I like target retirement funds. Clearly, they have some issues with their implementation. But I think that, done well, they have the potential to be a truly excellent savings vehicle for the investing public.

Morningstar’s John Rekenthaler recently gave testimony before the Senate Committee on Aging. His Five Concerns About Target Date Funds is, in my opinion, the single most worthwhile discussion I’ve read on the topic–giving credit to their potential as well as honestly addressing their shortcomings. If you haven’t read it yet, I encourage you to do so.

My other favorite articles from this week:

Investing Articles

• Don’t Forget Social Security in Your Roth Conversion Strategy from Getting Your Financial Ducks in a Row
• Drawing the Line Between Family and Financial Advisor guest post at My Life ROI by Kyle of Suburban Dollar
• Which Wins: 401k Match or High Interest Debt? from Pondering Money
• 23 Things Beginners Absolutely Must Know About Saving for Retirement from Money Under 30
• Perfect 10 Investing from Monevator
• “Top Down” Investing from ABCs of Investing

Other Personal Finance Articles

• How Working Overseas Helps Your Career from Brip Blap
• “Complexity of Tax Law” Not a Challenge for IRS? from Tax Girl
• What Do You Do for Frugal Fun? from Get Rich Slowly

Blog Carnivals

• Tax Carnival hosted by Don’t Mess With Taxes
• Carnival of Personal Finance hosted by The Centsible Life
• Festival of Stocks hosted by The Intelligent Speculator
• Best of the Best in Money and Personal Finance hosted by Len Penzo
• Best of the Financial and Investing World from 20sMoney

Thanks to each of you for reading. I hope you enjoy your weekends.

Get free shipping from Amazon when you buy my most recent book book, Investing Made Simple, together with Bill Bernstein's latest: The Investor's Manifesto.

Most of us have a huge portion of our assets invested via mutual funds, so it’s important to know how to choose them. Unfortunately, there’s a lot of misinformation out there. Keep the following facts in mind, and you should do just fine.

Past Performance

1. Past performance is not indicative of future results. The disclaimer you see everywhere isn’t just cover-your-ass legal mumbo jumbo. It’s based on real studies.

Costs Matter.

2. Sales loads are money down the drain.

3. “No-load” does not mean “free.” No mutual fund is free. Ever.

4. Always look for a low expense ratio. Within a given category of funds (government bond funds, for instance), expenses have been shown to be the best predictor of future results.

5. Portfolio turnover leads to expenses not included in the expense ratio. Always look for low turnover.

6. Without fail, the lowest-cost funds are index funds or ETFs. (Which is cheaper for you depends upon your situation.)

Asset Allocation

7. Asset allocation is the single biggest factor in determining the performance of your portfolio. Invest in a mutual fund because its asset allocation fits your needs, not because of its past performance.

8. Beware of style drift. You cannot control your asset allocation if you don’t know the asset allocation of the funds you own.

9. Before investing in a target date fund, check its asset allocation and glide path. Within funds of a given date (Retirement 2020, for example), the asset allocation can vary significantly between fund companies.

Taxes

10. Stock funds are naturally more tax-efficient than bond funds. Given the choice, tax-shelter your bond funds (via an IRA, for instance) before tax-sheltering your stock funds.

11. If you’re investing in a taxable account, portfolio turnover becomes twice as important because it leads to higher taxes as well as higher costs.

Get Moving!

There’s no need to make this into something more complicated than it really is:

• Look for low-cost, low-turnover funds that fit your asset allocation needs, then
• Start putting money into them.

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One of my favorite blogs, Bad Money Advice, recently linked to an older article of his that I hadn’t read. In the article, Frank challenges the assumption that “as you get older you should take fewer risks in your investment portfolio.”

This stopped me in my tracks given that:

1. I do generally think that investors should take less risk in their portfolios as they age (assuming, that is, that the intention is to consume the portfolio over the course of their lives rather than leave it to heirs).
2. Frank is not crazy. (Or at least, he appears to be as sane as anybody using the pen name “Frank Curmudgeon” could be.)
3. Frank is not dumb. (If you read his blog, it’s clear that he’s downright brilliant.)

Does order of returns matter?

A portion of Frank’s argument is that returns are multiplicative and that, therefore, the order doesn’t matter. As he puts it,

“Annual returns of +10%, -5%, +22% and -3% will always result in a four year return of +23.7% no matter what order they came in. So as far as you know, starting out risky and ending safe has exactly the same expected result as starting safe and ending risky.”

