There is a continuous debate that goes on in the context of investing through mutual funds.
Should I choose funds which are actively managed or choose Index funds which simply mirrors an index?
Some experts are strongly opinionated in favor of Index funds, whereas investment firms will always tout active investing for obvious reasons.
So what should we as investors choose?
Let’s see the different reasons why Index Funds are better choice for most investors.
Index Funds simply cost much lesser yet gives you the returns of the market.
Index Funds provide instant diversification from flavors such as Total market Index to specific themes and international market indices.
Index Funds do not have the need to reward performance and compete with other funds.
Index Funds do not need to trade very often, thus saving unnecessary tax liability due to capital gains.
Index Funds are simple to understand and follow.
So in an efficient market like the US, where information about good companies is widely available, beating the benchmark indices is not easy for fund managers. There are star fund managers who may have done that, but the percentage is very less, typically < 5%.
The simplest and most convenient in the US is the proverbial Bogleheads’ Three fund portfolio.
However the story may be different in other parts of the world, for example, emerging markets like India.
There are evidences of active fund management overtaking Index returns and in the short to medium term, even with the high costs of management, beat the index fund often.
However this is slowly changing and in recent years, the Index Fund is tilting to be the better choice for long term investors.
With more institutional money flowing into Index Funds as well, Fund managers will find it difficult to beat the index returns and the market efficiency will move towards that of developed markets like the US. To quote an article, it clearly shows the trend.
Over the last couple of years, many investors have increased exposure to index funds as returns from several categories of actively-managed funds failed to beat the Nifty 50 returns. In the past one year, the Nifty 50 has returned 12.51%.
I realized this with my own behavior. With more passion to manage investments and as I learn more, I started to tinker my portfolio almost every month, if possible every week coming up with a new plan.
Selling stocks and bonds, reallocating in the name of asset allocation, refinancing mortgages, buying exotic investments – all are detrimental to peace of mind, and moreover to the productivity of those little bundles of money sent to work for you.
Each investment needs time to grow. Except for hard cash, when you invest in something it needs to stay there to do its job. Equities and Real Estate are long term investments and bond and bond funds are medium term. But none is a short term get rich scheme.
So what makes us do this damaging exercise? The economy around us is constantly changing and producing a lot of noise. We dance to its tune and the sense of a smart ME, does not let us ignore the noise of the experts.
For example, the last few months the mortgage interest rate went down and down, and there was huge rush for refinancing mortgages. Hopefully all the refinancing makes sense in terms of cost and long term goals. It is perfectly fine to just not do anything if your mortgage is already in the low 4% or even lower.
Similarly, the news and predictions about an impending stock market crash is making a lot of investors shaky and market pundits elated at the same time. Equities are long term investments and there is no need of any action for a crash. The markets are cyclical and any equity investment should be part of a long term (> 15 years) portfolio.
Real Estate similarly is at an all time high, with REIT returns touching new highs and homes selling for record prices. This may well be time to be cautious and investors should not change anything in their Real Estate allocation, but just wait out the present jubilation. Or simply continue buying REITs at regular intervals like equity with a longer time (20 years) horizon.
I have also seen people switching their cash from one bank to another just to capture the extra 0.2% interest rate, or get that $300 bonus for opening a new account. A $300 free money does sound alluring, but read the fine prints of the terms and conditions. You have to setup a direct deposit and also deposit a lump sum of new money into the account and hold it for 90 days to get that $300. All this will cause huge changes in your financial plan and system. And then once you get the $300, what next? Another bank may offer $400, but are you going to change your direct deposits again, and move the surplus money which could have been invested?
Simply for changing your asset allocation, selling stocks and funds can incur a huge tax bill, if the capital gains and taxation are not taken into account. For example, short term capital gains are taxed as ordinary income than long term. So even though the asset allocation looks skewed than what you want, it is better to tweak your monthly investments to slowly adjust the portfolio towards desired asset allocation.
As an illustration, below is my asset allocation now and what I want it 5-7 years later.
Note that since I moved from India, a major allocation is still Emerging Market stocks, mostly in Indian stock market. I am also holding about 18% in cash, which needs to be redeployed.
The simple way to achieve this is to freeze the Emerging Markets and Cash allocation, and for next few years my investments will be heavily tilted towards US and International (developed market) stocks and bonds.
As I reflect on the 2019 year to date, I have been victim to this behavior of myself. Following are some of the tinkering I did, which left me with little tangible benefits but probably valuable lessons.
I refinanced a 3.625% mortgage (7-1 ARM going into 8.6% on 8th year) into a 4.125% fixed rate mortgage. The rationale was that a fixed rate mortgage will make cash flow predictable. Hence if I rent out my house few years from now, I will not be hit by increasing interest rate scenario. However with recent low in interest rate, I lost an opportunity to refinance at a fixed rate even lower than the ARM.
I hired a financial adviser to suggest mutual funds across all my portfolios (401k, taxable etc.) and paid him $500 for two sessions. At the end, as I learnt more I ended up choosing my own investments, although a part still came from his recommendation.
I bought a 5 year locked home warranty, possibly not so useful in the long run. I have used them only once in last year, and most of the expensive repairs they don’t cover anyways. I could have done better to save the money instead.
