Tag Archives: Mutual Funds

Am I Financially Agnostic?

I am not new to investing.  I have been an individual investor for a couple of decades.  Over that period of time, I have seen it all.  There have been booms, bubbles, and busts.  As the result of my experience, I wonder if I have become financially agnostic.

Over that same period of time, I have not sold low as the markets bottomed out or experienced irrational exuberance when the market soared.  My goal has always been to reach financial independence by way of investing in stocks and bonds.  As the result of studying personal finance, I knew that markets go up and down.  Corrections and recessions occur.  They are an opportunity to buy low and to build long-term wealth.  When I started this journey, my time horizon was long and my risk tolerance was high.

Following 9/11, the markets melted down.  My Mom asked me if I was going to sell my stock holdings and not risk losing all of my savings.  I said nope and kept buying. The markets did not recover for more than three years and I did not deviate from my plan.  With every paycheck, I just kept dollar-cost-averaging into my investment accounts.

My response was similar following the market crash of 2008.  My wife asked if we should sell all of our stock holdings.  I said nope because we had a couple of decades to go until we retired.  I kept our asset allocation the same and kept dollar cost averaging.  2008 was scary and I did not know that the next bull market was only a few months away.

The same can be said for chasing performance.  When I started investing, day-trading and investing in technology stocks with high growth potential was crazy.  My experience as an investor was limited, but my gut told me that making money was truly not that easy.

During the early 2000’s, the real estate market was heating up.  Credit was easy to come by.  People who should not have been given loans were signing for variable rate mortgages without knowing the consequences of what future potential rate hikes would do to their monthly payment.  Investors without any real estate investing experience were flipping houses and condos all over the county.  Again, my gut told me to say away because I knew that making money was not that easy and speculators tend to lose their money when the markets make a turn for the worst.

So, why do I ask if you think I am financially agnostic?  It is not because I have no faith in capitalism or the global economy.  There is proof that investing in a market-weighted portfolio has worked in the past and I believe that it will continue to produce results in the future.  There will be ups and downs, but this type of investing will always provide average returns.

I classify myself as being financially agnostic because I do not believe in anything other than investing in a couple of index funds.  I do not know what the future market returns will be.  Whatever the markets do return, I am positioned to capture these returns.

Based on past performance, there are many financial institutions that I have no faith in.  They have mostly failed investors in the past.  They will continue to mislead in the future.  There is no way to know when to trust them and when not to trust them.

Financial Media

Even though it has improved to some degree, I have little faith in the financial media.  Yes, they have come around to indexing, but that does not sell advertising.  The financial media is out to make money and sell advertising.  The five hot stocks that they say to buy for summer will be different from the best wealth-building stocks they suggest for winter.  Fear sells magazines and newspapers.  It does not build wealth.  If the authors of these articles or the talking heads on television knew so much, they would be out making their own fortune and not reporting about financial news.

Financial Advisors

I have no faith in financial advisors.  Yes, there are some good fee-based financial advisors.  Most, however, are just salesmen.  They are just out to make a buck and do so by selling complicated investment products that come with high fees and low performance.  Collin Cowherd once said, “I trust Smith Barney when it comes to managing my money, but not Barney Smith”.  I guess Smith Barney has not done much better since they are no longer in business.  There has been some legislation around the financial industry to improve the quality of advice that financial advisors sell, but the financial industry has fought the concept of putting their client’s interests ahead of earning a commision.  There is currently no proof for me to trust these people with managing my money.

Actively Managed Mutual Funds

Professional money managers do not have a track record that garnishes much faith.  You would think that an actively managed mutual fund would outperform the index that they are benchmarked against, but the vast majority don’t.  Some outperform the index they track for a year or two.  Over the long hall, most actually underperform the index and go out of business.  They also are inefficient from a tax standpoint due to turnover as the result of all of the buying and selling of stocks within the fund.

