Be the Expert: What would you tell this novice investor?

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If there is one thing that drives me crazy, it’s “experts” who make a quick buck off of ignorant people by recommending products that are NOT in their best interest.

One of my readers, Matt, recently emailed me for advice about applying the suggestions in my book. He was considering switching his mutual funds to index funds and asked what his financial adviser thought.

Here was her response:

Hi Matt – All mutual funds have expense ratios (fees) to cover transaction costs, statements, research, prospectus, etc.  While index funds typically have lower expenses than a managed fund, you are in effect only buying an index.  You have no one selecting the holdings for the fund, nor is there anyone who makes the decision to sell a stock that is dropping.

For example, in 2008, as banks stocks were dropping rapidly, if they were a part of an index like the S & P 500, they were still held by the fund,  while a  manager of a fund could lower the funds exposure to this sector, thus attempting to limit the downside risk to the portfolio.  Additionally, a fund manager researches and finds companies that could represent an excellent value or a stock that has strong potential growth prospects and add it to the portfolio.  An index fund does not do this.  They add a stock when the stock is added to the index itself.

Please let me know if you would like to discuss further.

What do you think? What would you recommend Matt do?

Note: Let’s be constructive. It would be easy to rip this adviser a new one. But what should Matt do?

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89 Comments

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  1. Ripping the adviser is irresponsible, we don’t have enough context.

    We need his original e-mail to his adviser to know why she would respond in that way. Did he ask “Why would I choose a manged fund over an index fund?” Her response could be valid based on the questions she was responding to. Or did he ask “What is the best type of fund available?”

    We also need to know his goals. Is he looking for higher risk and reward than an index fund can offer?

    I would suggest that he define his goals. From there you can research which combination of investments are most likely to meet his goals.

  2. My first thought is to check the accuracy of what the adviser is saying. What mutual funds was she advising in 2008-2009? Go to google finance and compare the selected funds to one of the low cost index funds championed by Ramit. Maybe she is truly a rockstar and recommends funds that consistently outperform the indexes.

    More likely, the situation she describes did not occur, and the managed fund did just as bad or worse than simply holding an index fund due to the additional management fees. Either way, take a look at the data so you can make an objective decision on the value of managed mutual funds versus index funds.

    • So I just went ahead and did a quick comparison and the results surprised me. I looked at a balanced mutual fund with an expense ratio of 1.42%, American Funds American Balanced C (BALCX).

      I compared this to a lower cost index fund by vanguard in the same morningstar style category (large blend). Vanguard Target Retirement 2045 Inv (VTIVX). This fund carries and expense ratio of just 0.19%. This fund is an example of the type of fund that Ramit recommends, and is one of my personal holdings.

      Looking at a comparison of both of the funds I was surprised to see the higher cost mutual fund outperformed the vanguard index fund in the past 1yr and 5yr time periods and performed nearly identically in the past 3yr time period, despite higher management fees. Link to Google Finance – http://goo.gl/GQAFn

      So maybe there is some truth to what his adviser is saying.

    • Paul E: lots of managed funds beat indexes in 1 or 3 or 5 years. Once you get over 10 is where the indexes tend to start winning, and over 20 almost no managed funds beat the indexes. At least part of the reason is the higher fees compound over larger periods of time negate any short-term wins.

  3. I would make the switch to index funds, and a strategy that does not attempt to outsmart the market or predict the future (I use an ETF version of Harry Browne’s Permanent Portfolio strategy, but there are several good strategies out there).

    Past results are not a guarantee of future performance, but he could ask her which funds she recommends, and ask what his balance would be vs. an S&P 500 index fund, both historically and specifically during the 2008 crisis. I don’t get the sense that actively-managed funds did much better than the index; most probably did worse. By specifying what his balance would be, that should take into account the effect of a higher expense ratio.

    Since multiple studies say that over the long-term, index funds outperform actively-managed funds, he could also ask why it would be good for him to make less money from his investments.

    I figure the answers to those two questions would pretty much seal the deal.

  4. If what his financial adviser recommends interests him, I’d suggest he should invest in a mutual fund with the guidance of his adviser. Together they can select a fund manager(s) that he feels will provide returns that will match his appetite for risk.

    However, Matt should be buying something like, SPY, where his expense ratio is far lower than a mutual fund. He can replicate the gains (losses) of the index, thus earning (losing) what the market is earning (losing). Over the long run, his average yearly compounded gains will be between 5 and 10 percent, or historically 8%.

    Matt should ask, how his adviser makes money. If she fails to address that she is compensated by selling mutual funds (most are), then Matt needs to run for the hills. If she does disclose this, Matt should consider a fee only adviser that can provide unbiased advice.

    He should also give a quick check to this website I found: https://www.futureadvisor.com/

    It will recommend low cost ETFs that will create a diversified portfolio based on his risk tolerance, time to retirement, etc.

  5. Don’t buy managed funds. The “experts” are *rarely* able to beat the index funds anyway. Get a lifecycle fund with the correct target retirement date for you. It will be automatically reallocated to become more conservative as you near that date. Plus, it maintains a certain percentage of each type of asset no matter what: if one chunk of the pie becomes too big, the fund will sell part it off and buy something of the types that are lacking.

    Net effect is that you get index-average returns, don’t have to micromanage your portfolio, and don’t have to pay someone else to micromanage your portfolio for you (and fail miserably the majority of the time). Just set up an automatic transfer from your bank account or direct deposit, and you’ll never even miss it.

    Your adviser may receive a commission on these products, and therefore may have a conflict of interests. If she doesn’t work for a fee from you, this is *definitely* the case. Approach with caution.

  6. From her response alone, I assume he either asked specifically about ETFs or that she works for a particular fund company w a vested interest. Where does she stand on managed index mutual funds? Is she pointing to a specific time period because she wants to sell him on the idea of managed funds or because he’s looking into investments for the short-term (vs. say in a retire accnt)?

