What Should You Do With Your Money? Part 2

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Disclaimer

When you have money to invest, ask yourself two basic questions: 1) Will I need the principal (the amount you invest) anytime in the next few years? 2) How much risk am I willing to take?

If the answer to the first question is yes, because you are saving for a house, for example, the answer to the second question should be none; you can't afford to risk possible loss of principal. In this case put your money into government-insured fixed income investments, the simplest of which are either treasury bills or bank certificates of deposit (CDs). Treasury bill investing can be done through a money market mutual fund that buys only treasury bills. There is no chance of default, and you can get your money out any time you want (you can also buy them directly from the U.S. Treasury or any Federal Reserve Bank). Also, the money earned is free of state and local taxes.

CDs are for a fixed period, but you can pick your expiration date and have a guaranteed amount when you need it. The CD interest is subject to state and local taxes. Another reasonable option to CDs is zero-coupon treasury bonds. You buy these "zeros" at a discount to their final maturity value, e.g., a 10-year $10000 zero guaranteeing 7% annual interest to maturity may cost only $5000. During the 10-year period, the value of the zero bond will fluctuate with changes in current interest rates (going down when interest rates exceed 7%, rising when they fall below 7%), but if you don't need the money before 10 years are up you have no risk.

If you have a longer time frame, and are willing to accept some risk, by all means choose the stock market; put the money into a no-load stock mutual fund, preferably an index fund that tracks the entire market or a major segment of the market, such as the Standard & Poor's 500 (500 large companies traded on the New York Stock Exchange). Do not buy individual stocks; that has to be considered a real gamble at your stage. You should instead diversify in order to prevent drastic losses on a single stock. (In the early 1990's many IBM employees had their retirement money heavily invested - in some cases totally invested - in that company. When IBM's stock went from over $120 to $41 share in less than two years, employees near retirement faced severe losses.)

The stock market historically has done better than fixed income investments over the long term, although there are major swings, and at any one time your investment could be worth less than what you put in. However, over the long haul (at least 10-15 years) investors have almost always done better when invested broadly in the market than with fixed-income investments. There are some exceptions. One is the period 1929-1954, which saw a world-wide depression followed by world war; people who were in the market in October 1929 had to wait until 1954 to have the same stock valuations (although they did receive dividends during this period if they held dividend-paying stocks). Another exception was 1972-1982, which witnessed an essentially flat stock market.

But if you are young and not impatient, and don't pull out when there are major downward swings in the market, history suggests you will be far ahead at retirement with stocks as opposed to fixed income investments.

When investing for the long term, whether or not in stocks, there are three basic rules:

1) Start as early as you can, and invest regularly as much as you can. Try to do it automatically, so a fixed amount of money is deducted from your paycheck or bank account without you having to do anything.

2) Always take advantage of tax-free retirement plans, to the maximum possible. If you work for a for-profit company, these are called 401(k) plans; if you work for a non-profit organization (e.g., a non-profit hospital or college), they are called 403(b) plans. If you are self-employed they are called Keogh or money-purchase plans. In all such plans the interest, dividends and any capital gains accrue tax-free until you retire and take the money out. Don't worry about what the "tax rates" will be when you retire. Let the money accrue tax free until you truly need it.

3) Don't invest in anything you feel uncomfortable about or don't understand. "Understand" is a term you will have to define yourself. I doubt one out of 10,000 physicians understands derivatives or commodities investing; both are guaranteed ways for the novice (and many "experts") to lose money. On the other hand, most physicians probably understand investing in stocks or mutual funds; if you do, invest in them. (If you don't understand how they work, avoid them until you learn more; see Bibliography).

Retirement plans are a great way to save. In most retirement plans you will have options for mutual fund investing, with either a full service broker or one of the large no-load mutual fund companies. Always choose the latter over the full-service, or load companies; over time you will make a lot more money, if for no other reason than much lower costs. If you are investing outside of a retirement plan (i.e., after-tax dollars), and don't know much about the stock market, call one of the no-load mutual fund companies; tell them you want their prospectuses on "index funds." Read these pamphlets and invest regularly (for the long term) in a stock index fund, i.e., an unmanaged fund that tracks the stock market or some large segment of the market.

Most large fund companies are now set up to provide information on the internet and/or commercial on-line services like America Online, Prodigy and CompuServe. Since you are using a computer to read this section, you can click on the underlined words to link to the various companies. In this way you should be able to get all or most of the information you need immediately.

The four largest purveyors of no-load mutual funds and their 24-hour toll-free numbers are listed below (you can link to them now by clicking on the underlined words, which should also be in color on most browsers).


