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Scott Burns' Articles -- Recent and Archived

The worst form of investing except for all the others

Q: Like you, I believe investing in index funds is a better way for individuals to invest. I was just about to start investing in index funds in my retirement accounts when I came across an old article by Gregg Wolper (Morningstar, 2/21/06) titled "The Hidden Drawback of Indexing." Wolper said that, "Believe it or not, index funds are, in effect, momentum players."

Although he did not discourage readers from investing in index funds, his concerns seem valid. I would like to know your opinion on the concerns raised in the article. I would also like to know whether it is the right time to jump into index funds at the peak of the market when most index funds are loaded with overvalued stocks. ---J.L., by e-mail

A: Winston Churchill once said: "No one pretends that democracy is perfect or all-wise. Indeed, it has been said that democracy is the worst form of government except all those other forms that have been tried from time to time." The same statement could be made of index funds as a form of money management. They aren't perfect, but they are better than all the other forms that have been tried.

While Gregg Wolper is correct -- there is a built-in momentum element in market capitalization-based index funds -- it has never been so great a problem that broad index funds haven't outperformed the majority of their managed competitors.

We live in an imperfect world. What we try to do as investors is work with the tools that give us the best results at the greatest efficiency. To me what is truly amazing about index funds is that a tool with such visible limitations has so easily and consistently beaten the majority of managed funds over not years but decades.

You buy an index fund to avoid stock selection risk.

You also buy an index fund to avoid market timing risk. You buy the asset class as a whole and use the best tool yet created to capture its returns -- and its risks. When you ask whether it is "the right time to jump into index funds at the peak of the market when most index funds are loaded with overvalued stocks," you are expressing an opinion about stocks, the market and the future. Opinions are something index investors try not to have -- because they are usually wrong. Overvalued stocks and overpriced markets often continue to rise. Undervalued stocks and underpriced markets often continue to sink.

We can be entertained by all those who have opinions about the value of stocks and the level of the market. But we should never forget that it is entertainment, not a visit to the Oracle of Delphi. Skeptics need only endure a few minutes of James Cramer's "Mad Money" to get a visceral understanding of opinions as entertainment.

When you become an index investor, you rest in the benign assurance that you will capture the market return of many asset classes. You also accept a historically verifiable idea: Flawed, vain, violent and covetous human beings, on balance, collectively manage to create more value than they destroy. Q: I am 60 years old and retired, with 80 percent of my savings in the stock market. Of that amount, about 40 percent is in alternative investments sanctioned by one of the largest financial firms in the world.

Should I be looking to move that money into safe investments such as CDs? If so, how does one do that when the FDIC insures only $100,000 per bank per customer? With my net worth, I'd be running all over town looking for banks. Yes, I know that's a good problem have! -- E.K., by e-mail

A: Unless you do a great deal of hunting, you will find that U.S. Treasury obligations generally yield more than bank CDs of the same maturity. If you visit http://www.banxquote.com/, for instance, you will find that the national average yield on a five-year CD is currently 3.91 percent. Visit http://www.bloomberg.com/ and you'll find that a five-year Treasury obligation yields 4.70 percent.

People with large portfolios -- those who have to worry about the limits of FDIC insurance -- get the best credit quality in the world with U.S. Treasury obligations. You can buy them through investment firms like Fidelity or Vanguard. You can also buy Treasury obligations directly at http://www.easysaver.gov/.
Published Jan 10 2007, 06:00 PM by scottb
Filed under: , ,

Comments

 

ABModerator03 said:

You're comparing AVERAGE yields on CDs to Treasurys. I would go to the top of the chart and look where the true competitors are. Also, check credit unions, online banks.

  

From Scott Burns:

I used the average yield for a reason--- it's a yield you're likely to be able to get. Many of the yields that top the list are very transient.

They are there for a day or two. Then they are gone. They aren't standing offers. As a consequence, many readers have reported spending a lot of time chasing a yield they never quite catch.
January 10, 2007 10:09 PM
 

ABModerator03 said:

Scott, first of all, I love your columns published in the Daily Herald (IL) and over the years have had questions to ask you but never took the time to do so. What prompts me to finally write is a reference you made in today's column (Index Funds) to Jim Cramer's show. I just started watching Mad Money in the last two weeks and have been tracking the stocks he recommends, etc. and note during my time period a larger percentage have gone up than down after his show airs. Question: has anyone ever tracked his stock recommendations over a longer period of time, such as a year, to see if his recommendations are actually valid or visceral (to use your word...which, by the way, I had to look up!) Limited vocabulary here.... :)

Thanks...