Given the context of the quote–a scenario in which an investor is investing a lump sum at the beginning–Frank’s statement is true. In real life, however, most investors are systematically investing over time. That is, there’s addition in the equation (and later, subtraction) as well as multiplication.

So as far as I can tell, the order of returns does matter. It matters a lot. And if the impact of volatility (i.e., the harm suffered as a result of a very poor year or the benefit derived as a result of a very good year) is significantly higher when an investor gets closer to retirement, wouldn’t it make sense to adjust one’s asset allocation to deal with that?

Time to Make Adjustments

Further, I think there’s something to be said for having time to make adjustments.

For example, in the case of somebody investing monthly in a 529 plan for her child’s education, if she were she to keep a constant 100% stock allocation, a bear market during the child’s late teenage years would be much more problematic than a bear market while the child is still a toddler.

I think that’s partly due to the fact that there’s not much that can be done at that point. If things go poorly in years 1-3, you have plenty of time to make adjustments to the plan. If something goes wrong in year 18, there’s not much you can do.

And I think the same thing applies to other investing goals. The farther into the future the goal is, the greater your ability to make adjustments if things don’t go according to plan.

Factors in Determining Asset Allocation

Frank argues that,

“How much risk you should take on has a little to do with how much money you have got, a lot to do with your level of risk aversion, and just about nothing to do with your age. And risk aversion, even though it can be described with fancy math, is ultimately simply a personal matter of psychology.”

I absolutely agree that a person’s psychological makeup has a huge role in what asset allocation they should have. And while I’d agree that age, as such, doesn’t matter, I would argue that:

• For most people, their age has a lot to do with how much money they’ve got (which does matter), and
• Expected holding period (which is generally related to age) also matters.

What do you think? Is there something I’m missing–some aspect of Frank’s argument that I’m not understanding? Or should we go on assuming that asset allocation and time horizon should generally be linked?

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I like balanced funds and target retirement funds as much as the next guy. (Actually, I probably like them more, presuming we’re talking about low-cost ones.) But buying a balanced fund in a taxable account is generally not a good idea.

Why? Because they’re not very tax-efficient.

Taxable Bond Funds

The bond portion of a balanced fund’s portfolio is generally made up of taxable bonds (or, perhaps, taxable bond funds). Because income from bonds is taxed at a higher rate than income from stocks, you generally want to make every effort to shelter them from taxes (by putting them in an IRA, for instance).

Simplified Example: Imagine that you have $100,000 in a Roth IRA and $100,000 in a taxable account and you’ve decided that a 60/40 stock/bond allocation is appropriate for you.

One option would be to buy a 60/40 balanced fund in each account. That would be easy, and it would give you the desired allocation. Alternatively, you could achieve the same allocation, while simultaneously reducing your overall tax burden, by implementing the following asset location strategy:

• Roth IRA: $80,000 in bond funds and $20,000 in stock funds.
• Taxable account: $100,000 in stock funds.

This way, all $80,000 of bond funds would be sheltered from income taxes rather than just $40,000 of bond funds.

(Relatively) High Turnover

Because they rebalance so frequently, many–though not all–balanced funds have relatively high portfolio turnover. Higher turnover always leads to higher costs in terms of commissions and bid/ask spreads. And if you’re investing in a taxable account, higher turnover leads to higher taxes as well.

The reason that high portfolio turnover leads to higher taxes is that the fund’s capital gains distributions will be primarily short-term rather than long-term, and they will therefore be taxed at your ordinary income tax rate rather than the more favorable long-term capital gains tax rate. Higher turnover also minimizes the potential for delaying taxes on capital appreciation.

Foreign Tax Credit

Many balanced funds (and, as far as I know, all target retirement funds) are funds of funds. And as we discussed recently, funds of funds don’t qualify for the foreign tax credit. Granted, in comparison to the effect of poor asset location and high portfolio turnover, the foreign tax credit isn’t that big of a deal. It’s simply another strike against holding balanced funds in taxable accounts.

My Suggestion

As wonderfully convenient as balanced funds are, they just don’t make sense in taxable accounts. Unless we’re talking about very small sums of money, the tax-efficiency gained by taking asset allocation into your own hands (via separate stock funds and bond funds rather than a fund that combines the two) will be well worth the effort.