    At any rate, who says you have to buy just one index fund. Her justification of “in effect only buying an index” assumes Matt will only be selecting a single fund. He’s read Ramit’s book, why would he ever do that?

  7. This is really a debate between passive vs. active investing. Taking a buy and hold approach with index funds and/or traditional mutual funds is how I would define passive investing, and by doing a little research you create an allocation yourself and don’t really need the services of a financial advisor. You can take the same approach with mutual funds that are managed by a portfolio manager, which in most cases is also taking a buy and hold approach within the mutual fund. Again, you can simply do a little research and buy and hold a portfolio of mutual funds. I consider this to be a passive strategy as well. The only major difference between these two approaches is the fees associated with purchasing index funds which tend to be much lower than traditional mutual funds. The latter approach is where you may seek the services of an advisor that can help in selecting good money managers that manage these mutual funds. The idea being that these “managed” mutual funds can perform better than a comparable index or index fund. The challege that the individual investor faces is finding an advisor that has the client’s best interest in mind and can do a good job of researching successful money managers over the long term. Very difficult to do as not all advisors (even within the same firm) are created equal.

  8. I would ask for an example of a mutual fund that beat the SPY index during 2008. I’m guessing she doesn’t know of one, it was just an example she was making. Always ask for data. And, if you have an index like the S&P 500, a stock that’s tanking falls out of it when it’s no longer in the 500.

    Matt, you essentially asked someone selling SUV’s if they think a Prius is a good idea. Of course she’s going to be against them. She doesn’t make money off of a Prius, she makes it off of an SUV. (Don’t prefer either actual vehicle, just best analogy I could think of, guys usually understand car analogies ;))

    My advice would be to read the Intelligent Asset Allocator book (or a review where they tell you the cliff notes) and then pick your ETF’s.

  9. Why not use both? Index funds and actively managed funds both have a place in a portfolio.

  10. I have been a financial adviser for 6 years. Here is my industry’s dirty little secret: Over 80% of actively managed mutual funds under-perform their benchmark after adjusting for fees/commissions and we all know it! Financial advisers put clients’ money in them because they pay us and mutual fund wholesalers provide us extra money/support to grow our businesses.

    But guess who performs much worse than these mutual fund managers? The average investor! Emotions tend to make the average person buy high and sell low.

    Financial advisers can add value buy helping individuals control the fear/greed emotions that lead to bad decisions. We also add value by offering other services (ex. financial/retirement/estate planning) that many are not directly compensated for.

    Matt needs to make sure he is receiving enough added value from the adviser to justify the fees/under-performance.

    • If you really need a financial adviser, use a fee-only adviser who has a fiduciary duty to look out for his clients best interests. These advisers almost always use low cost index funds and charge the client a percentage of invested money or a flat yearly fee.
      Another option is The Garrett Financial Planning Network. This is good for those with low account balances.
      My favorite and lowest cost method is to use the collective wisdom of The Bogleheads (http://www.bogleheads.org/)

    • I agree with what Kirk said. However, it is difficult to say what the purpose of the money is from the investor to switch to index funds. I am proponent for index funds. Financial advisors do make a percentage off the assets they gather assuming they are licensed accordingly.

      And the average investor does make their decisions based on emotions which is a losing stratedgy. They don’t realize it but they are timing the market.

  11. My next question would probably be – do the fund managers of the actively managed funds she is recommending have a track record of beating their index for the past 20 years?

    The only reason to pay more for something is to get more value.

  12. “Stock-market investing is often described as a roller coaster. Sometimes it’s a really steep drop, and it’s scary. But no one gets hurt on a roller coaster unless they jump off. You must be willing to ride the roller coaster down as well as up.”

    Yes, a mutual fund could have pulled out of banks to reduce risks, or you could have just ignored the market — taken a long term approach and continued to invest in your index fund. By using dollar cost averaging (per Ramit’s book), you would be buying these funds on the “Clearance Rack.”

    Your “adviser” failed to mention that three years later, the S&P has basically doubled since its 2009 low.

    To be a successful investor, you can’t worry about the ups and downs of the market. And you certainly can’t trust a mutual fund to protect you from it either.

  13. Step back. Are you trying to game the market to make short term gains or are you investing in the future, long term? That’s what I thought…

    Index funds also protect you from the mistakes and misses a manager might make while keeping your fees low. We only hear about the outcomes where a fund manager had great positive results (beat the market for a short period) or avoided a painful loss (for a short period).

    How many times do fund managers “cost” you money by missing good picks or not avoiding disasters? You never hear about those do you? It’s not because they never happens, it’s because they don’t [want to] talk about them!

    Invest 10 to 15% of your income into a one or a few lifetime index funds… you can play with 10% of that (1% of your salary in managed funds) or as much as you like as long as 15% of your income is dedicated to indexed funds. In other words if you are contributing 20% of your income, 25% of your retirement savings (5% of your annual income) can be used for managed funds.

  14. The problem here is that there’s never a black and white answer to what invest solutions/strategies will work best for everyone. Index funds vs. Mutual Funds is on going discussion that will never have a clear winner or loser. There will be situations and persons where one will be a better choice than the other, but it is situational and dependent on what the investor is looking for.

    There is nothing wrong with paying a professional to manage your money to try and out perform the markets. For those of you that think this cannot be done on a consistent basis, you are wrong. I live in Canada so the funds we have could be different then those available in the US. Dynamic Power American Growth has outperformed the S&P 500 on a 5 and 10 year time horizon and it has an Management Expense Ratio (MER) of 3.61%. Sure that’s a high fee, but if you’re getting value is that not what makes it worthwhile?

    On the other hand, if you want a low cost, low maintenance and simple investment solutions that you can easily manage on your own, an index based portfolio is a great choice. Though I would caution about using a bond index solution, since they track/mirror all the bonds in the index, including the really bad ones. The average person doesn’t want to research what is the best fund, who is the best portfolio managers, and so on. That’s typically what you’re paying your advisor to do.