The Financial Journeyman

This might or might not come as a surprise, but I also have no faith in myself when it comes to picking investments.  If both the Barney Smith’s and Smith Barney’s of the financial world cannot do it successfully, who am I to think that I can find alpha over the long term?  Easy answer, I cannot, so I do not even pretend to have any faith in my finite ability and resources to beat the market averages.  That is why I invest in my Sweet Dreams Portfolio and don’t pay too much attention to the markets.

History & Experience

Since I have little to no faith in all of those major financial institutions because they have all failed in the past, why do I have faith in the stock and bond market as a whole? My faith is based on experience.  By investing in index funds, an individual investor will outperform 90% of their peers.  I have captured average market returns for decades.  Those returns have allowed me to reach financial independence long before most people in my age group.  I have faith that my balanced-growth portfolio will produce average market returns.  By combining average market returns with a high savings rate and prudent living, I have faith that I will be able to retire early.  When I do retire, I will follow a similar approach with some scaled back risk during the drawdown period.

Conclusion

In life, I have learned to draw conclusions based on the evidence that is presented to me.  It is impossible to have trust in the financial industry that is not willing to take on a fiduciary responsibility.  Just as their goal is in to maximize ROI for shareholders, my goal is to earn the highest returns at the lowest costs to fund my retirement.  Up until this point, as well as moving forward, my faith is in playing the averages.

Are you financially agnostic?

Do you have any faith in the financial media, intuitions, or your own abilities as an investor?

Or, are you like me and believe in average market returns are both available and good enough to carry an investor too and through retirement?

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Using Beta to Measure Investment Risk

When an investment portfolio is being designed, there are a few basic factors to consider.  What is your age? What are your savings goals?  Do you know the type of returns do you expect to earn from your investments?  The most important factor to consider is much risk can you tolerate?  Using beta to measure investment risk is a great measurement to review.

When the stock market is soaring, investors tend to forget about risk.  Who wants to dampen the performance of their portfolio and miss out on the double-digit bull market returns?  It does not matter if you are an aggressive investor in your prime earning years or a more conservative investor who is nearing retirement when the markets start to get volatile, most investors tend to become more focused on risk management and risk tolerance.

Beta

It is important to know how risky the investments that make up your portfolio are.  One of the best ways to measure volatility is to measure the beta of an investment.  Beta is the second character of the Greek Alphabet.  Beta is used to determine how volatile an investment is in relation to its benchmark.

When measuring beta, the baseline is 1.  If an individual share of a publicly traded company, an EFT, or a mutual fund has a beta of 1, it moves exactly in step with its benchmark.  If an individual equity, ETF, or mutual fund has a beta that is greater than 1, the investment is more volatile than the benchmark that it tracks.  On the other hand, if an investment has a beta of less than 1, it would be less volatile than its benchmark.

In other words, beta is the risk measurement of investing in the stock market.  The stock market has a systematic risk.  If an investor wants to reduce the volatility of a market portfolio, they might want to consider adding some investments with a beta that is less than 1.

Investors who invest in a portfolio constructed of passive investments would generally be considered beta investors.  That is especially true for those who invest in broad market portfolios.  Investments such as large-cap index funds would have a beta of 1.  For example, an S&P 500 index would have a beta of 1 because it tracks the S&P 500 index. Investors who invest in a portfolio that incorporates bonds into their mix would have less volatility than a portfolio made up of only stocks because the beta would be less than 1. 

Below are a few mutual funds to consider if you are looking for a low beta option:

Fidelity Growth Strategies Fund FDEGX

Beta: 0.82

Fidelity Low-Priced Stock Fund FLPSX       

Beta: 0.54

Fidelity Small Cap Growth Fund FCPGX

Beta: 0.79

Vanguard Wellington Fund Investor Shares VWELX

Beta: 0.68

What are some investments that have a beta that is greater than 1?  It is not uncommon for actively managed mutual funds to have a beta higher than 1.  That is because fund managers are trying to beat the market.  There are index funds as well as ETFs that also have a beta higher than 1.  Micro-Cap funds and emerging markets tend to have a beta higher than 1. 

