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.

Oh, The Financial Mistakes We Make (part 1)

Want to have a quick lesson in real-life economics? Check out the May issue of The Atlantic and read Neal Gabler’s essay, “The Secret Shame of Middle-Class Americans,” in which he summarizes the financial plight of many Americans – which is enlightening enough – but then boldly summarizes his own life and the mistakes he’s made that helped lead to his rather precarious financial position. I admire his candor and plan to share it with all three of my children because his story reads like a what-not-to-do manual. If you ever wonder how someone who makes good money can become a financial mess, this is the article to read.  Gabler did virtually everything wrong, and though I suspect there are many other people who’ve gone down similar paths, he may have undermined his argument by lumping his experience into those millions of Americans who’ve done everything right yet still find themselves in financial dire straight. Gabler has no such claim.

(After you finish the article, scan through the comments section over a glass of wine or two or three – some are critical, some are empathetic, some are self-righteous, but nearly all are illuminating.)

The essay begins with frightening statistics about American’s lack of savings, lack of liquidity and lack of assets. Nearly half of Americans couldn’t cover a $1000 emergency room visit or $500 car repair out of their own pockets. This should scare the hell out of all of us, because how long can a society thrive and survive when half its population is “financially fragile”? These are real problems with real ramifications, no matter what your financial situation, and I suspect it’s why we find ourselves in such a heated and unexpected political campaign this year.

But then Gabler takes the courageous step of telling us his story, and in it he comes clean. He writes, “I am a financial illiterate, or worse—an ignoramus.” He’s not joking, and it’s troubling because he – like many Americans – not only hasn’t learned from his mistakes, he seems determined not to learn from them, as if being financially illiterate is a condition instead of a choice. In a world where TV and radio have made mini-celebrities out of financial self-help gurus like Suzy Orman, Dave Ramsey and Clark Howard, there’s no excuse not to become at least somewhat educated on financial matters. It’s as important – hell, it’s more important – than learning how to swim or throw a curve ball or learn a Bach prelude.

As parents we need to do much more to help our kids grow up to be financially-functioning adults. I’m going to do my part by forwarding Gabler’s article to my kids and I encourage you to do the same, but I also recognize that the odds of them actually reading the article are low. So next week I’m going to write a quick summary of financial no-brainers that I hope encapsulates all the what-not-to-do’s that Gabler did (and probably many he did not do) and then discuss it with my kids over dinner.  Stay tuned for part two...