Fidelity 1-800-544-0029
Charles Schwab 1-800-5-NO-LOAD
Vanguard 1-800-962-5024
Jack White & Co. 1-800-431-3500

The first three companies function as mutual fund super-markets, selling hundreds of funds from many companies in convenient "one-stop" shopping. Fidelity also manages over 200 of its own funds, and is by far the largest mutual fund company in the world. However, Vanguard advertises (and in fact has) the lowest fees, a fact which accounts for the excellent performance of its stock index funds (since high fees invariably erode performance).

Vanguard is a good place for the beginner to start investing. Vanguard's widely held Index 500 Fund, which tracks the S&P 500, charges only .19% a year ($19 per $1000 invested, compared to the average stock fund fee of 1.35% per year) and does better than about 75%-80% of actively managed funds over the long haul. This fact is not lost on the investing public. The Vanguard 500 Index fund pulls in more money than any other single stock fund, including all the funds managed by experts.

There are many ways to buy mutual funds, but the four companies listed above are a good place to begin shopping and learning about mutual fund investing. Until you feel comfortable branching out, I strongly recommend sticking with index funds. Three Vanguard Index funds and their annual fees are shown in the box. They should serve as benchmarks when shopping for a broad-based stock index fund.

When you become more knowledgeable, you might want to invest in a stock fund that, based on your research, has the opportunity to do better than an index fund. Examples would be an actively-managed small cap fund (invests in companies below a certain size), a growth fund that attempts to beat the S&P 500, and a fund that in invests overseas companies. There is nothing wrong with a little speculation, as long as you make the decision and not some salesperson whose large fees will almost guarantee poor performance. Once you've invested, you can track the fund's performance in the stock market pages; the closing value (called net asset value or NAV) for the previous day is listed under the fund family's name. 

              
Index Fund:                 Invests in:         	Annual fee:
              
Vanguard Index 500          500 largest stocks    	.19%
Vanguard Index Extended     Next 4500 stocks      	.20%
Vanguard Index Total        All 5000 stocks       	.20%                                             
Vanguard  1-800-962-5024

ADDITIONAL INFORMATION AND INTERNET LINKAGES

There is a plethora of financial services linkages on the internet aimed at the indivicual investor. Most charge for the information, or require an annual subscription. The most obvious advantage over almost anything printed is timeliness; another advantage is that you won't "lose" the information (you know where your computer is), in contrast to a magazine or newspaper which is never available when you want to look something up. However, if you are a novice investor I recommend you stick to printed materials initially. First of all, you should be in no hurry. Second, these internet services can be difficult to use, although they will get better over time. Listed below are selected sites; they are too new (and I have only examined them briefly) for me to make any blanket recommendations. Generally, if you find the printed versions useful, you will like the electronic versions also.


The Wall Street Journal The WSJ charges a fee, but it is cheaper than a subscription to the printed version.
Barron's Online -- A weekly newspaper put out by Dow Jones Company, publisher of the Wall Street Journal. Its subscribers have the highest average income of any general financial periodical.
Kiplinger On-Line -- One of several financial magazines on the internet; also contains many consumer-oriented articles in additional to financial info.
Money Magazine -- Another financial monthly on-line; competes with Kiplingers.
Mutual Funds Magazine - A magazine -- and web site -- devoted to the world of mutual funds; updated daily.
Pathfinder -- A service from Time Warner that includes Money Magazine, CNNfn (Cable News Network Financial News) and Fortune Magazine, among many others. A supermarket of information.
The Motley Fool -- Motley Fool is a proprietary site of Amercia On-line, also with an address on the Internet. Fool offers "contrarian" advice to investing, and has chalked up some big gains in small stocks.
INVESTtools -- Offers access to investment newsletters, each with its own separate fee.
Hulbert Financial Digest -- Hulberts rates all the investment newsletters around for actual performance. If you subscribe to a financial newsletter, or are thinking of doing so, check out its rating in Hulberts.

(Advice, continued. . . ) You should avoid mutual funds that charge a "load" or fee to purchase shares, or which charge a fee to maintain them on top of the fund's own built in fee. This is the policy at all full-service brokerage funds (Merrill Lynch, Smith Barney, Eaton Vance, Alliance Capital Management, Franklin, Prudential and any other "full-service" firm), all mutual funds sold by financial planners, and all banks. Because of the stigma associated with load funds, full service brokerage companies have come up with new gimmicks; they have hidden their loads by moving them from the front (paid on purchase) to the back (paid on exit from the fund). The result is the same. You will end up paying a large sales or maintenance fee in some fashion, and it will retard your return.

Back end loads usually disappear in 5 or 6 years, but during those years your annual expense for the fund will be 1.5x to 2x the annual expense for the exact same fund with a front end load; in other words the load is spread out over several years, but it doesn't stop. Year after year after year you continue to pay a much higher fee on the fund. And if the fund does poorly and you want to get out early? You will end up paying twice: the much higher annual expense while you were in the fund, and the sales fee to exit.

