have relatively high ranks for the 3-year period. Think about it--this means they would have had a high ranking 12 months ago. Also, they wouldn't even be an available choice if they hadn't had exceptional performance in the past. The bottom line is that exceptional performance doesn't tend to persist. More directly:  selecting funds on the basis of their past performance can be hazardous to your investment health.

Next time, we'll get to the recommended allocation. For homework, see if you can pick the two funds I will recommend.

The information presented here is for educational purposes only. Investors should do their own research or consult with a professional advisor before investing.

Financial Advice for the Younger Daughter: Part 1

A bit of back story:  The younger daughter graduated from the Culinary Institute of America in New York as a pastry chef, worked for several months in Australia, spent time traveling in New Zealand and India, and now is taking her first "real" American job at a restaurant opening on the Eastern Shore in Maryland. She is 23 years old--soon to be 24.

Mom moves her into her new apartment. Pop gets the details on the 401k.

Keep in mind I've managed assets for 30 years as we try to look, from the perspective of a young pastry chef,  at "Your Guide to Getting Started" put out by her fund provider Fidelity. Also keep in mind that Fidelity is one of the biggest players in the 401k market.

The booklet starts out with something us investment types (of which I guess I'm one)  like:  a bar graph showing the importance of saving and investing as soon as possible. It assumes a certain salary and shows her account balance at certain ages depending on the percent of salary contributed and a 7% return average annualized return. Great stuff. Not sure what the typical kitchen person or wait person will get out of it, but still all financial planner/investment types love this stuff.

Page 4 gets into eligibility, how to enroll (go to www.401k.com) and how to complete beneficiary form. It indicates when enrollment is effective, how much can be contributed, and how previous 401ks can be rolled into this one.

Next are two really important points:  matching and vesting. Her plan matches 100% of the first 3% contributed and 50% of the next 3%. So, for example, if she makes $40,000/year, she will contribute $2,400 (.06*40,000). The company will chip in $1,200 for the first $1,200 and $600 for the next $1,200. The total contribution then would be $4,200 for the year, with $1,800 of that being "free money."

On the very next phone call, my pressing question is "Jill, can you put 6% of what you make pre-tax into your 401k?"

Over the next 40 years, if the average annual return of the investment is 8%, that single contribution for her first year working will have grown to $91,243,  (4,200* (1.08)^40) ! Her father's advice:  do what you have to do, but contribute the 6% of salary to take full advantage of the match.

Next, the booklet points out that, to be fully vested, you have to work for the restaurant for 2 years. Tack on advice:  plan on working 2 years.

OK...so far so good. Everybody's on the same page. The rest of page 5 in the booklet talks about taking a loan from the account (don't do it), withdrawals (forget about it), planning for retirement ( start reading it in 30 years). So basically, up to this point, she really didn't need me. In fact, very little of these first few pages needed to be read. The bottom line is participate up to the match. It is important not to get bogged down in minutiae because the brain numbing part is straight ahead - in other words, the whitewater is right around the bend.

Page 8 starts with the investment nitty gritty. There we find an investment spectrum showing the list of investment choices in an horizontal framework ranging from most conservative ( money market) to more aggressive ( "Select Leisure Portfolio"). Here we get the line "For more complete information about any of the mutual funds available through the plan, including fees and expenses, log on to ...".  In fact, jumping ahead, there is nothing in the booklet as far as I could tell that specifies fees and expenses, although I can't swear to it because there is an awful lot of fine print.

Next we get into the fun part, and remember we are looking at this through the eyes of someone trained in the culinary arts. It makes us want to throw a recipe for creme brulee in front of the Fidelity reps and tell them to go make it and their future depends on how it turns out.

The Investment "Options"

 There are 35 fund choices. There is the "Buffalo Small Cap Fund," the "Fidelity Contrafund," and Oakmark Equity and Income Fund Class I" fund. In fact, looking across all the funds, there are all kinds of classes including "investor class," administrative class," "class I," "class P," etc. There are indexed funds and enhanced indexed funds. There are even "hybrid funds" and a "Four-in-one Index Fund."

Tomorrow we'll move deeper into the abyss and think about appropriate investment choices for a budding pastry chef.

Investment Management Fees - A Different Angle

DIY Investor is a proponent of paying attention to investment management fees and seeking ways to reduce them. Fees eat up a goodly proportion of people's nest eggs; and they aren't easy to detect because they are, in many cases, hidden. Fees come in the form of investment advisory fees, expense ratios, trading costs, 12b-1 fees, and the list goes on.

In fact, DIY Investor charges .40% management fees and invests primarily in low cost cost index funds (many of which now have zero commissions) which have an expense ratio of approximately .15%. In contrast, many advisors charge 1% management fees and use mutual funds that have expense ratios on the order of 1.3% and, to boot, are actively traded.

What is the impact on fees over the longer term? DIY Investor looked at this using actual market returns over the past 20 years as reported on the BlackRock table of investment performance. This analysis showed that, for a starting portfolio of $1.0 million, the end result was $857,585 less with a 1%/year management fee compared to a 0% (i.e. do-it-yourself investor) where both the manager and the do-it-yourselfer matched market returns. Of course, if you are convinced that your manager can "beat the market" by more than 1%/year then, by all means stay with the manager.

There is another way to look at the impact of fees using the FIRECalc calculator introduced previously. Click "Your Portfolio."  CLICK TO ENLARGE

This will bring you to a page where, at the top, you can input the cost of managing the portfolio in percentage terms: CLICK TO ENLARGE

Source: FIRECalc

There are a number of built-in assumptions for the results (all of which can be changed to reflect an individual's portfolio) that include starting value of portfolio ($750,000), asset allocation (75% stocks/25% bonds), period covered (since 1871), etc.