Cathy

From Scott Burns:

Someone probably has tried to track his record--- if you google "Jim Cramer track record" you'll find Cramer's response to a newspaper column that attempted to track his record--- but I'm not aware of anything definitive.

You should, however, consider the media effect of his mentioning anything. If a positive mention causes any increased purchases of a stock, its price is likely to rise. Studies of the performance of stocks mentioned on the late Louis Rukeyser's program, for instance, showed an immediate up tick that faded over a period of time. I suspect the Cramer effect would be the same.
January 11, 2007 6:45 AM
 

ABModerator03 said:

Dear Scott -

Today you said (San Antonio Express News), "When you become an index investor, you rest in the benign assurance that you will capture the market return of many asset classes."

My indexing mantra is, "I never, ever underperform the markets" (particularly when using Vanguard Admiral index funds). Not even Bill Miller can say this.

Works every time.

Dee

From Scott Burns:

That's the key. If you examine, say, the performance of the Vanguard S&P 500 fund against its managed peers you'll find that it is seldom below the 50th percentile and seldom above the 25th percentile. Managed funds, on the other hand, have more extreme performances. It only takes one or two extremely bad years to take the long term performance of a fund that is the envy of other funds to rank below the index.
January 15, 2007 7:19 AM
 

ABModerator03 said:

Dear Mr. Burns,

I look forward to reading each of your columns in the San Antonio Express/News. Your column in Monday's paper advises that U.S. Treasury obligations are the way to go for retired folks.

I agree with you that they are good and safe but I have found that watching the newspaper's advertisements can be worthwhile when it comes to investing in Certificates of Deposit. We just purchased 2 $40,000 CD's at the Pentagon Federal Credit Union. One is a 3 year and the other a 4 year to help our ladder. The APY on these is 6.25 which suits me just fine.

I can't find anything close to that at banxquote.com that came close to this. I can always redeem them if the interest rates go up substantially in that time period. And for the gentleman concerned about the FDIC $100,000 insurance. Their are ways around that, especially if he is married.

In closing I appreciate your sound advice in financial matters, but for us at this time CDs, Treasury Bonds, and some Municipal Bonds we still own are what we are feel secure with. Compounding has helped us become much wealthier than we ever expected. We still don't buy something expensive without giving it a lot of thought. We help our grandkids w/ college tuition and for now we are debating on replacing our 9 year old car with a Camry or a small Lexus. Knowing us it will probably be the Camry.

Myrtle

From Scott Burns:

If you're observant. If you take the time. Then you can find good yields on CDs. You should know, however, that CD yields are lower in some parts of the country than in others.

That means some people may have more difficulty finding attractive yields than others. If you visit www.banxquote.com and search their CD database, you'll see big differences between states.

Recently, for instance, I found that the national average for 1 year CD yields was 3.85 percent. But the average in Washington state was 3.60 percent. It was only 3.66 percent in Texas, 3.69 percent in California and 3.70 percent in Tennessee.

Florida, however, averaged 4.01 percent. New York averaged 4.25 percent and Massachusetts averaged a stunning 4.85 percent. Those are big differences.

Significantly, the yield on U.S. Treasury obligations maturing in 1 year was 5.04 percent.
January 17, 2007 1:33 AM
 

ABModerator03 said:

SB:

You got honorable mention @:

http://www.marketwatch.com/news/story/lazy-portfolios-beat-benchmarks-again/story.aspx?guid=%7BDABA48D1%2D0DDA%2D43F7%2D8700%2D275FEF592BD1%7D
January 17, 2007 11:03 AM
 

ABModerator03 said:

Your response to R.K., points out that national average 5 yr CD rates are under 4%. That's true, yet I often see ads in our local paper (San Antonio)for much higher rates. For example, yesterday's paper advertised one bank with a 1 yr CD at 5.64% (FDIC), another bank with a 7 mo CD at 5.25%(FDIC), and a credit union 3 yr certificate at 6.25% (NCUA).

Only a small portion of this discrepancy can be attributed to the shorter term and the inverted yield curve. Such high rates puzzle me. First, I don't understand what might cause a firm to offer rates which are so far out of line. Second, I wonder what's the worst that could happen if I purchase such (insured) certificates.