Some examples of funds with a high beta are:

ALPS Medical Breakthroughs EFT SBIO

Beta: 1.86

Consumer Discretionary Select Sector SPDS Fund XLY

Beta: 1.73

Fidelity Nasdaq Composite Index Tracking Stock ONEQ

Beta: 1.37

First Trust Dow Jones Select Micro-Cap Index Fund FDM

Beta: 1.33

Alpha

While the beta is used to measure risk, alpha is the benchmark that measures market-beating performance.  Alpha is the goal of active managers.  Alpha is the Holy Grail of active management.  Those who consistently produce alpha become legends.  Those who don’t ultimately receive a pink slip.

Many investors would like a portfolio that has both a low beta score and a high alpha.  Building a portfolio that has the combination of low-volatility and market-beating returns is very hard to accomplish.  That is why most active fund managers do not succeed. 

Formula

Alpha is based on PR – [RF + Beta * (MR – RF)]

PR is the return produced by the investment portfolio

RF is the risk-free rate of return (Treasury Bonds)

MR is the market return

It is very difficult for active fund managers to consistently produce market-beating returns.  It is possible in the short-term, but the vast majority of managers do not beat their benchmark over long periods of time.  Most produce a negative alpha beyond 5 years.

It is almost impossible for individual investors to produce market-beating returns year after year.  Individual investors have a more difficult time than professional investors because they do not possess the resources or information that professional fund managers possess.  It would be easier for an individual investor to use beta to help in designing a portfolio than trying to produce long-term alpha.  

Conclusion

There are many factors to consider when building an investment portfolio.  Beta is one of many measurements to use as a guide.  It is not the sole measurement that should be the determining factor when trying to decide if an investment fits in with the rest of your portfolio.

Focus on learning how much real-world risk you can tolerate.  Could you tolerate a (50%) drop in the value of your portfolio?  If not, a portfolio of 100% invested in stocks might not be for you. How about a (20%) drop?  If that sounds more bearable, you should consider a more balanced portfolio. To help track your portfolio, consider using Personal Capital to monitor your asset allocation and performance.

Before you ever make an investment decision, be sure to check with an investment professional. 

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Define Your Investment Style

There are many different approaches an investor can take in managing their money.  Some approaches are hands-off and require little effort to maintain the desired asset allocation.  Other approaches are more time intensive and might require daily or weekly management.  There are other approaches that fall somewhere in-between.  The key to success is to define your investment style.

No matter how you decide to invest, you need to have an investment philosophy.  It should be part of your financial plan.  Without having direction, there is just too much noise to misdirect you on a daily basis.  Every hot investment tip will sound like a good idea.  That will lead an investor to try to chase performance.

It is up to you to decide how you want to invest your money.  Some approaches are considered more favorable than others because they are tax efficient, cost very little, and allow investors to capture average market returns.  There are approaches that rely on investment professionals to try to beat the market.  Some investors feel confident that they can manage their own selection of individual securities and want to pick their own stocks.  There are also Robo-Advisors that investors can use to manage their investments.

When it comes to trying to invest to build wealth, there are countless avenues for investors to explore.  There is passive investing, active investing, crowdfunding, and countless other forms of ventures to invest in.  The purpose of this post is to cover some of the most common forms of investing where the transactions can occur with the click of a mouse.

Index Funds

Index funds are what their name implies.  An index fund is a mutual fund that is composed of stocks that track a specific index.  For example, if you buy a share of an S&P 500 index fund, you are buying an investment that is made up of the largest publicly traded U.S. corporations.

There is little actual management and turnover with index funds.  That is what makes them cheap and tax-efficient.  A management team is not required.  There are very little trading and turnover within most index funds.

There are index funds that track large-cap stocks, small-cap stocks, international stocks, and bonds.  There are index funds that hold every publicly traded stock in the world.  There are also index funds that track individual sectors or sub-asset classes such as consumer stables, natural resources, technology stocks, and other sectors.

An investor can keep it simple and buy three index funds like the total U.S. stock fund, total international stock fund, and total bond market fund that would allow them to own every publicly traded stock in the world.  An investor can slice and dice and break it down into many different funds and build a custom portfolio with different tilts.  There truly are limitless possibilities.