The results of changing the management fee, starting with a .25% fee and increasing by .25% increments to 1%, are shown in the table in terms of the maximum and minimum values the portfolio will achieve over 30-year periods for the Monte-Carlo analysis:

The results show meaningful swings in the maximum and minimum values over long periods of what many investors take as minor differences in expenses.


No matter how you look at it - portfolio management expenses are expensive over the long run!

1:30 am and Running Through the Antietam Battlefield

We have been put in charge of managing our own assets. Instead of company pension plans, we have 401ks. Instead of guaranteed Social Security, there will be changes. Instead of rational markets, there will be times of craziness with bubbles bursting. It's a long race. It's about pacing. It's about some creepy times,  and it's about the joy of completing the journey.

Here's another post with the exact same themes from Lori, my oldest daughter, and her husband Matt:

200 Miles . The American Odyssey Relay Run.

Shiller vs. Siegel

Robert Shiller of Yale (author of the well-timed Irrational Exuberance) and Jeremy Siegel of Wharton (author of the prescient Stocks for the Long Run) continue to disagree on the future course of the market. If you follow Shiller, you believe that stocks are at or close to being overvalued. Siegel's view is that stocks offer value at today's prices and now is a time to be bullish.

DIY Investor believes that the appropriate stance is to focus on developing a strong asset allocation plan and sticking with the plan. Still, the views of these two giants in the investment world are worth listening to:

How Long Will Your Money Last?

Running out of money is the number one concern of retirees. The probability of that occurring, and figuring out how much is needed to retire in the first place, has turned into a national past-time with the oncoming so-called "gray tsunami" of retiring baby boomers. At least it has for about 50% of the workforce. Apparently the other half is going to wing it. In any event, there is a neat little calculator for those seeking a ball-park estimate to this question produced by FIRECalc that DIY Investor came across at Free Money Finance.

This calculator starts out very simply and requires a portfolio amount and an assumed spending amount as shown:

Source:FIRECalc

 DIY Investor put in the portfolio amount of $1,000,000 and a spending level of $40,000 to test the 4% rule of thumb. Upon clicking "submit," FIRECalc returns a series of paths graphically. The result is that spending 4% on an inflation-adjusted basis would have been successful, i.e. the retiree would not have run out of money, 94.6% of the time based on 111,  30-year periods .

Just this simple step used in conjunction with expected Social Security, and maybe a possible pension, can start to give a retiree a good idea if his or her nest egg is close to being able to produce the desired income. The FIRECalc tool allows for more sophistication, as well, for those wanting to put in their own assumptions. Just click the tabs on the home page:

CLICK TO ENLARGE 

What is Monetizing the Debt?

On Friday DIY Investor looked at how the Federal Reserve puts money into the economy. Interestingly, just yesterday he saw a commenter somewhere ask the age old question of where does the Fed get the money to buy securities. The answer is - out of thin air. And this is the problem.

In many areas of life when a screwup occurs there is a choice. People have to pay for their screwup or they are bailed out. Many times it depends on where the screwup happens to be on the economic spectrum. At the lower income part of the spectrum, for example, a job loss can be a catastrophe. Towards the upper end not so much.

One function the Federal Reserve has taken on is bailing out the financial system when it screws up. This of course is the whole "moral hazard" /too big to fail issue.Our biggest financial institutions including investment banks, rating agencies, and even auditors thumb their noses and take excessive risks. They know they'll be bailed out.

The Federal Reserve's  "lender of last resort" function has morphed over time (thanks mostly to former Fed Chairman Greenspan) into a " lender whenever there is a small bump" function.

On Saturday DIY Investor described how the Fed and the Treasury are different. In basic terms Treasury borrows for the Federal government to fund its chronic deficit. Just like any corporation, it issues bonds. To see the actual issuance check out the Bloomberg Calendar where the weekly auctions of bills, notes, and bonds are listed. Treasury borrowing is only a problem in that it "crowds out" private sector borrowing and, in turn, this bcomes an issue as the economy moves towards full employment. It will push up interest rates and thereby worsen the deficit problem.

The real issue is when Treasury borrows and the Fed buys the issues it is selling. This is called "monetizing the debt". The two ballyhooed "Quantitative Easing" programs were basically just old fashioned "monetizing the debt" programs but they couldn't be called that. Certain phrases like "bailout" and "monetizing the debt" are not typically used in polite company.

What does monetizing the debt do? Simply it creates high powered money or what is officially called the monetary base. This is the stuff that bankers hold and use for their part to create money out of thin air. When they create money out of thin air it lowers the value of money. Just like anything, when supply increases, price drops. In terms of the monetary unit this is inflation. When your grandmother said the dollar doesn't buy what it used to it was just her way of saying there has been a lot of inflation.

Now you're probably wondering what the monetary base looks like today. Wonder no more:

The bottom line is this: banks have the potential for explosive growth in the nation's money supply. They have an incentive as well - banks earn profits (and they are profit maximizers like every other business all though that might not be obvious from recent experience) by making loans, i.e.creating money out of thin air.

Chairman Bernanke's press conference was basically to keep markets from freaking out over signs that inflation is picking up. He is attempting to inject confidence in the market as commodity prices skyrocket. He is trying to send a message that the Fed is in control.

All of this is reminiscent of 2006 when he was a leader in the ongoing refrain that the housing crisis was a localized event and wouldn't have a major impact on the broader economy.