    I will disclose that I’m an advisor with a Certified Financial Planner (CFP) designation and that I do receive compensation from the investments my clients are in. This is how I get paid. The difference between a good advisor and a bad one will be the additional services they will provide i.e. retirement planning, tax management, estate planning, insurance planning and other financial considerations.

    My advise to Matt would be to interview multiple advisors and find one that fits his needs; fee based vs. commissioned, investment advise vs. financial planning and to ask a lot of questions.

    • Another CFP here. Just want to distinguish that there’s a BIG difference between fee-based (they collect commissions PLUS charge you a fee) vs. fee-only advisors. Fee-only are beholden to no one and you’re probably not going to see recommendations for active management funds very often. The value is not only in picking out some set of hot funds but looking at your total financial picture, projecting where your savings and spending habits will get you, drilling into your tax return, checking out your insurance (I’ve yet to recommend whole life!) and sorting out all the crappy investments you’ve probably already been convinced into or what your 401k offers. My ideal client has read John Bogle, William Bernstein, and Rick Ferri and will be able to hear the good advice we’ll all give to invest in a portfolio of no-load index mutual funds. Target funds are great when you’re starting out, but as you rack up a little more, you might want to adjust to your own mix, risk tolerance, and goals.

    • Terrific comment, Danielle

    • Chris,

      With all do respect a Management Expense Ratio (MER) of 3.61% is outrageous. A big part of that goes to distribution fees to banks and advisors like yourself which is fine if there was real outperformance.

      You do not show an adequate analysis of its performance, you compare a midcap growth fund (which invests highly concentrated in 4 sectors) to the biggest 500 companies in the US.

      The problem is that it takes highly specialized knowledge to properly judge investment performance which is often not present or not used for obvious reasons.

      Regards,

      Boris

  15. I am sure this adviser is well meaning, but investment advisers and fund managers are emotional beings and make decisions good or bad based on this feelings.

    Her example of the banks is exactly the mistake most people make of selling low for the sake of “lower the downside risk.” We all know that banks will always be there. He would be better off buying the banks when they are low.

    Index Funds by their nature buy low and sell high because they are constantly rebalancing their portfolio. Plus, those management fees can eat away at most of your gains. Also, if he is purchasing shares at regular intervals, he will not be timing the market instead he’ll catch it at it’s lows and highs.

  16. Your asset allocation is much more important and influential on your portfolio than which funds you select. [re-read this 3 times and then continue] Once you have your asset allocation selected than you can fiddle with fund selection.

    If you have your asset allocation set and you’re still worried about expenses the go ahead and switch to index funds.

    • Great point. Most people will never understand the profound importance of that first sentence. Instead, they’ll spend their entire investing life “picking stocks” and funds, thinking that’s the most important thing they can do.

  17. Matt should ask the advisor how they determine if outperformance by an actively fund is generated by luck or skill.

  18. The action to take is easy:

    Say he has $10k to invest. Put $5k in an index fund, give $5k to the adviser to manage.

    After 6 months, evaluate which has more money. If the index fund has more money. ask the adviser why. If the adviser says anything other than “I didn’t do as well as I thought I could. I’m still learning.”… dump em.

  19. Alternately, ask to see the adviser’s own assets. If their portfolio hasn’t beaten an index fund, dump em. If they refuse to let you see their assets, dump em.

  20. @Ramit

    True. It’s a test of the adviser’s integrity more than their actual performance.

  21. I’ve been an indexer for several years, and I have often heard that active funds under perform the benchmark index after fees– that’s why I’m an indexer. What’s harder to find is actual data that supports this (or maybe I’ve been looking in the wrong places).

    I would greatly appreciate it if someone could point me to an academic article/ analysis that compares index and active funds.

    • S&P keeps track of this: http://www.standardandpoors.com/indices/spiva/en/us. The main takeaways are:
      1. Over multiple different trailing time periods, index funds as a whole outperform actively managed funds.
      2. Actively managed funds that actually do outperform index funds over some time period are highly likely to subsequently underperform over the next time period. That is, there are essentially no actively managed funds that consistently outperform. I’ve actually seen statistics from David Swensen that the % of active funds that outperform is less than what you would expect based on random chance. And people get paid to do this?

    • Matt, Thanks!!
      This is just what I was looking for.

      Ramit, I’ve read you’re book and I guess it’s been too long for me to remember that. I lent it to a friend, so I’ll have to get it back and check what you wrote. Thank you both.

    • Another thing to keep in mind when looking at Mutual Fund vs Index performance is survivorship bias. Mutual funds merge, close, and are renamed all the time therefore their “true” performance can be difficult to know.

      “Survivorship bias is the logical error of concentrating on the people or things that “survived” some process and inadvertently overlooking those that didn’t because of their lack of visibility. This can lead to false conclusions in several different ways.”
      http://en.wikipedia.org/wiki/Survivorship_bias

  22. I am a single family income. An extra $2001 would be right on time.

  23. It depends on the specific fund, but in most cases the rules a fund manager operates under (due to the prospectus) and the size of the fund dramatically limit most funds flexibility to such an extent that even if the manager knew the market was tanking, they couldn’t effectively address the situation. What this means is that if you are considering investing in a large, traditional mutual fund, you are probably better off just using an index fund- the fees will probably not be worth it.

    The situation would be different if you had the opportunity to invest in a fund that was free of those restrictions (small size and flexible prospectus) but these types of investment opportunities are typically only available to investors who have large sums to invest (large being several hundred thousand dollars) if Matt is just a regular investor, I’d say use the index fund.

  24. I’ve been a financial planner for over 6 years and put all of my clients in low-cost index funds. The facts show that timing the market is a loser’s game.

    Matt needs to do some more research and then decide if he truly believes a passive portfolio is best for him. If he doesn’t buy into or understand how index funds provide superior after-tax and after-cost returns, he’ll likely be swayed by someone with a slick sales pitch or hot stock tip.

    When he’s decided on his investment philosophy, he should look for an adviser that shares that same philosophy.

