Smart Sheep Investor

Short answer, probably not.

Robert Shiller points out in his book Irrational Exuberance that inflation-adjusted U.S. home prices increased 0.7% per year from 1940-2004. Whereas U.S census data from 1940-2004 shows that the self-assessed value increased 2% per year. Apparently there is a common misconception that a house is a great investment. In actuality, your expected return on your home should equal inflation plus a mere 0.7%! U.S. stocks on the other hand have averaged an inflation adjusted return of 7% per year since 1950. [U.S stock return source]

But what about the tax benefits of a house mortgage? Yes, interest on your home mortgage is tax deductible; however, there are additional costs associated with owning a home that, in my opinion, outweigh the benefits. Most significantly, owning a home may limit your ability to relocate. Home ownership means you are tied to a single asset (your home) in a single regional housing market. As we have seen, the only free lunch in investing is diversification and home ownership provides zero. If you were unfortunate enough to buy a home during a “bubble” as outlined in the graph above, you will likely not be able to sell that home until the market recovers which could take many years/decades. I have many friends that tragically bought a house in 2004-2006 and are now wed to the job market in their town because they cannot sell their house/apartment and incur the subsequent loss.

So rent forever? Well, I'd rent until you know for sure you will be in a certain labor market for at least 5 years. I'd also have realistic expectations about my return which, if the last 100 years is any indicator, should approximately equal the rate of inflation or ~2% per year.

Smart Sheep is a blog that promises to provide sound investment advice at no cost to the reader. I decided to put the site together after attending Harvard Business School where I took three semesters of finance to include a course that focused on investment management. I’ve also maintained a strong interest in investing since high school, and I have a handful of close friends that are full time investment professionals. In my humble opinion, this makes me a “smart sheep” in the investing world, but by no means do I claim to be a “wolf.”

In actuality, there are only a few investment “wolves” in the world that have a significant enough “edge” to consistently outperform their respective benchmarks after fees and expenses. Unfortunately, most investors do not have enough money to access these “wolves.” What’s an average investor to do? Step one, realize you are a sheep, step two, become a smart sheep.

None of the advice that follows is really that surprising, and most is just common sense with a small amount of math. What is surprising is how many people don’t follow these basic investment principles. It is also surprising how long the investment community has been able to charge unreasonable fees and expenses without any significant customer backlash. Becoming a smart sheep begins with understanding the current financial industry.

The Current Financial Industry

The vast majority of financial advisors today charge clients based on a percentage of their Assets Under Management (AUM), and then select investment products that charge an additional fee. For example, a typical financial advisor will charge his or her client 1.5% of AUM per annum and then select investment products that cost the client an additional 1.5% per annum, for a total expense to the client per annum of 3%.

Avoid Biased Advice

Many investment companies own and operate their own costly investment products, which they then have a perverse incentive to recommend to clients. Smart sheep need to be aware of this bias and look toward unbiased third parties for investment advice.

Start Early

Given the power of compound interest, it is very important to start making quality investment decisions as early as possible.

As the graph above illustrates, compound interest significantly rewards smart sheep who start investing early in life.

However, starting to invest early in life is only half the equation. Equally as important, smart sheep must avoid excessive fees. The graph above illustrates just how devastating per annum AUM and fund fees can be for investors over their lifetimes.

Avoid the Assets Under Management Fee

Charging a 1% AUM fee per year doesn’t sound like a significant amount of money, but over a lifetime this fee equates to more than half of your total savings. Regardless of the amount of money a client has, most financial advisors dedicate the same amount of time and resources to each, and most advisors charge the AUM fee regardless of annual performance, which brings into question the justification for the current AUM fee structure. Imagine if your doctor, after curing you of a disease, charged you for every year you were healthy after the visit. Ridiculous you say, well the financial industry goes a step further and charges you the AUM fee even if they lose you money for the year. Back to the doctor analogy, you would be uncured and still have to pay a medical bill each unhealthy year equal to half of your net worth at retirement! Smart sheep avoid AUM fees entirely because they don’t think their investment advisors are entitled to more than half of their life’s work!