Get free shipping from Amazon when you buy my most recent book book, Investing Made Simple, together with Bill Bernstein's latest: The Investor's Manifesto.

Courtesy of a giveaway run by Laura of Green Panda Treehouse, I recently received a copy of Bill Schultheis’s The New Coffeehouse Investor.

The message of the book is that it’s possible to invest in such a way that you can meet your goals without having to pay attention to day-to-day market movements, product pitches from brokers, or meaningless noise coming from the financial media.

Given that that’s precisely the message of this very blog, it should be no surprise that I quite liked the book.

The Three Coffeehouse Investing Principles

Schultheis argues that the following common sense principles are all you really need to know in order to invest successfully:

1. “Don’t put all your eggs in one basket.”–Diversify within asset classes and across asset classes.
2. “There’s no such thing as a free lunch.”–Markets are (mostly) efficient. Use index funds rather than trying to beat the market.
3. “Save for a rainy day.”–Make sure you’re saving enough to meet your goals.

I think he’s spot on with all three. (At the same time, I can’t help but be amused by the juxtaposition of principles #1 and #2, given that diversification has often been described as a “free lunch.”)

Money and Life

The book also offers sound financial advice outside of the realm of investing. For example, Schultheis is a big proponent of tracking your spending:

“I hate budgets as much as you do, but keeping track of expenses has nothing to do with budgeting and everything to do with creating an awareness of how I spend my money.”

That sums up exactly why Kalinda and I track our expenses as well. It’s not about setting restrictions. It’s about making sure that the way we use our money is actually in line with our goals and values.

Would I recommend it?

I think The New Coffeehouse Investor provides an excellent, easy-to-read introduction to buy & hold index investing. It is, however, not very heavy on facts and figures. If you’re into that type of thing, I’d suggest picking up The Four Pillars of Investing or The Little Book of Common Sense Investing instead.

And of course I won’t neglect to mention that if you buy The New Coffeehouse Investor together with Investing Made Simple, you’ll qualify for free shipping from Amazon.

Get free shipping from Amazon when you buy my most recent book book, Investing Made Simple, together with Bill Bernstein's latest: The Investor's Manifesto.

Happy Friday, everybody.

This week I want to highlight a 3-part series from Allan Roth (author of How a Second Grader Beats Wall Street). Allan recently received an email from an insurance salesperson promising that he could give an 8% return with no downside risk. How did Allan respond?

“I gave Mr. Anderson a call this week and told him I was ready to plunk down $100,000 to buy my first annuity.  All he had to do was to convince me.”

How the story plays out is pretty entertaining, and it contains some worthwhile lessons. I’d suggest checking it out: “Insurance Investing and the Hundred Thousand Dollar Challenge” (Part 1, Part 2, Part 3).

Investing Articles

• Roth Conversion: Do You Have the Headroom? from The Incidental Economist
• Socially Responsible Investing from Four Pillars
• Solo 401(k) Plans for Dummies from Amateur Asset Allocator
• Factoring Your Job into Asset Allocation from MoneyNing
• 9 Lazy ETF Portfolios for UK Investors from Monevator

Other Money-Related Articles

• Fairness vs. Favoritism in Gifting, Wills, and More from Darwin’s Finance
• Hey Kid, Wanna Buy a House? from Tax Girl

Blog Carnivals

• Best of Money Carnival, hosted by The Skilled Investor
• Festival of Stocks, hosted by Modern Graham
• Carnival of Personal Finance, hosted by Money Crashers
• Economy and Your Finances Carnival, hosted by OneMint
• Carnival of Financial Planning, hosted by Zach Stocks

Get free shipping from Amazon when you buy my most recent book book, Investing Made Simple, together with Bill Bernstein's latest: The Investor's Manifesto.

A solid understanding of the foreign tax credit can help minimize your investment-related taxes. What’s the foreign tax credit? The IRS explains it this way:

“You can claim a credit for foreign taxes that are imposed on you by a foreign country or US possession. Generally, only income, war profits and excess profits taxes qualify for the credit.”

In short, the idea of the credit is to eliminate double taxation on foreign income.

Example: You earn $500 in foreign dividend income over the course of the year and you pay $100 in foreign taxes on that income. You can claim a $100 credit for foreign taxes paid, thereby reducing your U.S. income tax obligation by $100.