    In addition to Ramit’s book, I’d suggest Matt read Rick Ferri, Larry Swedroe, Allan Roth, and William Bernstein.

  25. Technically, everything the “advisor” said is true — index funds are “unmanaged.” However, please note the advisor’s use of the word “attempt,” which is very telling. I would refer Matt to the books, “A Random Walk Down Wall Street,” by Burton Malkiel or “The Investment Answer,” by Daniel Goldie & Gordon Murrey, and also the Standard & Poor’s SPIVA report, which they publish semi-annually, available here: http://www.standardandpoors.com/indices/spiva/en/us
    Bottom line — the vast majority of active fund managers fail to beat simple, unmanaged indices.
    Sidenote — Is this “advisor” a stock broker? If so, fire them. Stock brokers are not advisors. and it really annoys me when they use that label. If they don’t have the fiduciary obligation that comes with being an SEC Registered Investment Advisor (RIA) — and most stock brokers don’t — then they are just salesmen, not ADVISORS.

  26. There are a lot of good comments in response to this question . Mine is a combination of some things that have already been mentioned and some of my thoughts . There are many sources that show that in the long run (key concept) index funds outperform actively managed funds. While no one knows what is going to happen tomorrow the major economies of the world are not in great shape right now Matt the potential for volatility in your investment portfolio is high whether your in active or passively managed funds.Think about your stomach for accepting this volatility and then disperse your funds accordingly . You need to remember that an investment adviser’s first interest is to himself and his family your’s should be also spend some time learning the game that is being played here it is always easier to play when you know the rules.I believe it is true that you will outperform an actively managed fund with an index fund there is no reason why you could not invest a portion of your portfolio in managed funds if you think you have found a few good ones and another portion in index funds.My response rambles and could ramble more that is because the subject is a little more complex than it first appears . To understand this better you need to self educate a bit before you make your move an excellent place to start is to read “A random walk down wall street”.
    Good Luck

  27. I’ve been investing in mutual funds since I was in college in the 90s. At first in managed growth funds that rode the internet bubble and later shifted them to Vanguard target retirement index fund. However over a 15 year span my IRA investments are basically flat, with about an overall 0-10% gain depending on what the stock market is doing. A few thousand I put into a managed China fund is doing better than the index funds and even the rare company stock I own due to a contribution match has done better over a 10 year span. I max out my IRA contributions and just keep having faith that the index funds will turn out for the better in the long run. As a diversified investor I also bought a small studio apartment in Paris in 2004 with the rent easily covering the mortgage. I could also sell it for double what I paid. Certainly wouldn’t put all my money into real estate, but I wouldn’t recommend putting everything in an index fund either.

  28. The thing that the adviser argues is a strength of managed funds over index funds, the human component, is actually their biggest weakness because humans fall prey to some crazy psychological traps when it comes to taking risks.

    Loss Aversion is a behavior that humans have developed as we evolved. Basically, we instinctively feel the pain of a loss much more than we would feel the joy of a gain of equal value. It is a fantastic survival instinct, but makes people bad at investing in the stock market. For example, if you find $20 on the street, it is worth less to you than having to spend $20 from a savings account. That may not seem like a big deal, but consider it in a different light.

    Say you have $1,000 invested in the stock market — $500 in two different stocks. The price of one of the stocks starts going up while the price of the other starts falling. Studies* have shown that people are more likely to sell off the stock whose price is rising (because they want to cash in before it starts going back down in order to “lock in their gains”) and hold on to the stock whose price is falling (because they don’t want to make the loss “real”). So you sell all of your shares of the first stock and wind up with $650 (a profit of $150) and hold on to the shares of the second stock (thinking that it will turn around any day now) until one day it’s announced on the news that the mining company you invested in was just a shell company running a pyramid scheme through the stock market. All of a sudden your shares are worthless. You’ve lost $500. So your $1,000 investment resulted in a $350 loss, overall.

    There are a whole boatload of other psychological traps that people fall into (the above example also involved the “sunk cost fallacy”), but what it comes down to is this: actively managed funds are extremely risky BECAUSE of the human element. Plus, look at all the people (this adviser included) who fall into the overconfidence trap. “I know that the human element makes it risky, but, because I am aware of that risk I will be able to successfully avoid it.” <—WRONG!

    Anyway, index funds are definitely the way to go. Good luck!

    *My source for these studies is the book "Why Smart People Make Big Money Mistakes & How to Correct Them" by Gary Belsky and Thomas Gilovich. It is an extremely well written and informative introduction to the science of behavioral economics, and, if, like me, you read Ramit's book and wondered, "Hmm, it makes sense, but where's the science that backs up his argument?", then this is the book for you! Seriously. Check it out.

  29. Most of you are playing the wrong game. Sure, you can save a few dollars by buying index funds over managed funds. Sure, the managed funds may have the occasional year of outperformance. The problem is that if you are simply trusting asset allocation to take care of you, you have surrendered the most important component of portfolio management – risk management. Ask some Japanese investors how effective those rebalancing trades have been over the last 20 years. Ask an Icelandic investor.

    The stock markets of every single developed economy on the planet have suffered drawdowns in excess of 80% on at least one occasion in their past. Every single one. You don’t live long enough to recover from that. Trusting your future to the altruism of the markets is lunacy. Capital markets are simply tools and, like any other tool, at times they can provide a great benefit and at other times they can inflict serious damage. Whether you decide to use index funds or managed funds, if you want to make money, you’ll make risk management your primary goal.

    Saving 50 basis points in expenses is great. Doing it while you’re down 40% in a cratering market is just a really expensive form of turd polishing.

  30. A lot of people get caught up in what to invest in, what allocation to have, but almost everyone is not saving enough. 401k’s are extremely under-funded. People need to think long term and make some sacrifices now in order to max out their retirement accounts. Once you’ve accomplished this, worry about what funds to invest in. 1% doesn’t make much of a difference on a $100,000 401k. 1% makes a big difference on a $1,000,000 401k..

