Financial stuff can be VERY intimidating, especially since most of us had no real training or education on it. I totally get that. You have friends in the financial industry, they get you to meet with them. They give you a shiny folder, with a great mix of funds for you. It shows you how well it has done the last few years and there are lots of bright-colored charts and graphs. “Now if you put your money with me, or roll-over your old 401k, you’ll see some great returns !” they say with a smile.
While these people may have their place, I think many would be better slaying this dragon and going at it with their own management, with passive index funds. I have been sitting at a desk getting the sales pitch. A few of my friends are financial advisers too. I love them still despite this stuff. And remember, they are trying to make a living too, so it’s all good. But you don’t have to take your money and put it in their pocket, which is often what you’re doing with these fee-based adviser firms. You can totally do it yourself. Don’t be afraid to tell your friend “no,” or pull your stuff out of their great investments at their firm. If they are really your friend they’ll shake their head and understand, and still be your friend over beers or football or whatever. If not, they were just a leech. For me, most people get the benefit of the doubt and live up to my life expectations, and after their sales pitch falls flat to me, we’re still cool. Your experience may vary.
So anyway, why you should take over is another matter. First, when you do your research, you’ll find that most financial adviser firms will charge between 1-2% for fees on any fund they recommend. That means, any gains you see, get subtracted by that amount. Any losses you have from your portfolio in reality have larger losses. In addition, they also tend to recommend “front-end loaded” or “back-end loaded” fees (vs. no-load fees). These are expenses that get added onto the annual fees. So, an average front-end load fee that your “dude” may recommend is 5%. So automatically reduce your earning potential by that amount with a front end load fund. Instead, maybe they try and confuse you by contingent deferred sales load (CDSL) or back-end load. Don’t be fooled. They simply grab your 5% on the back-side when you sell or move to a different fund. This is in addition to gross expense fees that all funds have, though index funds tend to be very small, while (as I noted above) the fees typical firms charge are 1-2%.
What your adviser friend is going to sell you is that even after fees, they are “beating the market.” Maybe they are the next Warren Buffet, but more than likely they aren’t. The number will vary from year to year, but on average, only 30% of funds beat a broader market index such as the S&P 1500 (largest 1500 stocks traded in U.S.). And the thing is, those that do beat it, even for years, will change management and end up back with the herd. This little article at Forbes talks about this a little (along with 5 other reasons your funds underperform the market). So while maybe your firm has beaten the market for a short while (and who knows why – my adviser friend told me his “best” and most recommended fund right now is a leveraged stock fund, which may be killing it right now in the bull market, but I would expect would get creamed if the tides suddenly turned).
I promise, we’ll get into nerd-math in a minute. As you likely already know, Index Funds have minimal fees. My Vanguard total fee for my whole diversified portfolio is just above 0.10%. I want to leave that as a benchmark. For my administered 401k (with S&P 500 index, bond fund, international), I’m at about 0.3% fees. This is heavily weighted in S&P 500 index fund, that has a fee around 0.10%. For the sake of argument, let’s say your two options you’re evaluating against are 1) the fund the investment guy is trying to sell you, that has beat the market by 1% over the last 3 years, has gross expenses of 1.5%, and a front-end load of 5% and B) a vanguard index fund (say a Vanguard Target Fund – which may or may not meet your risk tolerance, I am only using it to illustrate my point). These funds are roughly 0.2% expense fee (it’s actually lower), and no loads.
For assumptions, I’ll use a $10,000 lump sum investment, 25 year time horizon, compounding at 7% for Option B, and 8% for Option A (NOTE: you can play with these numbers, the AFTER inflation annualized return was 8.4 for the last 30 years, so 7% may be conservative. Check out this moneychimp calculator if you want to see the returns before or after inflation for any historical period) that assumes that your managed fund bucks all historic trends and continues to be totally awesome (which it likely won’t). Also, interest assumptions compounds continuously (365 times per year). The outputs, after fees are then:
So despite your managed fund totally kicking ass for 25 years, you are still have 12% less money than simply letting it ride in an index fund. The reality is, your managed funds (whether in a 401k or other investment or retirement account) has a number of disadvantages compared to passive index funds. Your managed funds are trying to beat the market, so are constantly churning their funds looking for deals. Frequent trading results in more fees. Second, frequent trading results in more taxes paid (capital gains). Then you have the fact that actually hitting on the right funds, can be a roll of the dice. Even Warren Buffett and Jim Cramer recommend index investing over managed funds.
I talked about my experiences rolling over an old IRA/401k into Vanguard. It’s pretty easy, even for a taxable account. The hard part is breaking up with your adviser. They’ll talk you out of it, since you’ll be taking money from their pocket. They may even reluctantly invest in Index funds on your behalf, but just be aware of their fee structure for doing that. Change is hard. Slay the dragon and you can succeed by empowering yourself. Selecting your funds can be as easy as a Target Fund, or you can slice and dice to get the allocation you want. But that’s an article for another day.