Wednesday, March 28, 2012

More On Owning Stocks vs. Bonds ... Stay Away From Investment Advisors

The best way to keep more of what we earn is to spend less of those earnings.

Today's discussion topic concerns how much we waste needlessly on paying financial intermediaries, aka investment advisors, for what frequently are non-value added or even value subtracting services. Think OPM versus MOM and all that entails.

As an example, let's assume that we have $100 to invest and that the $100 investment is placed 50% in fixed income (cash and bonds) and 50% in stocks. We'll further assume that we have retained an investment advisor and agreed to pay that advisor annually 1% of the assets under management.

Since we have $100 in assets, we pay the advisor $1 annually. That doesn't seem like much, but let's look closer. Actually, it's a waste of money, and perhaps worse than that.

We'll further note that we could instead have elected to buy the bonds or keep the cash ourselves, so we're really paying the advisor 2% annually to manage the stock portion of our investment portfolio.

If our $50 invested in stocks earns an average 8% annually, we'll earn $4 on the stock portion of the portfolio. If we pay the advisor $1 annually, we're paying him a 25% commission on the stocks' earnings. And that $1 will represent 67% of the $1.50 in cash dividends received, assuming our stocks' average dividend yield is 3%. But it's even worse than that.

It's worse because most advisors simply don't add any market beating value to the portfolio's performance. The investment returns don't even keep pace with a random selection of stocks.

"A Random Walk Down Wall Street" is a famous book on investing by Burton Malkiel, economics professor at Princeton University. Therein Mr. Malkiel argues that a passive strategy of individual investing generally beats an active "professionally managed" investment approach.

Accordingly, Malkiel advocates not using investment advisors, since they generally add no value to returns for individual investors.

In other words, when we hire investment advisors, we end up paying approximately 25% of our earnings for no reason.

In essence, we're paying the financial "experts" to do nothing but take our money. Accordingly, the best way to improve a stock portfolio's performance would be to eliminate the costly "professional" advice.

But what to do? Here's what. Learn to manage your assets yourself, and you can always get started with the help of someone older and more experienced who has managed a self directed portfolio. If that person is trying to be helpful, he won't charge you a nickel for sharing his experiences and offering aid. By charging you zero, he'll prove he's in it just to help. Maybe there is such a thing as a free lunch.

In that regard, What Does The Prudent Investor Do Now? is a timely editorial by Burton Malkiel about the relative attractiveness of self investing in stocks, bonds and real estate today. Here's what he says:

"The economic news has certainly improved in recent weeks. . . .

In short, the chances of a self-sustaining recovery have improved—a "virtuous cycle" where increased employment leads to better consumer sentiment, stronger sales, and continued increases in employment.

But let's not uncork the champagne quite yet. . . . Rising gasoline prices will put increased pressure on consumers. And a number of strong economic headwinds still exist.

The economies of the euro zone are getting worse, not better. The housing sector has yet to make a convincing turn for the better, and the economic data, as a whole, suggest the economy is growing at a rate nearer to 2% rather than its previous trend rate of 3%-4%. The realistic conclusion for investors should be "Yes, things are better, but we still have a long way to go."

Given the present economic outlook, what is the best strategy for investors? Let's look at three asset classes in reverse order. I will rank them from worst to best.

Bonds are the worst asset class for investors. Usually thought of as the safest of investments, they are anything but safe today. At a yield of 2.25%, the 10-year U.S. Treasury note is a sure loser.

Even if the overall inflation rate is only 2.25% over the next decade, an investor who holds a 10-year Treasury until maturity will realize a zero real (after-inflation) return. If the investor sells prior to maturity, it will likely be for less than the face value of the note if the inflation rate rises.

Even if the inflation rate remains moderate, interest rates are likely to rise to more normal levels as the economy continues to recover. Investors with long memories should recall that over the entire period from the 1940s until 1980, bonds were a horrible place to be. Given the likely trends, U.S. Treasurys and high quality bonds are likely to be extremely poor investments and are very risky.

Equities on the other hand are still attractively priced, despite their substantial rise from the October 2011 lows. A good way to estimate the likely long-run rate of return from common stocks is to add today's dividend yield (around 2%) to the long-run growth of nominal corporate earnings (around 5%).

This calculation would suggest that long-run equity returns will be about 7%—five percentage points more than the safest bonds. This five-percentage point equity risk premium is close to the historical average. . . .

Real estate is a particularly attractive asset class. Investors who are currently renting the place in which they live should strongly consider buying.

Real-estate prices have fallen sharply, if not to their absolute lows, then certainly very near to them. Long-term mortgages are below 4% for those who can qualify. Housing affordability (a measure based on house prices and mortgage rates) has never been more attractive. Moreover, under present tax laws there are advantages to owning since mortgage interest is deductible and rent is not.

Too many people invest with a rearview mirror. Housing has been a dreadful investment since the housing bubble burst in 2007. I believe it will be one of the best investments over the next decade. . . .

In today's environment, the minimization of investment fees is more important than ever. A 1% investment management fee may appear to be very low when measured against assets. But when measured against a 7% equity return, that fee represents more than 14% of the return. Against a 2% dividend yield, the fee absorbs one half of the dividend income.

And measured against the mediocre return of the typical actively-managed equity fund compared to lower-cost, broad-based index funds and ETFs, management fees can be very high indeed. (During 2011, over 80% of actively-managed equity funds were outperformed by the broad-based S&P 1500 Stock Index.) Despite the considerable economies of scale that characterize the investment management business, the annual management fees charged to mutual-fund investors have not declined over time. Investors can't control returns offered by the U.S. and world financial markets. But the one thing they can control is fees paid to investment managers.

The only way to ensure that you can enjoy top quartile investment returns is to choose investment funds that have bottom quartile expense ratios. And, of course, the quintessential low-expense instruments are broad-based, indexed mutual funds and ETFs."

The Bottom Line

Makes sense to me. Increase your investment earnings by one third by reducing wasted expenses by 25%.

And gain some much needed knowledge about finance in the process of doing so.

And perhaps the best part of all is that the knowledge gained will come in helpful in countless other ways.

All at no cost.

Thanks. Bob.

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