  31. I would advise him on something else entirely.

    I would ask him: Hey Matt, look, your financial advisor has her own ideas, so we should just take a look at what strategy we should take here.

    Let us argue, during the crisis, you would have taken one of those funds. Would it have lost 50%? It would. And as you can see, it would have just come back up.
    Now, your financial advisor is advising you to take a fund that SELLS like crazy in those turbulent times and from a perspective of being human and being compensated, i can absolutely understand her. But let us say that in fact instead of being scaredy cats, we did nothing. Instead, we hoarded some money on an active bank account. What should we have done looking in this perspective? RIGHT. We should have BOUGHT stuff. So once the market really starts taking the toll, it might feel like you are loosing money. But in reality, that is not what is happening. A market crash isn’t loosing money, a market crash means there is the ultimate summer sale in stocks and you need to get in.

    Actually, I would even argue that you should save money! Save money on a bank account with mediocre interest. Now it feels a little like hurting, I know Matt. But when the time comes, and believe me, it will come as long as this system exists… (And if it doesn’t anymore, your mutual fund vs. index fund might be a problem no one cares about anymore )… you can just take the money and go investment shopping.

    Now, investment shopping? Yeah. Investment shopping. You see, when everything broke down, everyone was talking crisis, there were people who made billions. Those were the guys that stood up, leveraged all their money and started buying. LIke Warren Buffet, Donald Trump, the Rockefellers, the Rothschilds. They just go, take as much money as they can and start buying, because it is just a summer sale for them.

    And now ask yourself that question: If you want to be RICH, do you want to act like a financial advisor making 100k? A salesman making 100k? A shopping clerk being F’ed by the economy making 30k? Or do you want to own life, want to rake in the cash? Because then, be like Warren. When the crash starts coming, if you are the one buying at the lowest point, you are the winner. If you are selling, like a mutual fund manager, you are the looser.

    Now think about that Matt. And think about having a talk with your financial advisor.

  32. If you’re putting money into shares without knowing what you are doing you may as well spend a night at the casino because investing without knowing what you are doing is just gambling in disguise. Don’t rely on advice from people making money from your ignorance (i.e. Financial Advisors). The most successful investor in the world is a man named Warren Buffett – look him up (and start doing your own research).

  33. The adviser’s note is misleading. Academic studies have documented that actively managed funds under-perform index funds over the long-term.

    Rather than tossing his adviser just because of one item, Matt should go through the steps below to determine what benefits the adviser provides and if he should toss him/her. As an added benefit, if Matt decides to get a new advisor, the steps below will prepare him to know what he’s looking for in an adviser.

    1: Decide what benefits the adviser provides outside of stock picking
    - If the adviser is doing a good job providing other benefits, keep him/her.
    - If not, find a new adviser.

    2. If those benefits equal or exceed the adviser’s fee, keep the adviser and current fee structure
    - If not, meet with your financial adviser to discuss lowering the fee or/and consider changing advisors

    3. If you decide to keep the adviser, tell the adviser to invest your money in index funds and work with him/her to choose the most appropriate fund

    4. Ask questions to see whether the adviser was purposely or unknowingly mislead you.
    - If it was purposeful, I’d consider changing advisors.
    - It it’s not purposeful, acknowledge that your adviser has blind spots and decide if he/she provider enough value in other areas for you to stick with him/her. Consider changing to someone whose investment philosophy matches yours and provides other non-stock financial advice.

  34. since Matt is already paying a mgt fee on his account he most likely knows what it is… it would be nice to have numbers in the advisor’s illustration… if Matt asked about the difference the advisor can easily give him a comparison of the costs between the 2 and saying somthing like: so you are paying $xx more in a mutual fund to have people look at it everyday versus relying on an index classification to rotate stocks in-and-out of the portfolio…

  35. According to “The Ten Biggest Investment Mistakes Canadians Make” (http://link.jbrains.ca/LJslSn), you need to watch a Fund Manager for 35 years to have 90% confidence that his performance comes from his skill, rather than from random luck. Said differently, you CANNOT know whether a Fund Manager is good or lucky. If you invest to gamble, and it’s OK if you do, then go for a managed fund, but don’t pretend that managed funds are any less gambling than picking throwing darts at a dartboard of stock symbols.

  36. I would think that for a true novice, an index fund is probably safer. The market always increases in value (even if only by inflation) over the long term, while mutual funds fail all the time.

  37. All kinds of problems but the big one that is just factually wrong and indefensible is this:

    “All mutual funds have expense ratios (fees) to cover transaction costs, statements, research, prospectus, etc.”

    NOOOOOOOO!!!! The transaction costs are an expense IN ADDITION TO the expense ratio–and of course, funds that trade a lot will have higher transaction costs that drag down their returns.

    See, for instance, this:

    http://online.wsj.com/article/SB10001424052748703382904575059690954870722.html

  38. I can agree that index funds are the way to go. In agree-ance with many of you that posted before me, Ramit’s book is a must read. I use to have my large portofio at E.J. and when I wanted to pull all my money out and switch I got a similar kind of message.

    Using index funds and getting the market return minus the extremely small expense ratio is fine with me. I much prefer this over an advisor making guesses or bets as they will most likely be wrong some percentage of the time. As Ramit’s book proves it is more often than not. Why would I pay 1.03% per year when I can get a more predictable return and only give away .019%. That is a saving of more than $1200 per year on a portfolio of the low XXX,XXX. Over the course of a lifetime with compounding, etc you are talking about a serious amount of money.

    When I first transition to Vanguard I also made the mistake of selecting my own index funds (total stock market US, total stock market world (excluding US), and a REIT). The overall portfolio was great but having to rebalance once or twice per year in all the different accounts was a pain. I have since moved all accounts into a target date fund and couldn’t be happier.