Managed Funds

Managed funds are like index funds.  They invest in a basket of different stocks or bonds.  The major difference is that they do not track an index.  They have a fund manager or team of managers who try to beat a benchmark.  For example, a managed large-cap growth stock fund would try to beat the S&P 500 index.

Compared to index funds, managed funds have higher fees.  The average expense ratio for a managed large-cap stock fund is 0.99%.  The expense ratio for the Vanguard S&P 500 is 0.04%.  That is almost one whole basis point.

The goal of the fund manager is to outperform its benchmark.  Based on the difference in fees, the fund manager must outperform the S&P 500 by almost 1% per year to just break even.  That is very difficult to do.  It is getting even harder as the result of the shrinking alpha.

For the fund manager to try to beat their respective benchmark, they need to make trades.  They are paid to buy stocks within the fund that they think will outperform.  They also must identify the stocks that they think will underperform and sell them.

All of that buying and selling is called turnover.  Some managed funds have a turnover ratio of 90% or more of their portfolio annually.  If a managed fund is held in a taxable account, all those trades trigger capital gains that are passed on to the investor.

Most managed funds do not beat their benchmark.  In 2016, only 34% of large-cap mutual funds beat the S&P 500.  It gets worse with time.  Only 10% of large-cap mutual funds beat the S&P 500 over the last 15 years.

What happens to the underperformers?  Usually, a new manager is brought in to right the ship.  If its performance does not improve, it normally merges with another fund.

Individual Stocks

Investing in individual stocks can be rewarding.  If you select the right stock, you will outperform the major indexes.  Just look at Google, Amazon, or even Apple.

The problem with investing in individual stocks is that it is hard.  Most active mutual fund managers who have unlimited resources cannot consistently do it.  It is not likely that an individual investor will outperform the S&P 500 for a decade or longer.

Can an investor get lucky when they buy a few stocks?  Sure, they can.  That, however, is speculation.  Investing is not gambling.

When an investor buys an individual stock, it is a vote of confidence in a company.  It is a vote that they know the stock is undervalued compared to its market price.  They are making a statement that says they know more about the fundamental business operations of the company and they are positive that it is sure to appreciate.

They do not know any of those details.  The individual investor receives their information from the financial media or a stock screener.  They are the last to know anything about the value of a stock.  The professionals, analysists, and insiders know before the media.  They provide the information to the media.  The media informs the individual investor.

Robo Advisors

Robo-Advisors are the new frontier for individual investors.  Robo-Advisors are financial management platforms that allow investors to manage their investments based on algorithm-based variables.  An investor plugs in their goals, risk profile, and other survey data and Robo-Adviser does the rest.

The technology used by Robo-Advisors is not new.  The investment industry has been using it to rebalance accounts since the early 2000’s.  It is new, however, for individual investors to have access to this type of asset management technology.

Even though it has been around for some time, it is fascinating technology.  Since it is automated and based off an algorithm, there is not much room for human error.  Not only can it be used for investment selection, but it can also be used for more sophisticated processes like tax-loss harvesting.

There are some nice benefits to using a Robo-Advisor.  They are a much more affordable option than having to hire a human Financial Advisor.  The annual fee to use a Robo-Advisor is between 0.2% to 0.5%.  That is much more affordable than must shell out up to 2% for a human financial advisor.  The minimum amount that is required to invest with a Robo-Advisor is much lower than the standard six-figure minimum that many traditional human financial advisors require.

Conclusion

The above investment styles are just a few of the more popular methods for individual investors.  Over the years, my portfolio has become primarily made up of a few index funds.  I have invested in a few managed funds but sold off all except one.  As far as individual stocks, I have only bought and sold five individual stocks since I started investing.  I have not owned any individual stocks since 2004.  Many investors in the financial independence community use individual stocks as part of their dividend strategy.  As for the Rob-Advisors, I have invested using that technology, but do see its value for tax-loss-harvesting in a retirement account.

What is your approach to investing?

Do you follow any of the methods that I covered or a blend of a few different approaches?

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