Index Funds and Financial Planners

There’s been a lot of hubbub in recent financial publications about index funds, and not surprisingly financial planners have had the most to say about it, since index funds in many cases make financial planning largely unnecessary.  When something starts to encroach on your turf, you do what you can to protect your turf. 

This appears to be the case for Robert C. Lawton, who wrote an article for Forbes last month, making the claim that index funds are often not the way to go because they absorb 100% of market downturns and by definition ensure only average returns. His advice?  To use index funds for asset classes that are “widely covered and researched,” but to use actively managed funds for all other asset classes.

But Rick Ferri – also for Forbes – wrote a sort of rebuttal to the aforementioned article, summarizing research done by Jason Zweig of the Wall Street Journal that shows how Lawson’s conclusions were based on a Fidelity report that excluded “high fee active funds and poor performing active funds.”   Fidelity has since removed public access to the study.

Oops.

If all of this is gobbledygook to you, I highly recommend reading about index funds, asset allocation, asset growth and financial planners’ abilities to beat the market.  I’m not a financial genius, but here’s what I’ve learned:

1)     Financial planners typically charge you 1% of your assets to manage your money.  Sometimes even more.  So if you have $1 million in assets, you’ll pay your financial planner $10,000 a year.

2)     This means that a financial planner will have to beat the market by at least 1% in order to justify the expense.

3)     This also means that financial planners don’t have an incentive to recommend index funds because that will ensure you lose to the market.  Instead, you’ll earn exactly what the markets dictate MINUS the financial planner fee of 1%.  (I HIGHLY recommend that you read this article, especially if you don’t know how losing 1% of earnings year after year affects your portfolio.)

4)     Financial planners therefore have an incentive to invest your money in actively managed funds to try to beat the market.  The result?  Again, READ or LISTEN to this excellent Freakonomics episode from 2017 called “The Stupidest Thing You Can Do With Your Money,” in which Kenneth French, professor of finance at Dartmouth discusses a study that concluded that only 2-3% of actively managed funds cover their cost.  That’s ON TOP of the 1% you might pay a financial planner to manage your portfolio.

Allow me to reiterate: if you allow a financial planner to manage your portfolio for 1% and invest in index funds, you automatically earn 1% less than the market.  If your financial planner invests in actively managed funds, you not only lost 1% to the market, but 98% of the funds you invest in won’t even cover their costs.  It’s a lose-lose situation. Here are a few more articles you might want to consider reading.

So what to do?  Well, I would suggest reading a lot, figuring out an asset allocation model that makes sense for you, and investing in four or five index funds that cover different asset categories.

But what if you really don’t know anything about finance and you find it terribly intimidating?  Heck, I remember working at a credit union for teachers back in the early 90s, and these were educated people who often had $50,000 in loans for things like boats, RVs, credit cards, etc. and who were only making $40,000 a year!  I get it.  Some people truly aren’t educated when it come to finance.  So what to do?  Well, again I suggest reading.  If you can read you can learn.  I highly recommend a book I purchased for my daughters called The Index Card. It’s an easy read.  It’s concise.  And it includes very specific rules you should follow.

In addition, there is another way to benefit from a financial planner without breaking the bank.

Even though I’m somewhat literate in finance (but only somewhat), I pay a financial planner a fixed fee every five years or so to review my portfolio, my tax strategies, my insurance, etc.  I couldn’t be happier with this arrangement.  Just last month I spent $500 to my planner – so only $100 a year – and in return he offered some suggestions about where to tweak my portfolio, adjustments I should consider making in insurance, and a few tax-savings strategies I might want to employ.  I’ll spend the next few months following up on his advice, and in five years I’ll pay him again to review my portfolio.  I can tell you that one simple tax strategy he suggested five years ago has saved me $1000 a year for the past five years and will continue to do so for the next two or three.  So for $500 I saved about $8000.  So I’m not saying financial planners don’t have something to offer.  They do.  I just don’t know if managing portfolios is one of them.

I’ve met several financial planners over the years.  Some nice, some absolute tools.  Some smart, some no smarter than you and me.  To me, it’s just too much of a crapshoot to trust someone enough to manage your portfolio and pay him/her 1% to do it.  It makes no sense to me.

For me, reading a lot and investing in index funds are the way to go.

The Big Short and Being Human

Back in the late 80s when I attended UW-Madison, I had a conversation with a fellow student and expressed my opinion that the way we value a nation’s economy is going to have to change – that we can’t continue to measure economic growth largely by how much of its natural resources we’re expending. In essence, I argued that the entire world economy is a one giant Ponzi scheme (though I didn’t know the term Ponzi scheme until Bernie Madoff entered the picture). I still believe this to be the case. After all, a stock’s price is supposedly the present value of all future earnings, but we know that most companies that exist today will one day disappear and be sold for peanuts (Pan Am, Blockbuster, Enron, Woolworths, Tower Records), and the present value of a string of zeros is zero, so we’re really betting on short-term earnings. Even Amazon founder Jeff Bezos who has a rare long view when it comes to business success recognizes that his company will one day be disrupted and perhaps no longer exist (watch 13:20 of this 60 Minutes video).

It’s one thing to have this viewpoint about a system that’s largely on the up and up: that’s run by smart people with good intentions but who sometimes fall short or make mistakes. It’s quite another to discover that the people driving our economy are incompetent, greedy, short-sighted, ruthless criminals. If you’ve seen The Big Short or read the Michael Lewis book upon which the film is based, you’ll likely spend some time rethinking your investment strategy. After all, does it make sense to invest your retirement savings in corporations run by buffoons? The answer: what choice do you have? If you could earn 5% guaranteed in CDs you might do so, but you can’t, so if you’re like me you’ll throw the dice and hope that the pyramid scheme of the U.S. economy can hang in there for a little while longer.

I tried reading The Big Short a few years ago and had some difficulty. It does get complicated. But having a visual helps me enormously, and the film’s director Adam McKay (of Anchorman fame) does a marvelous job of acknowledging the complexity of the movie’s subject while helping the audience along the way. I still left the movie with a few lingering questions (that I hope to answer by giving the book another shot), but generally felt more informed than when I arrived, while still being entertained in between. 

No small feat.

Michael Lewis has a terrific piece in the week’s Vanity Fair that describes the minor miracle that any of his books have been made into movies (and successful ones at that: Moneyball, The Blind Side), least of all a film about credit-default swaps and collateralized debt obligations. You’ll also learn what you likely already knew: that incompetence and greed are as prevalent in Hollywood as they are on Wall Street. 

If only it ended there. But it doesn’t matter whether it’s Wall Street, Hollywood, government agencies, the Chicago police force, horny priests, Oregon ranchers or religious zealots: we as humans seem to be preprogrammed to abuse power, blur the lines between right and wrong, desire more even when we have enough, sacrifice long-term benefits for short-term gains, and hurt people for our own benefit. So why is it when we read about our brethren behaving badly we feel smug about it and think we would never fall into the same trap despite history telling us otherwise?

There are different schools of thought here. My own viewpoint is that religion – for all its faults – helps ground us in humility and gratitude, two essential ingredients to keep from following our worst instincts. Perhaps the people running our biggest firms would do well to spend more time in the pews or our nation’s religious institutions and less in the office.

But then how do you explain the clergy sex abuse scandal? Yeah, that's tricky. After you see The Big Short go watch the marvelous film Spotlight and then tell me your faith in mankind hasn’t been just a wee bit shaken.