    My Recommendation to Matt as well as most anyone else would be to pick a the proper year Target Date Fund (not necessarily the same year you retire fund). A target date fund will allow you to focus all of your time and energy into putting more money into the fund as opposed to dealing with the hassles of re-balancing, tracking, etc.

    Good luck Matt, JUST DO IT NOW, don’t procrastinate any longer!

  39. I don’t trust most advisers. Most advisers were wrong about the crash in 2008. They were wrong about crashes before. They were and are wrong about so much. It’s ridiculous. And their defense is “Well everyone was wrong.” But I feel if I pay you to manage my money, I pay you to be right even when others are wrong.

    (If you care to find out how wrong people are about their financial predictions just read anything by Nassim Taleb. It’s a scary wake up call. Or “What I Learned Losing A Million Dollars” by Jim Paul. It’s all about the psychology of losses and how to control them.)

    So anyways, I think it’s better to just buy an index fund. Just get your compounding interest going. Besides, this is what Warren Buffett recommends for most investors.

  40. If I am correct, William Sharpe won the Nobel Prize in economics from his observation that 90% (or so) of capital gains come from asset class, 8% from choosing the right stock (or whatever) in that asset class, and the remaining 2% from timing. Thus choosing the right asset classes are most important. When you couple that with the fact that most actively managed mutual funds underperform the market, index funds seem the way to go.

    Personally I’m a fan of the David Swensen model portfolio- he manages the Yale endowment fund and has “beat the market” over long periods (e.g. 15 years). Anyone can “beat the market” over a year- just get lucky- and over five years- get lucky and don’t screw up- but fifteen years is another story. His solution: 1) asset allocation, using a few select assets that tend to have good return/risk and perform in an uncorrelated way, 2) index funds (he thinks most mutual fund managers should be indicted for fraud), and 3) rebalancing instead of “timing”. You can do all this without paying a single cent to a financial adviser.

    That said, perhaps the biggest job a financial adviser can play is to hold your hand and convince you *not* to panic and capitulate e.g. cash out when the market collapses and everyone thinks we are entering a new depression, for example in 2008.

    As for the guy in question above- My answer assumes he is investing for the long term e.g. 10+ years.

  41. Unless a person is extremely good at choosing the fund manager who will correctly decide what to invest in and when to invest in it, a person will be better off putting their money with an index fund.

    If you want to speculate with fund managers or individual stocks, do that with a small portion of your assets and understand it as going for home runs with money that you will most likely strike out with.

  42. I thought you said he read your book? Why does he still have a financial advisor? If he trusted her advice I assume he wouldn’t need ours.

    There is no mention of the cost of switching between the funds, but if he has read your book then he would probably choose an index fund or lifecycle fund. Unless he really wants to pay someone he doesn’t know to manage his money by choosing stocks.

    Everything his financial advisor said would make a sane person pick the index fund.

  43. see the current fiscal situation of the country and when ur heart allow to do then once introspect putting his eyes of and having the name of God do with courageous. Her example of the banks is exactly the mistake most people make of selling low for the sake of “lower the downside risk.” We all know that banks will always be there. He would be better off buying the banks when they are low.

  44. To be able to answer…….. what are his goals ? Does he have some cash stashed for a rainy day ? Credit cards paid off ? …. then i would go with the index funds. But, he could do some of each…
    ~ Christie

  45. I’d tell him to read David Swenson’s Unconventional Success: A Fundamental Approach to Personal Investment

  46. I know nothing about investing so I shouldn’t say anything. But as long as he keeps the majority of his money in cash and away from the stock market he’s good. Most people including me don’t know squat about investing.

    Just do what I do. Keep your money in cash, work a job and work a small business. Only use money you can afford to lose in a business. But start a business you like, understand and will make extra money for you.

    Sorry Ramit, but I don’t trust any mutual funds,stocks or hedge funds. It’s all nonsense and pure luck if you make money.

    Mark

  47. I think this guy is in an exciting place. He has infinite options, and there is no “right” way to go about it.

    If he wants to do a lot of research on individual companies, he could become a value investor and buy what will lead to long term wealth instead of what some salesperson recommends. But most people won’t put in that kind of effort.

    If he wants to do things the really easy way, he can buy a few broad market index funds that charge low fees and more than pay for them through dividends, which he can set to automatically reinvest themselves.

    We usually take for granted that a person’s entire financial picture is pitch-perfect except for the “right” investments. Danielle hit the nail on the head with the tax return and insurance things.

    But it worries me that people think of their retirement funds as essentially a glorified savings account instead of investments that let you own real assets — not toys like cars and homes, but things that really pay you. I don’t think it’s possible to have investments that don’t require some research and effort on your part, even if it’s only reading a few dozen prospectuses.

    I know you can always work longer if your investments turn out bad, but “I’ll work until I die” is easy to say when you’re 20-something. This falls back on entrepreneurship — taking calculated risks for awesome returns. With decades of time put in, though, you don’t get a lot of chances to be wrong.

    Ever think of joining a commune?

  48. I’m assuming he doesn’t want to spend any time managing his money. With that I would tell him that while active managed funds would save him time but the fees you pay them aren’t worth it. The reason why is that there are stats that say that “99.9%” of financial managers cannot beat the index. On the same token, I wouldn’t suggest he just ignore the advisor’s advise. There is some merit to having his money being managed, just not with her, because there is another way to grow his money.

    I would suggest he look into an age based investment funds like Fidelity Freedom Funds or Vanguards Retirement fund. These types of funds’ risk profile (stocks vs bonds allocation) are managed automatically as the funds “mature” or as you age. The type of funds that are invested are index type funds. These funds also typically offer very low annual acct fees (aka expense ratios) far less than the active funds. You just automate your money deposits into the account and sit back and have more time doing things you love to do.

  49. Why limit to mutual and index funds? He needs to check out ETF’s.

  50. Simple answer from a Finance professional from Holland:

    The Advisor implies 2 things:
    Fund Managers have stock picking skills and Fund Managers can time the market. (wrong!)

