Emotional Investing

Investing according to your gut is one of the most dangerous things you can do.  When the market it way up and you see double or triple digit returns, your gut tells you to buy.  When the market is tanking into the abyss and you’re losing lots of money, your guts tells you to sell.  So if you follow your gut, you’re buying HIGH and selling LOW!  I can’t tell you how many hundreds of people have told me they do just that!  A money manager can take some of the emotions out of the process, or talk you away from the ledge, and hopefully avoid this common trap.

Chasing Returns

This is really related to emotional investing, but it happens more often.  You look at your holdings and the Morningstar reports on the funds you own.  You see that you have some dogs (1, 2, or 3-star funds), and you decide it would be better to buy some 5-star funds.  So you sell your dogs and buy some hot funds that have been way up in the last year.  Seems like the right thing to do, right?  Wrong.  What you’re really doing here is once again, selling LOW and buying HIGH.  You’re selling something that has underperformed the market, and buying something that is already way up and has been outperforming the market.  Things go in cylces.  A money manager can help you construct an all-weather portfolio.

The Test

I call this the money management T-I-R-E-D test, to help you decide if you’re tired of managing your own money.

T – Time.  Do you have the time it takes to properly manage your money?  Doing investment research, evaluating your holdings, calculating rebalancing changes, making the changes, keeping up with tax law changes, updating beneficiaries and account information, reviewing your insurance holdings…it all takes a lot of time, and time is money.

I – Inclination.  Do you really enjoy managing your investments?  Most people would rather eat shards of broken glass than read a mutual fund prospectus.  You really can’t blame them, they are written by attorneys.  But even if you do enjoy researching and reading about investment products, trends and strategies, is it really what you want to do with your free time?  Or would you rather be playing golf, working in the garden, watching your kid play a sport, or spending time with the grandkids?  No matter what it is, if you don’t like doing it, you probably won’t do it.  And your investments are something you really should not ignore.

R – Research.  Do you feel that you have access to the kinds of research that you need to manage your money most effectively?  Reports from Morningstar, Lipper, Standard & Poors can be costly and not easy to come by.  Professional money managers also have access get on conference calls with best mutual fund managers and ask them questions about thier funds.  Having all the right information can make a world of difference.

E – Expertise.  Do you have enough expertise in the investment world to effectively manage your money?  Everyone has an area of expertise, and it makes sense to leverage your own, and others areas of expertise.  You wouldn’t hire a plumber to fix your car.  Nor would you pay your dentist to put a pool in your backyard.  A good professional money manager will easily pay for himself with the money he can save you in taxes, fees, penalties, not to mention the extra returns he can put in your portfolio.

D – Discipline.  Do you have the discipline it takes to strategically manage your own money and stick to a plan?  This one relates in part to the emotional investing discussed earlier.  It’s easy to stick to a plan when the market it up.  But when things are crazy, having a level-headed money manager to stand by you and help you makes all the difference.  To become financially independant, it takes time  and the dedication to follow a disciplined strategy.  Having someone to keep you accountable and make sure you stick to your plan can really help.

If you answered NO to any of these questions, then it would be good idea for you to find a money manager whom you could work well with.  The annual fee that you would pay them to help you with this most important task will be well worth it.  I have found in my 15+ years of doing personal financial planning, that I can usually increase a clients returns by at least 2-3% even after my fee comes out.  But the best part for the client is that they no longer have to worry about it at all.

Rising Debt

But there are some signs looming out there that indicate that all the trouble may not be over.  One of the biggest signs of trouble is the amount of debt that the United States is accumulating at a rapid rate.  In the next year, the total debt held by the US government will rise to $12 trillion.  All the economic stimulus and the war in Afghanistan continues to fuel this burden.  As the trend continues, our dollar is worth less and less (because we keep printing more and more of them).  The largest holders of all this US debt (which is in the form of treasury bonds) are Asian and European countries.  Once these investors get tired of our fiscal irresponsibility and the low rates that our bonds are paying them, they will start heading for the exits.  As they start selling bonds, the values of the bonds will drop, and interest rates will rise.

How Soon Could This Happen?

The United States has a very large credit limit, so this is not likely to be something that happens very quickly.  But in the next three to five years, this scenario is very possible.  When it does happen, stock and bond markets will take a tumble, and interest rates, inflation and unemployment will rise to levels we haven’t seen in a few decades.

What Can I Do?

Fortunately there are some steps you can start taking to protect yourself from another financial meltdown, and it doesn’t involve putting your money in the mattress.  Stay tuned in the days to come for some personal financial planning ideas that could help you stay afloat if the economy starts to sink again.