Remember: You Are Not a Wolf

Investment professionals that have a true “edge” are able to deliver above benchmark returns year after year. Unfortunately, it is extremely difficult to distinguish between a wolf with an edge and just someone who has gotten lucky for a few years. Buying or selling a stock based on a sound bite you hear on Mad Money is not an investment strategy you should be willing to bet your children’s education or your retirement on. Whatever small edge some mutual fund managers do have are very likely lost in the long run when you calculate for fees and expenses.

Solution

I recommend you invest in Exchange Traded Funds (ETFs) and follow the simple portfolio distributions outlined at the end of this document. This will ensure you are invested in the lowest cost investment vehicles and completely avoid an AUM fee.

Exchange Traded Funds (ETFs)

Mutual funds and Exchange Traded Funds (ETFs) are the two most widely used products that give investors equity and fixed income exposure. ETFs will likely outperform their more expensive mutual fund equivalents, and ETFs boast the lowest fees and expenses of any investment product available. Most ETFs simply track broad indexes versus mutual fundswhere managers attempt to pick individual stocks or bonds. Standard and Poors periodically publishes an Index Versus Active Fund Scorecard (SPIVA) and the indexes the ETFs track consistently outperform their mutual fund equivalents, even before taking into account mutual fund fees and expenses that average 1%-2% above their ETF equivalents. Over the last 5 years ending in 2008, 72% of all US large cap mutual funds were outperformed by the S&P 500 index equivalents.

Some mutual fund managers at investments banks including Goldman Sachs will argue for a “core-satellite” strategy. This strategy invests in indexes corresponding to large cap equity in developed economies and uses mutual funds to gain exposure to small cap and emerging market equity. Goldman and other investment banks argue it’s easier for mutual fund managers to gain an “edge” investing in small cap equity and developing economies because fewer analysts cover the companies included in these asset classes. However, the data from the last 5 years ending in 2008 does not support the investment bank “core-satellite” strategy. The S&P US small cap index beat 86% of its equivalent mutual funds and the S&P emerging market index beat a staggering 90% of its more expensive mutual fund competitors. The data strongly suggests that the vast majority of small cap and emerging market mutual fund managers do not have any significant edge over their index fund competitors.

So, if past performance is any indication of future returns, ETFs will outperform their mutual fund rivals. In addition, an ETF’s fees and expenses are considerably less than the average mutual fund. Specifically, ETFs average approximately .3% per annum versus the typical mutual fund which costs 1.4% per annum [http://www.investopedia.com/university/mutualfunds/mutualfunds2.asp].Of all the companies that offer ETFs, Vanguard boasts the lowest cost. My recommendation is to purchase Vanguard ETFs consistent with the portfolio distributions at the end of this document. Note: I receive no compensation from Vanguard for stating my personal opinions and the facts regarding their ETF fees and expense rates.

Finally, if you weren’t already sold on ETFs, they are also more tax efficient, transparent and transaction-cost efficient versus mutual funds. Elaborating on these points would take some time, so just trust me that I’ve done my homework.

Additional information about ETFs can be found at the following link: http://www.investopedia.com/terms/e/etf.asp

Modern Portfolio Theory

The portfolios I recommend include a number of non-correlated asset classes. Modern portfolio theory states that a combined fund comprised of non-correlated securities will increase returns while decreasing its volatility. In other words, when one fund zigs the other fund zags, the investor will reap increased returns and decrease volatility. Wolves and smart sheep will tell you diversification is the only “free lunch” in investing.