    Finance Literature* says:
    - 80% of fundmanagers do underperform their benchmark
    - you cannot predict which managers (20%?) will outperform in the future (yes morningstar is mostly useless except for avoiding the really bad ones)
    -If you want to outperform the market with market timing you need to be right 70% of the time*
    -out of those 20% many do not really deliver alpha (skill) after accounting for risk factors. (google: carhart four factor model)

    Conclusion regardless of asset allocation, active fund management is a statistically losing bet. Most people (95% of people who answered on this forum) will be best of by buying index funds.

    What to do?
    -join the http://www.aaii.com/
    - Invest with a company like wealthfront (index investing for 0.25%)
    - Get an independent advisor. Only an advisor that you pay an hourly fee can give you objective advice. The value of a good advisor comes not from his outperformance in the stock market but from shielding you from yourself and the mistakes you will make if you start investing actively yourself (or listening to your private banker). (google behavioral finance)
    Ideally a financial planner helps you with your financial plan and asset allocation and an investment advisor should expose you to the desired riskfactors at lowest possible cost.

    Next step for people wanting to know more what are the suitable riskfactors? check http://bit.ly/LBjW5m

    I have no website or company nor am I affiliated to anything, this post was not ment to be this long. But I like to inform people with all the bs around.

    *I do not have time to quote the literature

  51. Problem #1 – asking the financial adviser for input. The adviser is going to advise the client to invest in managed funds as they provide a commission to the adviser. The adviser is going to say the managed fund is better. And it may be. Just like Las Vegas, some people do win. However, the numbers tell a different story. Selecting a broad index fund, like say, the Vanguard 500 Index, would have yielded better returns for 1,3, 5 and 10 years than 70% of its managed competitors.

    Unfortunately, it’s hard to know which of the 30% of managed funds to pick. The simplest and most efficient decision for the investor would be to stick with an index fund.

    The adviser’s own advice displays some of the problems associated with managed funds. Even if the managed fund did, as claimed, dump troubled stocks during the 2008 meltdown, when would it have purchased them back? It was the quick rebound in the spring of 2009 that helped funds recover. Had the managed fund sold out of key positions, and then missed the first few days or weeks of the bull push in March 2009, it wold have missed out on key gains.

  52. For a novice investor, I think it’s best to take advice from poker. “If you can’t see the sucker in the room, it’s you”

    You should be happy to get average performance, so I’d suggest trying to get index performance with minimal fees, rather than trying to be “smart” and try to hedge against risks you don’t understand.

    Also, if you start to pick active funds, there’s an impulse to DO SOMETHING as opposed to go with the flow. Should I sell? Should I pick another fund?
    Choosing your own funds creates new options and takes up willpower you should spend on something else.

    With rigor as a bonus, you can rely on the fact that managed funds are mathematically losers on average.

    And in response to the questions introduced in the comments about ETFs, I say no. Creates the impulse to trade, and buying shares isn’t typically as automated as with a mutual fund, so your system is less automated.

  53. Fire the advisor. Do the reasearch and or join an investment club. Stop paying someone else.

  54. For the most part the adviser is accurate in her comments. However, there is a more important issue to address and that is net performance.

    It is far to simplistic to say you should only use ETF’s or you should only use mutual funds. The way to ensure the best possible overall performance for your portfolio is to select the best investment option from the universe of available options within an asset category. Of course, all investments will be considered net of fees.

    You should always begin with assessing your risk tolerance and time horizon. From there you develop your target portfolio allocations within each asset category. Next you should select the best investments for each category within your allocation. Sometimes this “best investment” may be an ETF and sometimes it may be a managed mutual fund.

    It’s simple to use Yahoo finance or Morningstar to run your fund / etf screens and if you have an on-line brokerage account like Schwab or E*Trade you can use their more robust fund screening options.

    Bottom line: it’s silly to argue over whether ETF’s or mutual funds are “better” because there is no better, it’s all relative to the investment category you are looking at. Select the best investment (ETF or mutual fund) for each category within your portfolio and move on.

  55. Matt,
    It’s true an index fund only represents the index that is the point! You are guaranteed to get market returns minus the funds fees.
    There is no ONLY about getting market returns, especially over the decades that you will invest for your retirement.
    People want to believe that “experts” are able to predict the future and pick superior stocks but the evidence does NOT back that up.
    If you do some research, such as reading Ramit’s book, you will find most actively managed funds don’t beat their benchmark indexes in the short term and almost none beat their indexes in the long term. Predicting the future is damn hard. The truth is that no one is really smart enough to predict the future, and reacting to events after the fact is usually too late.
    Maybe your financial advisor will be able to pick superior funds- but the odds are against it… do you want to gamble YOUR future on her predictions?
    -Rick Francis

  56. Read Ramit’s book again, in detail. When the stock market goes down, it’s an opportunity to buy more of the index fund. Regular investing with funds that one can invest for the long time horizon is the key to investing success. Concentrate more on asset allocation and automate the process so that you have enough funds to meet the emergencies of life. The active funds guarantee the expenses that they charge but can never guarantee returns! Also, because there is very little overlap in the holdings (stocks) that index funds have, asset allocation is a breeze. Active funds have a lot of stock holding overlap which makes asset allocation more difficult. Doing at least yearly balancing amond index funds and not panicking during downturns will give you success. Timing the market is a loser’s game for sure, in the long run. Also understand the subtlties of asset location. Figure out which assets belong in taxable or tax-favored accounts. If you really need an advisor to do projections, say for retirement planning, contact a fee-only advisor who does not get commissions. I also think understanding clearly one’s risk tolerance and capacity for risk is very important. Don’t succumb to fear, educate yourself and define your own course of action.

  57. I don’t know why people are playing around with mutual/index funds. Why not dab into futures/forex? Much more leverage and lower starting balances to get started.