OK, so you’re just about ready to see my list. The best mutual funds to own tend to be index type funds. The truth is, most actively managed mutual funds UNDER-perform the major market indexes over time. There are a lot of reasons for this, and we’ve already mentioned most of them. Commissions, expense ratios, and taxes all add to the cost of owned actively managed funds. All these costs make it much harder for the manager to keep up with, not to mention out-perform the market index.

“…the best way to own common stocks is through index funds… - Warren Buffett, Berkshire Hathaway Inc. 1996 Shareholder Letter

“A very low-cost index is going to beat a majority of the amateur-managed money or professionally-managed money,” - Warren Buffett 2007

“Additionally, those index funds that are very low-cost (such as Vanguard’s) are investor-friendly by definition and are the best selection for most of those who wish to own equities.” - see page 10 of Berkshire Hathaway Inc. 2003 Annual Report

“Over the 35 years, American business has delivered terrific results. It should therefore have been easy for investors to earn juicy returns: All they had to do was piggyback Corporate America in a diversified, low-expense way. An index fund that they never touched would have done the job. Instead many investors have had experiences ranging from mediocre to disastrous.” - page 5, 2004 Berkshire Hathaway Annual Report

“Most individual investors would be better off in an index mutual fund.” - Peter Lynch

The Best Mutual Funds for 2009 (and beyond!)

The following are all no-load funds. (Of course!)

Dimensional Small Cap Value (DFSVX) This is a small cap value fund that I believe is poised to perform extremely well as the market and economy begin to recover from this recession. Small cap stocks tend to be the first to recover after a recenssion ends, and this fund should be a top performer. Dimensional funds are index funds, but they are enhanced index funds. Dimensional Fund Advisors takes a market index and then screens out the stocks they feel are less likely to perform as well. They use 26 different screening methods to narrow down the list of stocks they want to buy. Then they use some timing and trading strategies to determine when to buy the stock.

Dimensional Emerging Markets Value (DFEVX) This is an index fund that invests in emerging foreign countries. Emerging markets, or under-developed countries, also tend to lead in performace coming out of a recession. This fund invests in countries like Brazil, Chile, China, South Africa, Czech Republic, Hungary, Mexico, Poland, Israel, Malaysia, South Korea, Indonesia, Phillipeans, Thailand & Turkey. It does not invest currently in Argentina.

Dimensional Tax Managed US Marketwide (DTMMX) This is another index fund that invests in large, mid and small cap companies here in the United States. Morningstar has is rated as a mid cap, but it really invests in all of them. Due to it’s heavy mid and small cap holdings, I believe it is also poised to do well coming out of this recession.

iShares FTSE/Xinhua China 25 Index (FXI) This is actually an ETF (which is basically a mutual fund). To read more about the benefits of ETF’s click here. Basically this is an index fund that buys the 25 largest and most liquid Chinese companies. The Chinese market lost a huge amount of it’s value in 2008 and has some great potential for 2009. This fund trades on the NY stock exchange, and trades just like a stock. This fund lost almost 68% of it’s value during the last 12 months, so there can be some heavy volatility here. Don’t bet the farm on it, but this would be a nice portion of your international exposure. Save yourself the effort of doing research on Chinese companies and just buy some of this.

 iShares U.S. Financial Sector (IYF) This is another ETF index fund that tracks the Dow Jones U.S. Financials Index. This fund lost over 75% of it’s value during the last 12 months, and is now having a nice rebound as you can imagine. I think there is most likely some great potential for returns in the financial sector, and a low cost index fund like this is an excellent way to get some exposure.

Energy Select Sector SPDR (XLE) Yes, it’s another ETF index fund that invests in companies from oil, gas, energy equipment & energy services. This is a great, low-cost way to get exposure to the entire energy sector, including the servicing companies. These stocks all tend to move up and down with the price of oil. Last year oil got over $147/barrel in May, and by October it was below $38/barrell. We could easily see oil prices right back up above $100 in no time at all.

Dimensional International Value (DFIVX) This is another DFA index fund that invests in developed foreign countries. This would include the following: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom. This would be an excellent choice for the bulk of your international exposure.

Amana Mutual Income (AMANX) This is a large cap value fund that invests in mostly U.S. stocks for preservation of capital and current income. It’s has a 5-star rating from Morningstar and you can check out it’s details at www.Fidelity.com Although this is not a small cap fund, you still need to have some exposure to large caps at all times in your portfolio. The unique thing about this fund is that investment decisions are made in accordance with Islamic principals. It diversifies investments across industries and companies, and generally follows a value investment style.

Fidelity Strategic Income (FSICX) This is another one of my best mutual funds picks for 2009. This is a bond fund that invest in many different types of bonds, so it’s called a multi-sector bond fund. It invests primarily in debt securities by allocating assets among four general investment categories: high yield securities, U.S. Government and investment-grade securities, emerging market securities, and foreign developed market securities. The fund uses a neutral mix of approximately 40% high yield, 30% U.S. Government and investment-grade, 15% emerging markets, and 15% foreign developed markets. High yield bonds are another type of investment that tend to out-perform as the economy and market begins to recover.