I accumulated a decent amount of cash and procrastinated to invest it. In fact it was a decision on which I vacillated between buying real estate or investing in equities. I did nothing and it just sat there in a savings account, earning less than 2%. At the end of the year, now I have the urge (or somewhat a need) to buy a second car. This money had it been invested earlier, would have forced me to think more creatively on how to acquire the second car. I don’t like car loans, so probably I will now use this cash to buy the second car, a depreciating asset.
So sometimes action is good and inaction is bad.
At other times, too much action should be avoided since long term investments need the long (really long) term to perform. Here inaction is the best way forward.
If you are just starting off with organizing your personal finance, or restarting from scratch, here is a step by step way to get started.
Most of the times, we get started haphazardly, the first account in the local bank or the ad-hoc insurance policy or even the next stock tip forces us to open a brokerage account.
However there is a need to get started in a more planned way.
When I moved to the US couple of years back, the below is how I setup my money system. I had a similar one running in India for a long time and it has given me very good results.
Here is the starter kit that you need to get organized and get started.
Since it is built in a systematic manner, it will help you automatically organize and keep your finances in order.
A checking account
This is the first step as you need a place to deposit your income, be it direct deposit from your employer or you get checks at the end of the month.
Get a simple checking account at a Credit Union which provides you with a basic ATM and Debit card. Try to find a credit union or bank which has very low fees. Obviously they will have some like overdraft fees that we will anyway avoid, but others like ATM access are something unavoidable, so shop around a little.
This is where all your income will come in and get deposited.
A credit card
We are going to be responsible spenders, right? If not, do not get this and use your debit card from your checking account.
The key to being a responsible spender is to make a budget, stick to it and pay off the credit card bill in full every month. Lets just assume you agree to all of this.
There are many credit cards in the market with various features like cash back, travel rewards etc.
As a starter kit, you will just get one from the same bank or credit union where you hold your checking account. The reason is ease of payments and setting up automatic transfers from your checking account to pay it off at end of month.
The bonus will be of course if the card also has generous cash back benefits or other similar perks. But get a free one and not one with annual fee loaded just for extra perks.
The credit card will be your main expense vehicle. It gives you automatic fraud protection, insurance and easier account tracking.
If you do not do any further, you have setup the very basic system. You earn money which get deposited into the checking account, you spend with your credit card (on a budget!!) and your checking account pays it off every month.
But this sounds like living paycheck to paycheck or Living on the Edge, right?
We are going to do better – save and invest.
First what we need is a planner. As the above system of checking account and credit card gets working in a flow, you will start getting an idea of how much you are spending every month.
For the next 2-3 months, track your spending to categorize your money into only 4 parts.
Food and Dining
Utilities and Transportation
Clothing and miscellaneous
You will automatically get motivated to squeeze the first 3 categories and increase your surplus every month.
This is similar to Dave Ramsey’s first 3 baby steps, where you start with saving $1000, then get out of debt (hopefully you have none if you started with this) and finally build a cushion of 3-6 months of expenses.
I use an online savings account like CapitalOne 360, Ally Bank or Synchrony. There are many others, and online banks provide little more interest on your deposits than brick-and-mortar banks, or the one where you have your checking account.
Setup an automatic transfer of your Surplus from your checking account to this Savings account. Set this up for beginning of the month, so that your budget works with just the right amount needed (to pay off the credit card at end of month).
Get to this step only when you have a running budget, able to generate surplus consistently and stacked up 3-6 months of expenses in your savings account.
From here on, you become a pro in personal finance as you are about to invest and grow your net worth.
There are two main investment accounts, a retirement account and brokerage account.
Contact your employer for a 401k (Pretax or Roth) account and contribute to it, if there is a match. If this exhausts your projected surplus, no worries you have got started.
If there is still surplus, good news. Open a brokerage account in one of Schwab, Vanguard or Fidelity. Preferably open a Roth IRA account if your income is within eligible limits.
How are emotions and investments linked? Or should they?
The two are actually intricately linked in our financial lives.
Emotions define investments, and investments define emotions.
For example, most people who invest in stocks buy the next stock based on hot tips, be it from the last night party or the media channels doling out expert advice on stocks.
Or even the general euphoria about the economy and stock market makes us greedy and plunge into get-rich-quick behavior.
Thus an investment is made based on emotions for most people.
Now the same investments cause further emotions. The stock market is down, there is a trade war with China, the media is predicting a crash and so on.. We give in to the noise around us because we are now invested in the market, and it is our duty to become emotional with the world. Otherwise we are deemed too careless about the investments we made so emotionally.
Proven? – Emotions define investments, and investments define emotions.
However the above linkage can be controlled and severed at the right place to make it advantageous to long term investments.
There are only 3 steps to build a successful investment strategy.
Take your emotions into account in planning your investments and portfolio. See which areas of your financial life needs more focus, be it retirement, kids education, emergency fund or long term wealth. This is where most of the emotions should be used (as every one has different life goals and situation), but this is planning only – not yet buying any investment product.
Once you have decided what to invest in and how much, automate your plan. All banks and brokerage services provide automatic transfers and investments.
Take rest of your emotions elsewhere. Just forget the investments as they build up. You just need to tweak it once a year. However this is where people pour in maximum emotions as the noise in the market and the economy rise and fall. Instead hold your investments for the long term as if the account is locked, and you forgot the password.