Important note: Unless you meet three requirements, there is a limit to the credit you can take (please see IRS Publication 514 for details on the limit). The three requirements are as follows:

• Your only foreign income is passive income (passive income being things like dividends, interest, and rents),
• Your qualified foreign taxes for the tax year are not more than $300 ($600 if married filing jointly), and
• All of your gross foreign income and the foreign taxes are reported to you on a payee statement such as a Form 1099-DIV or 1099-INT.

And now the fun part: How can you put this knowledge to use?

Look for qualifying mutual funds.

From IRS Publication 514:

“If you are a shareholder of a mutual fund or other regulated investment company (RIC), you may be able to claim the credit based on your share of foreign income taxes paid by the fund if it chooses to pass the credit on to its shareholders.”

The tricky part here is that “funds of funds” don’t qualify. Why? Because they don’t actually pay the foreign taxes themselves. (It’s the underlying funds that pay them.) So if you’re looking for an international stock fund to hold in a taxable account, you might as well find one that qualifies for the credit.

Example: Until 2008, Vanguard’s Total International Stock Index Fund was a fund of funds. As a result, many investors opted to use Vanguard’s FTSE All-World Ex-US Index Fund instead when investing in a taxable account, despite the fact that it has a slightly higher expense ratio and a very similar asset allocation. (As of today though, both funds are eligible for the credit.)

Use it to help determine your asset location.

Funds held in a retirement account–like an IRA or 401(k)–do not qualify for the credit even if they’re funds that would qualify were they held in a taxable account.

Does this mean that you should only buy international stock funds in taxable accounts rather than retirement accounts? No. Not at all. The benefit from tax-deferred or tax-free growth far outweighs this little credit.

If, however, you’re simply deciding which fund to hold in your retirement account (domestic stock fund vs. international stock fund) and which fund to hold in your taxable account, then it’s probably best to tax-shelter your domestic stock funds before tax-sheltering your international stock funds.

Claiming the Credit

Generally, you have to file Form 1116 to claim the foreign tax credit. If, however, you meet a few requirements (the same as the requirements listed above to avoid the limitation on the credit), you can simply enter your foreign taxes directly on Form 1040, line 47.

Fun how a little tax knowledge can save you significant money, isn’t it?

Get free shipping from Amazon when you buy my most recent book book, Investing Made Simple, together with Bill Bernstein's latest: The Investor's Manifesto.

A recent Get Rich Slowly post asked whether one should stop investing for retirement in order to pay off debt. It’s an important question, and one that I’ve attempted to tackle before. But what I really want to talk about are the comments that were left on the GRS post.

They’re frightening. And I’m not saying this just to be snarky (though, admittedly, I do partake in a little snark from time to time).

Some people were attempting to mathematically justify paying down debt rather than taking advantage of a fully vested, 100% employer match. Now, if you gain a valuable psychological benefit from paying down debt, that’s fine. Go for it. But how somebody could argue that a 20% return is mathematically superior to a 100% return escapes me.

Other commenters argued that, if an investor is young, it’s better mathematically to invest for retirement, rather than to pay down debt–even if there’s no employer match to be gained, and even if the interest rate on the debt is higher than the rate of return from investing for retirement.

“The Horsepower to Do the Math”

This all reminded me of an article William Bernstein wrote a few months back, where he argues that most people just aren’t qualified to invest on their own. Bernstein estimates that less than 10% of the population has “the horsepower to do the math.” He elaborates,

“Fractions are a stretch for 90% of the population. The Discounted Dividend Model, or at least the Gordon Equation? Geometric versus arithmetic return? Standard deviation? Correlation, for God’s sake? Fuggedaboudit!”

I’m inclined to think that his estimate is overly pessimistic. (Is it really that hard to explain correlation?) And I’ve always thought investing mistakes aren’t caused by a lack of math skills so much as by a decision process that’s not based on math at all. (”I’ll just hold this stock until it gets back to where I bought it,” for example.)

But I may be wrong. Thoughts?

Get free shipping from Amazon when you buy my most recent book book, Investing Made Simple, together with Bill Bernstein's latest: The Investor's Manifesto.

Russell Kinnel, director of mutual fund research at Morningstar, recently compared investor returns at Vanguard to investor returns at Fidelity. His study is interesting because it looks at investor returns (aka “dollar-weighted returns“) rather than investment returns (aka “time-weighted returns”).