From Scott:

Individual financial institutions will often pay a premium rate to raise the money needed to fund a loan commitment. That also explains why the institution offering highest yield CD changes so quickly on the top yield lists you'll find on www.bankrate.com and www.banxquote.com.

Another factor is a little scary. In answering ads from independent vendors, you will find that it is frequently a "bait and switch" deal. You will be told that the FDIC insured CD is no longer available. But they have some interesting high yield alternatives available. These alternatives may be high yield notes backed by equipment or fixed rate annuities with punitive redemption returns.
January 22, 2007 10:33 AM
 

ABModerator03 said:

Hello Mr. Burns,

In a recent column (Akron Beacon Journal, 1/22/07) you suggested that it requires a great deal of hunting to find bank CD's that yield more than Treasury obligations. However, if you go to bankrate.com, you'll find many CD's that exceed the Treasury obligation yields by more than 0.5%. For example, on January 23rd, bankrate.com showed 13 FDIC insured banks with 5-year yields ranging from 5.14% to 5.35%. The 5 year Treasury obligation yield that same day was 4.625. For large CD holdings, an additional 0.7% per year can be significant. These CD's can easily be established via telephone and/or the Internet. IRA transfers, as always, require a little more work. However, IRA CD's are FDIC insured up to $250,000 which would reduce the number required for individuals with large holdings.

Regards,

Joe

From Scott Burns:

Thanks. Actually, I've been mentioning both www.bankrate.com and www.banxquote.com for years as sources of higher yield CDs. Reader feedback, however, suggests that many of the top deals on their lists as snapped up faster than most people respond. You must be a quick draw!
January 23, 2007 7:39 AM
 

ABModerator03 said:

Scott,

There have been a few questions I've heard discussed lately and it seems the answer to these question are hard to find and also vary dependant on who you ask. The first has to do with indexing and what is tracked within the index. I realize that there are multiple components of total return. Using the S&P 500 for example, does this index simply track the change in share prices or does the index include dividends, etc. as well. I've read where dividends in sectors such as this have accounted for approximately 40% of the total return over the years and that would have a big bearing on the efficiency of indexing.

The second question has to do with low cost investing. It seems that a few years back, there was a justifiable rush of concern about excess fees with mutual funds. However, it seems that this concern has somewhat went to an extreme and now these companies that are charging the "cheapest" fees are seeing a larger turnover and less retention in money managers. Don't you feel this could have a great effect on long term returns? I certainly don't want too pay too much for something but I've always considered that you do get what you pay for.

Thanks for your time.

WH

From Scott Burns:

If you buy an index fund you will get both the change in capital value, plus or minus, and any dividends. One of the reasons some observers, e.g. Rob Arnott, are concerned about future common stock returns not living up to past common stock returns is that current dividend yields are so low and higher dividend yields, reinvested, in the past have contributed over 40 percent of total return.

I believe the loss of many mutual fund portfolio managers has not been caused by expense pressures from index funds but by opportunities offered by hedge funds. Run a mutual fund and you may share in 1 percent fees. Run a hedge fund and you may share in 2 percent fees plus 20 percent of any profits.

That makes sense, thanks for your response.   In regards to non-indexed mutual funds, is it safe to say that just because something is no-load doesn't make it a better fund.   I've done some research that shows loaded funds outperforming no-loads even after the fees are paid.

I guess my question is, there seems to be more to the story than simply the fees?

From Scott Burns:

It is save to say that being no-load doesn't make a fund inherently superior. I haven't done the analysis in years but I once found that a percentage of purported no-load funds had higher long term costs than the average load fund. The best example of this is the American Funds group. Their funds are broker distributed and have loads but their expense ratios are so much lower than most funds, load or no load, that they turn out to be a good buy even before your consider their better than average performance.