Additional information about Modern Portfolio Theory can be found at the following link: http://www.investopedia.com/terms/m/modernportfoliotheory.asp

Diversification within Asset Classes

My ETF recommendations track indexes comprised of 100+ companies. So, why do you have to own hundreds of companies within each asset class? It is not prudent to only invest in relatively small number of companies within an asset class because you become too exposed to idiosyncratic risk, or risk that can be almost eliminated through diversification. For example if you only own 5 stocks within an asset class and one of your holdings within that class undergoes a significant and unforeseen change thereby reducing its market value, your portfolio takes a significant hit. Versus owning 50+ different companies within each asset class so that a single catastrophic company event will have little impact on your portfolio and you are still able to maintain systematic risk inherent in said asset class for which you should be compensated for over time.

Trade Execution

There are two things to consider when executing your trades; one, dollar-cost-averaging into your most risky ETFs, and two, the bid-ask spread of the ETF you plan on purchasing. As for dollar-cost-averaging, I would immediately buy your less risky US equity positions and over the course of a year build your international equity positions. Second, be mindful of the bid ask spreads on the Vanguard ETFs I recommend. You may want to set a reasonable limit versus market order when you trade. I would contact your discount broker to discuss limit orders and bid ask spreads in more depth if you still feel uncomfortable.

Additional information about dollar cost averaging and bid ask spreads can be found at the following links: http://www.investopedia.com/terms/d/dollarcostaveraging.asp ; http://www.investopedia.com/terms/b/bid-askspread.asp

Additional tips on trading ETFs can be found in my 10 February 2010 post, link follows: http://smartsheepinvestor.blogspot.com/2010/02/interesting-articles.html. Focus on the article "Risks Lurk for ETF Investors" and my comments in the post.

Discount Brokers

Brokers will allow you to purchase ETFs using the internet. You want to find a discount broker that executes trades as inexpensively as possible. A few reasonable alternatives to large investment bankers include Charles Schwab, TDAmeritrade, ETrade, etc. Since you are going to invest in ETF indexes the broker will have nothing to do with managing your risk exposure and the company name is not that important. Note: I receive no compensation from any discount brokers based on this recommendation.

Still Not Convinced?

There are companies such as Edward Jones that have offices in most towns where financial advisors are on call to comfort clients and field questions. As discussed above, this “on call service” and the fees associated with it will cost you more than half of your retirement! Ironically, we are all most likely to buy and sell into the market at the least opportune times. Generally, the more long-term investors trade into and out of the market the more value they destroy. Consequently, I highly discourage you from significantly deviating from my recommended portfolio distributions, especially when faced with a major market pullback.

Practice What You Preach

I actually invest in the products and strategy I recommend. Unfortunately, many investment professionals do not own the very funds that they sell because many are aware that they deliver very little value.

In Review

Avoid Asset Under Management (AUM) fees and expensive underperforming mutual funds, the associated fees and expenses will devastate your retirement fund over the long-term. Instead, invest in a diversified portfolio of industry leading low cost Vanguard ETFs, and simply don’t sell when times get tough. Again, I practice what I preach; I’ve bet my retirement on this exact strategy.

Notes on the Portfolio Distributions

What follows are recommended portfolios based on an investor’s number of years until retirement and risk tolerance. Remember, the worst thing an investor can do is sell in the midst of a correction, so make sure you are realistic about which risk category you fall into. Included in each portfolio you will find index ETFs that correspond to a number of uncorrelated asset classes. There are decent arguments for slightly increasing or decreasing each asset class’s percent distributions; however, no one knows what the “optimal” mix actually is and the following portfolios easily represent the 90% solution.

Help Grow the Herd of Smart Sheep

Hopefully you have found this tour of the financial industry useful, or at least sadly entertaining. An old professor once told me “life is hard, and it’s harder if you are ill-informed.” So, please do your part to help grow the herd of smart sheep, share the Smart Sheep message with family and friends. Even better, write your congressman to encourage mandatory financial education in high school that will help save you and future generations at least half of their retirement. Finally, feel free to post any questions or comments. Until next time, stay with the smart sheep to avoid the wolves.

Tables in percentages per asset class given an investor's risk tolerance and years to retirement