I apologize for not answering some of the questions... I wish I could answer all of them, but I simply don't have the time. I try to pick out questions which are interesting or relevant to as many readers as possible. For specific personal finance and investing questions -- e.g. which funds in my 401k to invest or should I refinance -- I strongly recommend posting over on Bogleheads.org which is an incredibly helpful and knowledgeable community of individual investors. Again, I apologize if I did not answer your specific question.
1. Reader Question
How much extra cost is an index's weighting worth? I am invested in an allocation of Vanguard ETF because I understand how important annual fees are. I note that these funds are weighted by market capitalization. I understand a simple weight like this helps keep costs low but I have trouble with the effect: as a firm's stock price rises (say, AAPL) then its weight will increase in the index. If I was buying individual stocks then this is not how I would buy more. Is the PowerShares FTSE RAFI US 1000 (PRF) ( weight "based on the following four fundamental measures of firm size: book value, cash flow, sales and dividends") at .39% worth the extra cost?
Unless I have a really good (approaching mathematical certainty) reason to believe a particular strategy is bound to beat the market after all additional expenses and any extra taxes, I would hold the standard capitalization-weighted whole-market portfolio because it lets me minimize those all-important expenses.
Minimizing expenses is the one and only absolute sure thing in investing. Everything else is some version of hopes and dreams. Some of those hopes may be reasonable and have a good chance to materialize. But none of them are guaranteed the way lower expenses are guaranteed to take a smaller bite out of your returns.
PRF very closely parallels the broad market. Since its inception it has pulled slightly ahead of the broad market but it also dipped lower than it during the 2008-9 plunge. This means, roughly, that its holdings are slightly riskier in bad times and are therefore expected to have slightly higher returns in good times (such as now). Another example of same phenomenon are small-cap stocks. Here are all three -- broad market (VTSMX), PRF, and small-caps (NAESX) on a single chart, since PRF's inception (all dividends included):
In fact if you look closely you'll note that NAESX didn't dip quite as low as PRF in the 2008-9 bear market while outperforming it now. Not that it means that NAESX is a superior investment -- though many people do overweight small-caps in hope that their riskiness will lead to higher returns over the years. I'm only including NAESX in this comparison to show that there is nothing special about PRF. I would not invest in PRF over conventional low-cost capitalization-weighted index funds.
2. Reader Question
I have a question about the investment industry - with a "long term" perspective... Where do you see the industry business model down the road. We have seen in our generation - stockbrokers go from charging high front loads and big commissions per trade to be almost gone by now. Most "wealth managers" now push Asset Under Management (AUM), and some even get 2%. To me that might be better than the old model, but it still has major flaws especially if you have a lot of assets but are low maintenance. It seems the CPA model is fair to all - you pay your accountant for work done each year - you don't pay him a percentage of your taxes.
That's a very good question. I would expect the trend away from expensive active investment management and toward low-cost indexing to continue until we reach some sort of equilibrium. Active investing will never disappear completely -- or even come close to disappearing -- because if indexing ever does become the overwhelmingly dominant model the markets will be less efficient (since indexing does not contribute to efficiency) opening up new opportunities for active investors to profit by exploiting these inefficiencies. This is a very good thing, since efficient markets are very important economically. And of course there will always be a large contingent of investors willing to pay extra for a shot at market-beating returns even if markets are already quite efficient. So we can be guaranteed that active investing will never be pushed to the brink of extinction. I do hope that fee structures evolve to reward investment managers for beating the benchmarks rather than merely accumulating large AUM. Something like the infamous 2-plus-20, except more along the lines of 0.5-plus-40-above-benchmark. Of course there would need to be mechanisms in place to prevent fund managers from taking on much more risk than the benchmark in an attempt to cash in performance-based fees.
As for wealth management / financial advisory, there is no question that these jobs must be done on fixed-fee basis. There is zero extra work in handling the extra zero. Shuffling around tens of millions of dollars from is just as easy as shuffling around hundreds of thousands. Unlike an investment manager -- for whom a larger AUM brings the need to find more and more market-beating investments -- a wealth manager does not have to do anything differently with a larger AUM. A wealth manager or a financial advisor should be paid on fixed-fee basis like every other professional, from lawyer to plumber to accountant. That percent-of-AUM model dominates wealth management industry is a travesty -- even more so than the percent-of-AUM model that dominates investment management.
3. Reader Question
Hi LTR, I've got $200k that needs to be put into a taxable account. I'm in the 25% bracket, 48 and looking at a 30 year investment period. What's left over goes to the kids. Don't mind being aggressive and using a mix VTSMX/VTFSX and muni's. What I need to be able to do is withdrawal anywhere from 2-6% per year to increase my income and don't care if anything is left over at the end of the 30 years. I have looked at various online calculators and this seems to be doable. Does this sound reasonable? Or would you recommend a different method to achieve these goals? What I don't understand is the tax hit that will take place. Is it 15% of what I take out or ? I can stall a couple of years before withdrawing. Regarding re-investment of dividends, people over at Bogleheads have all sorts of opinions on the best strategy. What's your opinion on this topic? Thanks so much for your advice.
It's a bit hard to give a meaningful answer since there's a big difference between 2% withdrawals and 6% withdrawals. And you probably do have a preference between using as much of your funds as possible or leaving more to your kids. The 30-year time frame is also a bit strange -- what happens if you live past 78? Those might be the years when you need this money most.
The way you wrote your question and dovetailing into your re-invested dividends question, the simplest way to go is to select a mix of VTSAX (US stocks), VTIAX (international stocks), and VWLUX or VWALX (muni bond funds -- "regular" and "high yield" respectively). All of these yield in 2-3% range. So you could just pick the mix of these three you like and collect the dividends and interest as part of your 2-6% withdrawals, letting the principal ride.
If you truly don't care about the risk involved in stocks and don't mind if half or more of their value might be wiped out, then something like $100-120K in VTSAX and $80-100K in VTIAX would do it.
It's probably a bit more reasonable to hold 20-40% in bonds, in which case you might hold something like $80K in VTSAX, $60K in VTIAX, and $60K in VWLUX or VWALX.
Again, the exact mix is up to you once you settle on just how risky a portfolio you wish to hold. If you decide that you need withdrawals higher than 2-3% you can always sell some of the principal. The appropriate thing to do there would be to sell more of the fund that has done better than the other two, as to bring their relative more in line with the original plan.