    Is this the part where you respond “it’s risky”? Sure, when you trade the money yourself you may win or lose. At least it is a result of your direct decisions; and you have an opportunity to improve your choices. When you hand your money over to someone else; what incentive do they have to make money for you? Especially if they “get paid” anyway and they do not offer any type of guarantee [earnings]? Evaluating these types of funds are very subjective; and while the numbers don’t lie, they can be placed in a way that are deceptive (as I think Kirk eluded to).

    Kirk did have a point that there may be other secondary/auxiliary benefits that the financial planner may be able to assist you with retirement planning.

  58. Need more information. Age of investor? How is financial adviser compensated? Seems that risk profile needs addressing. Is this $$$ held in a taxable account? Ratio of account to total assets?

  59. Okay, the advise given in the post is not the best argument for active funds but I would still like to question the common theme that index funds are always better. Its not a everlasting rule that passive funds always are better since they have lower fees.

    Given the fact that there is enough active investors out there the competition is hard (you could say the market is more efficient) you dont get enough value to justify the active managers fees just as historical data suggest.

    If a majority of the investors only had index fund it would change the dynamics.Given that everyone followed the common index advise we would get a potentially less effecient market and therefor the value from active management increases. The index funds only works if there is enough active investors out there to make the analysis.
    You could say that index funds are free riders on the active investors work.

    If you look outside the big well functioning indeces and you want to get, for example, emerging market exposure the value of good active management increases. Its also hard as foreign investor to judge if a market is effecient enough for passive investment (its dynamic and might change from year to year).

  60. I am a poor single mother of two,but i have the believe that i will not remain poor,my biggest win will help me establish,i just share it with my friend on face book.

  61. Let’s be honest, there is no such thing as in independent financial advisor even if they advertise as such. Someone will always have a bias towards a particular type of financial advice or organisation.

  62. Neither.

    Until you invest locally in peoples and businesses that you know, you are just a piece of the machine. You will have no financial security. However, if you invest locally, you will have relationship, financial, and community security.

    • What does that even mean? You want to invest in Uncle Jo’s trailer farm?

    • My guess is ‘I’ means to build a relationship with those who have a direct connection to you. Any of the three ways I can interpret Ramit’s example of ‘Uncle Jo’s trailer farm’ would work:
      1. raised bed farming environment = access to and investment in food supply
      2. tractor trailer supplies for farms = investment in food supply
      3. residential area usually known as a trailer park = investment in land, income from leasing land, and opportunity for community/social development.
      These all look like positive options to provide meaningful work and employment.

  63. First, I’ll make sure that you only invest the money that YOU AFFORD to lose, not the money that you highly dependent on.
    Than, the only question that I would ask first would be: “What is your time horizon of investing?”
    Is it short term or long term gain?
    If it short term, I recommend you to avoid stock market.
    But if you choose a long term, both option (index and mutual funds) is a good option. Because in short term, market moves volatile and you’ll battling your own greed and fear (which many of peoples failed). While in long term, good company’s stock will eventually reflected to its price.

    Choose the renowned funds with good historical performance and management, invest and go to sleep, peacefully.

  64. Is the “advisor” fee based or commission based? I bet, based on her comments, that she is commission based. These types are disasterous.
    1) they are a major reason that most people lost big in 2008. Due to the way that they get paid, they encouraged their investors to stay in and ride out the crash.
    2) they are salespeople and by training don’t know anything about their product, only how to sell it.

    A) dump the “advisor” and NEVER use commissioned based help again.
    B) Read up on funds. Index is the way to go if you don’t want to be an expert. Start with ANYTHING by Warren Buffett and his teacher Graham.
    C) Check out Motley Fool. They are “snake oil salesmen” so “trust but verify”. They are the best if the bunch however.
    D) if you want an advisor, find a fee based one with lots of references and actually talk to the references.
    E) if you really want to make money learn about real estate. Start with the book CASHFLOW QUADRANT.
    F) ALWAYS participate in your company 401k – nowhere else will you get an immediate 50% return on investment that you don’t have to do any thinking to get.

  65. RAMIT
    I don’t know about Uncle Joe but
    Pappa Carls trailer farm is a money machine!
    He bought it in 1970.
    It is free and clear.
    it is worth about $2,000,000.
    It grosses $450,000 a year and nets after all expenses $270,000.

    I am about to buy another similarly sized “Pappa Carl” place that nets $50,000+ with no money down.

    If you need a broker – send me a note.

  66. I would tell him that the adviser is neglecting to mention that there is data that clearly supports the notion that on average, actively managed funds underperform broad-index benchmark performance. This is the case whether we’re talking large-cap all the way to small-cap.

    Along those lines, I’d also tell him that one should always keep in mind who he or she is taking advice from, and what the other person’s motivations are. This applies in many aspects of life, not just with respect to personal finance. Just because somebody is a “professional”, it doesn’t mean they are A) working purely in your best interest, or B) competent.

  67. I suggest, read ramit`s I will teach you to be reach, page 58.

    He covers this in depth

  68. Over the long term almost zero actively managed funds will outperform the market. Over the short term an actively managed fund may outperform the market. This is usually followed by investors flocking to that fund and often times the managers have trouble managing the additional assets. The additional assets will mean the manager will either need more stocks as good as the stocks that led to the market outperformance or pour more money into the stocks that have already had a good runup. Warren Buffett has said in the past that he could return something like 30% per year if he only had to invest $100,000 (I might be off on the numbers, but the idea is it is easier to have good returns with less money if you know what you are doing).

  69. I suggest reading Robert & Kim Kiyosaki’s Rich Dad/Rich Woman series, which also has titles by other financial professionals.

    • Varaneka, I would disagree with recommending Robert Kiyosaki. While he has some general knowledge on finance, its nothings that hasn’t been taught elsewhere nor is he really deep enough to warrant much attention. He is more of a creature of MLM than anything else.
      Check out this report by John T Reed showing what a hack he is:

      http://www.johntreed.com/Kiyosaki.html

  70. [...] Get Rich Slowly reader shared his financial advisor’s advice when asked whether he should go with mutual funds or index [...]