If you would like to learn more about the benefits of hiring a professional money manager to help you manage your portfolio of mutual funds, including your 401K plan, click here.

12b-1 Fees

These are another kind of internal fee that some funds will charge you. You’ll never see these fees show up on a monthly or annual statement.  In fact, the only way you’ll know if you’re paying them is to look in the fund prospectus.  Most loaded funds have 12b-1 fees, and a few no-load funds do too. These are basically an annual trailing commission that goes to the broker who sold you the fund. It’s supposed to be his or her incentive to continue to take care of your account. It’s generally .25% per year, so it’s not going to break you. But when you add that on to an up front commission of 5.75%, and an expense ratio of 1.50% or 2.5%, and it starts to become very difficult to keep up with the market. If you’re looking for the best mutual funds, try to avoid 12b-1 fees.  The more you pay in fees, the less your returns will be.

No-Load Funds

No load funds are funds that have no commission for the investor to pay at all. So every $1 that you invest goes right into the fund. Some famous no-load mutual fund companies are Fidelity Investments, Vanguard, and the Dimensional Funds. The only way a no-load mutual fund makes money is from the internal expense ratios. But that doesn’t mean that their expense ratios are higher. In fact, quite the opposite can be true. No-load funds are in our opinion are some of the best mutual funds available today.

Most full-cost brokers (ie. Merrill Lynch, Edward Jones, bank guys, etc.) won’t ever educate you about the way fund companies charge fees and make money. They will usually tell you that the best mutual funds are their own, which are generally loaded with fees and commissions. Knowing this can save you thousands of dollars and make a huge difference in the size of your account years from now.

ACTIVELY Managed Funds

Actively managed mutual funds have fund managers who are actively buying and selling securities inside the fund in attempt to outperform the market. Many people think that actively managed funds are the best mutual funds. Keep in mind that each time a trade is placed, the fund has to pay a commission. These commissions are in addition to the funds expense ratio and 12b-1 fees, and are only reported in the annual report. Morningstar says that these trading commissions can run as high as 1% – 2% of the funds assets per year if the manager is a very active trader. You can get a feel for how much trading is going on by looking at the funds turnover rate, which is also reported by Morningstar. If a fund has a turnover ratio of 50%, that means the manager is selling and then buying again 50% of the funds assets each year. Many stock funds commonly have turnover ratios of over 100% per year.

Also, when a stock inside a fund is sold by the manager, any capital gains that are realized from that sale will be passed on to you as the shareholder. So even though you didn’t do anything, you could be paying taxes on your investment at the end of the year. Funds will estimate the amount of capital gains that they plan to pay out at the end of each year. It’s important to look at those estimates (usually published in November) and see if you should sell your shares before they pay it to you. This way you can avoid taking that gain and getting taxed on it. Yet, some of the best mutual funds are still actively managed.

PASSIVELY Managed Funds

A Passively managed fund, usually called an index fund, is a portfolio of stocks or bonds that replicate a major market index. The S&P 500 or the Lehman Brothers Aggregate Bond Index are two major indexes that most people have heard of. There are a lot of people who now agree that the best mutual funds are passively managed. Passively managed funds are very low cost funds to own because there are not a lot of analysts doing research on what stocks to buy and sell. These kinds of funds generally don’t do much trading of the stock or bonds they own, so this keeps the trading commissions and taxes low. Expense ratios of passively managed funds are usually in the 0.08% – 0.5% range, much lower than actively managed funds. These are an excellent choice for an investor who is satisfied to match the performance of the index.  And for most investors, index mutual funds will perform better than actively managed funds in the long run.

These are the legions of 401(k) investors who don’t merely buy and hold; they buy, hold and sit stock-still. Even as the U.S. stock market fell 55% between October 2007 and March 2009, these people barely budged. Among the more than three million 401(k) participants served by Vanguard Group, 17% were 100% in stocks in 2007; at year-end 2008, 16% still were. Of the 11.2 million participants served by

The sitting bulls present a problem for hedge-fund managers and other professional investors who have argued that all it would take to shake individual investors’ grip on stocks was a good old-fashioned bear market.

To be sure, the share of U.S. households that own stocks in any account has fallen from 53% in 2001 to around 45% in 2008, according to the Investment Company Institute and the Securities Industry and Financial Markets Association. Since 2007, 401(k) investors at both Fidelity and Vanguard have lowered the rate of new contributions they are putting into stocks.