If you read my columns, I don't make claims that no load funds are superior to load funds. I make claims that index funds are superior to the vast majority of managed funds and that the average investor should not indulge in "manager risk." The quarterly SPIVA report from Standard and Poor's, for instance, shows that 70 to 90 percent of managed funds in all major categories underperformed their benchmark index, research that has been replayed for longer than I have been a financial journalist.
January 28, 2007 6:14 PM
 

ABModerator03 said:

Looking for some objective advice. I am male and over 60 years old. Married, unemployed/retired for two years. A "victim" of a corporate buyout/re-organization. Escaped with severance benefits/vacation pay/retirement lump sum/401K/IRA of about $900K. So far I have not found a job. I haven't tried that hard because I have managed to survive with healthy market returns due to heavy international stock concentration. I watch the market closely and monitor daily. So far I have lived on money market assets and not liquidated my mutual funds holdings. Nearly everything I own is in Fidelity. I appreciate that my current circumstances are not unusual, moreover that I am more fortunate than most.

I have been following your financial column for several years in the Houston Chronicle. You emphasize simple investment strategies and minimal cost investments.

Fidelity justly views market timing/fund transfers as undesirable. While I have not currently been guilty of such behavior, what I anticipate of my possible future actions would be.

A review of your previous columns and your response to questions on your website suggests a possible solution. I have examined some ETFs mentioned in your columns and found that they correspond favorably with my holdings in Fidelity funds. I am speaking specifically of EFV and PRF which correspond to the FSIVX and FUSEX which I currently hold.

While I have always been a buy and hold long term investor, that was when I was younger and had some prospect of riding out bear markets. As I view the current investing environment, I see the need for nimble feet to avoid downturns which I formerly ignored. Market timing is the proper name for this.

My proposed course of action is to convert my Fidelity holdings to their ETF equivalents and monitor closely. In the event of market down turns I would bail out of the ETFs in to a safe money market fund. When good times return, go back to the ETFs. Risk is obviously there, especially if an extended bull market requires substantial draw down of capital. No one knows the future.

My concern is the liquidity of the market in these relatively thinly traded ETFs. Can you comment on my action plan? Yes, I know about asset allocation. My assets are too meager to conform to a 4% draw and maintain current living standards. I need to take risks.

From Scott Burns:

Unfortunately, no one rings a bell at the beginning (or end) of a market downturn. So I think your market timing plan is dangerous and likely to fail. A better option would be to:

1) diversify,

2) build a low risk buffer zone in your portfolio that would allow you to avoid selling equities in a downturn,

3) and make a careful examination of your spending needs so that you can adjust your spending down to a level that is appropriate to the level of your assets and future Social Security income.

You should also consider the impact of your future Social Security income. With a $900k lump sum/401k accumulation I'd be willing to bet that you will receive near maximum Social Security benefits, adjusted for your age when you start.

Here's a very rough, back of the envelope calculation. Let's assume that you take SS benefits at age 67, around your full retirement age. Let's also assume they will be close to the max, around $25,000 in today's money.

So it would require a reserve fund of about $150,000 (earning 5 percent) to "bridge" you to age 67.

That leaves $750,000 for a lifetime investment fund that could provide an income of $30,000 a year at a 4 percent withdrawal rate. With $25,000 in Social Security benefits (or bridge funds) your total income would be about $55,000.

That, or slightly more, should be your spending target.

If you decide to spend more, hoping for higher returns, you are likely to feel great remorse at some future date when losses force a dramatic reduction in your spending.

There is a good online tool for playing with all these options at this URL: http://firecalc.com/firecalc.php
February 10, 2007 5:09 PM

About scottb

Scott Burns has covered the changing world of personal finance and investments for nearly 40 years. Today, he ranks as one of the five most widely read personal finance writers in the country. Scott began his career as a newspaper columnist at the Boston Herald in 1977 where he was also the financial editor. Nationally syndicated in 1981 and now distributed by Universal Press, the column appears in newspapers from Boston to Seattle. In 1985 he joined the staff of the Dallas Morning News where his column quickly became one of the most widely read features in the paper. He left the Dallas Morning News in 2006 to become one of the founders of AssetBuilder and its Chief Investment Strategist. Burns is a graduate of Massachusetts Institute of Technology (1962). He has written four books, including "The Coming Generational Storm" (MIT Press, 2004) coauthored with economist Laurence J. Kotlikoff. His fourth book, also coauthored with Kotlikoff, will be published this spring by Simon & Schuster. "Spend Til' the End" uses consumption smoothing to demonstrate the errors of conventional financial planning. His business experience includes working as a staffer for a major consulting company and service as a director and audit chairman of a NASDAQ listed manufacturing company. He and his wife divide their time between Dallas and Santa Fe, New Mexico.
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