Rescue Your Money: The Most Important Part Of The Secret
Excerpted from Rescue Your Money by Ric Edelman. Copyright ©2009, 2016 by Ric Edelman. Published by Simon & Schuster.
So the secret is out. Diversification.
You get it. You agree with it. And you already do it.
Or at least you think you do.
People often tell me they are diversified. They brag that they own ten — count ’em, ten — mutual funds.
A fellow once showed me his account statements.
He was very proud of himself because he had 80 mutual funds. He told me he was “highly diversified.”
(I wrote about him in Discover the Wealth Within You.)
Rescue Your Money by Ric Edelman
A close look revealed he owned eight money market funds, 23 government bond funds, and 49 U.S. stock funds. But not a single foreign stock fund. No real estate. No natural resources.
Forty-nine stock funds? Every one of them owned shares of Microsoft!
He wasn’t diversified.
He was redundant.
Let me show you what diversification really looks like. Look at Figure 8.1.
A truly diversified portfolio will own U.S. stocks: large companies, midsize companies, and small companies, broken down by growth and value sectors.
It will own foreign stocks, including emerging markets.
It will own bonds, government and corporate, U.S. and foreign, each sector including short term, intermediate, and long term, and — for the corporate portion — high quality and high yield.
It will own real estate: commercial, residential, retail, industrial, and agricultural, all geographically dispersed.
It will own natural resources, including oil and gas, minerals and precious metals, exponential technologies, and commodities.
A truly diversified portfolio will own it all, all the time!
Anyway, that’s how we do it in our firm’s practice.
Our clients’ portfolios typically feature 20 asset classes and market sectors from the global financial marketplace. They typically own upwards of 10,000 stocks from 40 countries.
And they do it by owning just four to 22 funds.
Surprised we don’t buy individual stocks and bonds? Too risky for us. Too risky for our clients.
For the five years preceding December 31, 2015, as shown in Figure 8.2, only 49% of all stocks listed on the New York Stock Exchange made money.23
During that same period, 99% of mutual funds made money.24
And as Figure 8.3 shows, the average return of mutual funds was 9.8% during this period,25 while the average individual stock fell 6.5%.26
The reason funds have lower risks and higher returns is simple.
Funds are diversified.
Even the worst of them own dozens of securities, while the best own thousands.
That’s why we invest in funds for our clients.
Simple.
Easy.
And you can do it too.
But we don’t use retail mutual funds for the Edelman Managed Asset Program®.
Instead, my firm recommends exchange-traded funds and institutional shares for our clients.
It wasn’t always this way.
In past decades, we used to recommend traditional retail mutual funds. Why we don’t anymore, and how we went about making the conversion, is explained in great detail in my book, The Lies About Money, which won the Gold Medal for personal finance in 2008 from the Axiom Business Book Awards. And in 2009, it won an EIFLE Award (Excellence in Financial Literacy Education) from the Institute for Financial Literacy as “Retail Book of the Year.”
In Lies, I reveal 25 deceptive business practices used by the retail mutual fund industry. To help you avoid having to read another book, here are two of the more onerous business practices retail mutual funds use, which cause investors to incur greater risk, higher fees, and lower returns than you realize.
Turnover
Turnover is the enemy of long-term investors. The average stock mutual fund experiences 80% turnover annually.27 In other words, 80% of the assets owned by the fund on January 1 are sold during the year and replaced with new assets.
It’s ironic. You consider yourself a long-term investor. But if your mutual fund is flipping 80% of your assets annually, your fund has converted you into a short-term trader!
All that trading forces you to pay more taxes. That’s because trading triggers short-term capital gains, which you must pay at your maximum tax rate. It will come in the way of IRS Form 1099, which the retail fund company will send you. You’ll have to pay as much as 56.7% in federal and state income taxes, even if you reinvest the distributions back into the fund.
Remember how volatile the markets were in 2008? Amid that volatility, many retail mutual funds made distributions equal to 20% or more of their assets. Anyone with $100,000 in such a fund could have incurred $7,000 or more in taxes.
And that’s not all.
Fees
All that trading also increases your costs.
After all, someone has to pay the brokerage commissions when your fund buys or sells a security. This is one reason why investors of retail mutual funds pay high fees.
Yet, amazingly, most consumers think they don’t pay any fees to own their mutual funds. That’s what AARP discovered in 2011 when it surveyed workers around the country. An astonishing 71% said they don’t pay any fees to own the mutual funds in their 401(k) and other workplace retirement plans.
Who do they think is paying for the fund company to issue statements and provide toll-free telephone numbers and staff to answer those phone calls? Clearly there are fees involved. It’s just that the fees aren’t obvious.
They aren’t obvious because they aren’t on your statement.
If your bank charges you a fee, that fee appears on your statement. When you buy a car, you know how much you’re paying. Even your mortgage statement shows you how much of your payment is going toward interest on the loan.
But mutual fund fees don’t appear on your statement. The statement shows only the number of shares you own and the share price.
But never the fee.
No wonder so many consumers think they aren’t paying anything to own their mutual funds.
Of course there is a fee, called the annual expense ratio. The average for all retail mutual funds is 1.19% per year, according to Morningstar.
But don’t look for this information on your statement; it isn’t there. You’ll have to read the prospectus to
find it.
The expense ratio covers the routine costs of fund operations: staff, facilities, marketing, and so on.
It does not include the costs of trading. That expense is found in another document called the Statement of Additional Information. The average retail mutual fund charges 1.44% annually in trading expenses, according to a 2013 study published in the Financial Analysts Journal.28
In all, you’re paying the average retail mutual fund 2.63% per year. Based on the stock market’s average annual return of 9.6% a year,29 that means you’re giving away 27% of your profits on an annual basis.
Imagine giving a waiter a 27% tip.
This might explain why so many members of the Forbes 400 (the wealthiest people in America) are the founders or owners of big mutual-fund companies.
Ned and Abby Johnson, whose family owns Fidelity Investments, are worth $22 billion, according to the 2015 Forbes list.
Charlie and Rupert Johnson (no relation to Ned and Abby) are worth $10 billion. They own the Franklin Templeton mutual fund family.
Bill Gross of Janus Funds is worth about $2 billion.
The U.S. retail mutual fund industry had nearly $16 trillion in assets at year-end 2014 (the latest data available), according to the Investment Company Institute. U.S. stock and bond mutual funds charge $420.8 billion in fees each year. No wonder these guys are among the wealthiest people in America.
Turnover and fees are just two of the 25 deceptive business practices used by the retail mutual fund industry. That’s why we say no to them.
Instead we use institutional mutual funds and exchange-traded funds. Most folks are unaware of these investments, yet they represent the solution to the deceptive and manipulative business practices of the retail mutual fund world.
Now, you might be a little confused. I just told you to say no to retail mutual funds, and now I’m recommending institutional mutual funds. Let me explain the difference.
An institutional fund is typically marketed to institutions and often requires you to invest millions of dollars. That’s why you’ve never heard of them. As a retail investor working with a retail advisor at a retail brokerage firm, you don’t have access to them.
You see, others with billions of dollars to invest approach the investment decision differently from those of us who have, say, smaller amounts of money.
Here’s what I mean. Imagine I give $1,000 to you and another $1,000 to your friend. I send you both to Walmart with only one instruction: You must both spend all the money. Will you and your friend emerge with the same merchandise?
With more than 117,000 products in the store and a million items for sale online,30 probably not.
So let’s change the rules. I send you both back to Walmart. But this time you each get $1 billion. Now will you both emerge with the same merchandise?
You certainly will.
Rescue Your Money by Ric Edelman