But those trends hardly constitute a stampede. At Vanguard, says Stephen Utkus of the Vanguard Center for Retirement Research, only 16% of 401(k) investors made any trades in 2008, barely up from 15% in 2007 and down from 20% in 2004. That includes rebalancing across funds to restore an asset mix to target levels.

“It is kind of striking,” Mr. Utkus says. “We had the most drastic market decline since the Depression, we nearly had a total collapse of the global financial system, and all that caused most people not to do much at all.”

After the Great Crash of 1929, individual investors abandoned the stock market for a generation. What keeps today’s sitting bulls from running off?

First, these people are largely doing what they have been told, by researchers who have argued that stocks are risk-free in the long run, by mutual-fund companies that earn higher fees on stock funds and by stock-market advocates in the financial media.

Another factor is what Mr. Utkus calls the “contribution effect.” For workers who are young, newly hired or lower-paid, falling market values are counteracted by the new cash pumped in with each payroll contribution. More than one-third of Vanguard’s 401(k) investors didn’t lose money in 2008, while another 10th lost 10% or less. These people were barely scathed by the stock-market crash.

Furthermore, 401(k) contributions are automatic and withdrawals are often decades in the future, reducing the apparent need for action today. Sir Isaac Newton’s first law of motion might be reapplied to 401(k) investing: An investor at rest tends to stay at rest, even when acted upon by an unbalanced force.

This bovine behavior is driven partly by a very human need to simplify decisions that feel complex. Forced to choose how much money they want to put into stocks, many 401(k) investors don’t treat it as a decision about how much risk they wish to take. Instead, they look for obvious rules of thumb. If you like stocks, why not put 100% of your money into them? If you don’t, then why not set a zero allocation to stocks? And once you pick a nice round number, why change it?

Accounting professor Shlomo Benartzi of UCLA studied a large sample of investors who filled out a risk-tolerance questionnaire for a major 401(k) provider. Only 7% described themselves as aggressive; yet 33% invest as if they are, putting 80% to 100% of their 401(k) into stocks.

So inertia is often a state of mind, rather than a deliberate choice. It worked well in the 1980s and 1990s, and again over the past six months as the market partially rebounded from its collapse. For the past decade as a whole, it hasn’t worked well. So investors should be patient, but not catatonic; they should rebalance annually to sell some of what has gone up and buy some of what has gone down.

If stocks are halved again, or we get another decade of poor returns, the sitting bulls might finally get up and leave the field. But nothing short of that seems likely to make them budge. Bears can maul most livestock, but they are no match for sitting bulls.

You’ve come to the right place to find out!

But before we get to naming a list of my favorite fund picks, lets cover some mutual fund 101 basics.

What is a mutual fund?

A mutual fund is the most popular form of a pooled investment known today. They are designed for people who want to have their money professionally managed at a fairly reasonable cost. In addition to professional management, they give an investor convenience, diversification, record keeping, tax reporting, and safekeeping of securities.

How do mutual funds make money?

Mutual funds make money in several ways. The main way is from internal fees that are called expense ratios. Expense ratio sounds a lot better than FEES, right? But it’s the same thing. It’s a percentage of the funds assets that are taken out every day, and it’s how the mutual fund company stays in business. You never see these fees come out, but they definitely affect your annual returns. You want to try to make sure your expense ratios are around 1% or less per year. Some specialty funds are going to be higher, but for the most part you should try to buy funds that are under 1%. Funds are required by law to produce a document called a prospectus, which no one ever reads, that tells you important information about the fund. Fortunately, Morningstar reports most of this same information in a much easier to understand way. The best mutual funds will keep these internal costs to a minimum.

What about commissions?

This is an important one. Many mutual funds sold today by bank brokers and full-cost brokers like Merrill Lynch and Edward Jones have commissions, or loads. Loaded funds commissions can vary, but most are between 1% and 5.75%. That means for every $1000 you invest, $45 to $57.50 could be coming out for a commission to the broker, and the rest gets invested into your account. That’s not such a bad thing if the broker getting paid is actually helping you manage your account of mutual funds. Loaded funds can have either front-end or back-end commissions. Front-end means you pay it when you go into the fund with new money, these are called A share funds. Back-end means you pay it when you eventually sell the shares, these are called B share funds. With a B share, the back-end commission gradually declines the longer you hold it. It’s usually completely gone after 7 years. The problem is, B share funds have much higher internal expense ratios, sometimes 2.5% per year. This is how they make up for the commission that they paid the broker when you bought it. If you’re going to buy a loaded fund, you should NOT buy a B share. The other option is a C share. C share funds have no commission when you buy it, and a 1% back-end commission if you sell within the first year. The best mutual funds will have little or no commission on them at all.

I know this stuff may be too basic for some readers, but investor education is very important to me.  Come back again for “The Best Mutual Funds Parts 2 & 3″ to learn more and see my list of top picks for this year and next.