A brief example of dollar-weighted returns

If Mutual Fund ABC earned a 25% return in Year 1, then lost 20% in Year 2, its effective annual return over the two years would have been 0% (because it would be back exactly where it started).

If, however, the fund had doubled in size at the end of Year 1–due to investors chasing performance and buying the fund after a great year–its dollar-weighted return would be significantly below 0%, because the performance in Year 2 would be weighted twice as heavily in the calculation. In short, dollar-weighted returns measure how the investors performed rather than how the investments performed.

What did Morningstar’s research show?

The study showed that Vanguard investors earned greater returns than Fidelity investors over the last 10 years. But that doesn’t really mean a great deal to me. It could simply be the result of Vanguard’s larger funds being in more successful asset classes than Fidelity’s.

What does interest me, however, are the two following facts:

• As usual, mutual fund investors underperformed their own investments across the board.
• Vanguard’s investors underperformed their investments by a smaller margin than Fidelity’s investors.

Why do we underperform?

We underperform because we try to time the market, and we (usually) fail. We chase performance–both in terms of hot asset classes and in terms of hot funds–and it destroys our returns.

Why do Vanguard investors perform better?

My hypothesis is that it has to do with the core philosophies of the two companies. As a company whose success has been based on index funds, Vanguard’s core tenets are minimizing costs, diversifying, and buying and holding.

In contrast, Fidelity, at its core, is about active investment. Many of their own fund managers turn over their portfolios more than once per year. It wouldn’t be terribly surprising to learn that their investors do something similar.

Kinnel has a similar opinion:

“It’s possible that the performance gap also has something to do with each firm’s message to investors. Vanguard preaches long-term investing and goes so far as to warn investors away from hot-performing funds…Fidelity also preaches long-term investing, but it sometimes nudges people to invest based on short-term results.”

What can we learn here?

Surely, some people will look at this study and see it as evidence of an opportunity to outperform the market. They’ll draw the conclusion that we must learn to “be fearful when others are greedy and greedy when others are fearful,” as Warren Buffett would say.

To me, the lesson is slightly different. I see it as another piece of evidence that our predictive abilities are decidedly lacking. After all, nearly every single one of those people who underperformed sincerely believed that he was going to outperform.

“I am above average!” is the battle cry of underperformance.

Get free shipping from Amazon when you buy my most recent book book, Investing Made Simple, together with Bill Bernstein's latest: The Investor's Manifesto.

Today (10/26/09) is The Oblivious Investor’s first birthday.

A few statistics of interest:

• 285 posts,
• ~ 600 subscribers,
• 1,359 comments,
• Currently getting ~ 230 first-time visitors each day via search engines, and
• 2 new books launched.

On growth and goals:

I’m happy with that level of growth. I can’t say whether or not it exceeded my expectations, because I didn’t have any. This being my first blog, I had no clue what to expect. Similarly, I don’t know what to expect by the end of year two. 1,000 subscribers? 2,000? 3,000? No idea really.

I’m comfortable with the fact that this blog will never be comparable to Get Rich Slowly or The Simple Dollar in terms of readership. It focuses on too narrow a niche for that to happen. That is, it only appeals to people with a serious interest in investing. And within that group, it only appeals to people who don’t mind the fact that I openly criticize activities such as stock picking, market timing, etc.

Giving thanks where due:

The blog has been an absolute blast to write so far. And with a growing group of people reading and participating in the discussion, it’s becoming more fun as time passes. So thanks to all of you for reading, and thanks to everyone who has participated in the discussion whether via comments, email, or replies on your own blogs.

Also, to everyone who has helped to share this blog (and its ideas) with others, whether by linking to it, tweeting about it, stumbling posts, voting for posts on Tipd, or good old-fashioned word of mouth: Thanks!

Similarly, I’m quite grateful to everybody who has helped with the two books, whether linking to them, reviewing them on Amazon, or, of course, buying them.

Where we go from here:

For my part, I’ll be continuing to write on a regular schedule, most likely on a range of similar topics. But a large part of where the blog goes from here is up to you. For example:

• How quickly it spreads/grows is primarily a function of how many of you are compelled to share it with others.
• In terms of topics, if you have something you’d like me to cover or questions you’d like me to address, please let me know.

Thanks again, everyone. I’m looking forward to year #2.

Get free shipping from Amazon when you buy my most recent book book, Investing Made Simple, together with Bill Bernstein's latest: The Investor's Manifesto.