You must also beware of buying a fund based on the fund company's name. Fidelity, the largest purveyor of mutual funds, including many that carry no load, also sells several funds with front end loads (e.g., Magellen). Moreover, Fidelity sells many of its "no-load" funds through brokers and financial planners, in which case they are Fidelity Advisor Funds; you get the same funds as if you bought them on your own, but at a much higher fee (in other words, the fund includes a load).

One financial planner tells his clients: "I work for one percent a year. How do you want to pay it?" He is being honest, as he is telling the client up front:
'You are going to pay me 1% in addition to the annual expense of the mutual fund you buy.' While such honesty is commendable, his fee also means that the client will have a poorer return than if she bought the same or similar fund herself, directly from a true no-load company.

To find out exactly how you will pay the seller's high fees, read the prospectus accompanying every mutual fund. The fee information is always in there, in tabular form on page 2. Anyway, it is virtually impossible to keep up with all the ways full-service brokers (and banks and financial planners) hide their sales fees. Some have now divided their array of mutual funds into A, B, C, and D shares, all variations of the same thing: heavy sales loads, either front, middle, or back. Avoid them. Always. Remember, the load buys nothing extra in performance. Its only purpose is to compensate the person for selling it to you. Anyone who tells you the load buys superior performance is lying (or just too stupid to know better, and very few people in this business are stupid). The fact that some load funds do perform better than an index fund from time to time has nothing to do with the sales load; anyone who tells you otherwise is lying.

The newest wrinkle to the sales charge gimmick are "index funds" sold through full service brokerage firms. Because of all the money that has poured into index funds like Vanguard's, full service firms are trying to get in on the business. They heretofore never sold index funds because the fees were simply too low. Now they are offering index funds - with a catch. They can only be purchased (at full service firms) if they are included in a "company account" that will charge you 1 to 1.5% of the total assets in the account .

This 1 to 1.5% company fee (sometimes called a "wrap" fee) is in addition to the mutual fund's annual expense ratio, which can still be a signficant 0.5%. In other words, the full service firm will sell you a stock index fund, but will charge you 1 to 1.5% of the total in the account plus the fund's own expense charge. All this merely to to "keep the books," as it were, since the index fund requires no decision making, no research, no management. You could buy the same fund at a place like Vanguard for about 0.2% yearly fee! That's 0.2% vs. up to 2.0% at a full service brokerage firm (the fund's expenses plus the brokerage company's added charge). That's a ten fold difference! Over the years, a 10-fold difference in fees will make a huge difference in your account's performance.

So the full service firm's yearly fee for an index fund guarantees that you will significantly trail the stock market by at least that amount. It is the same as a sales load, only worse, since the fee recurs every year. The broker makes no decision for you, does not use any research (it's an index fund, after all) and you will lose mightily compared to a true no-load index fund from a company without the added fees.

Basically, the rule is this: If you rely on someone else - anyone else who is in business to sell something - to purchase anything for you, you will pay handsomely -- and guarantee a sub-par performance. If you need hand holding, and want to enrich a friendly stockbroker, use a full service firm. No matter what the stock broker or financial planner or banker tells you, the mutual fund he (or she) wants to sell will have high fees; otherwise he (or she) wouldn't try to sell it. Sadly, this is now true with no-load index funds -- if they are sold by a full service stock broker. On the other hand, if you can make a phone call on your own, or visit one of the no-load companies that have offices around the country (mainly Charles Schwab and Fidelity; Vanguard doesn't, which is one reason why its fees are less), you can easily avoid the steep 1 to 1.5% yearly fee.

By starting out with a broad-based stock index fund sold by a no-load company, you will have two things going for you: history and common sense. History shows that since 1925 the stock market has returned on average 10.2% a year. There are many down years, and flat periods, but in the long run the stock market does much better than bonds and other fixed income investments. You just have to be prepared to wait, and not need your money for a long time; you also have to be prepared to accept losses on paper. (If paper losses make you lose sleep or cause too much anxiety, then the stock market is probably not for you; stick with fixed income investments.)

Common sense shows that if you avoid the high fees charged by "full service" advice givers, you will maximize your returns. Again, realize that the recommendations of most financial advisors do less well than the market averages, that most mutual funds managed by well-paid executives under perform compared to index funds over the long haul.

It is one astounding, amazing, stupefying, incredible fact that most experts paid to manage other people's money actually do worse than an unmanaged index fund.

I say "most experts" under perform compared to the stock market indexes. Some managers do "beat the market" in any given year. When this happens it is mostly random chance, luck, and very few managers are lucky over the long term. Statistically, of course, some people will beat the market; the winners happen to be in the right stocks or stock sectors (or in down years, not in stocks) at the right time. Then they write articles or books, speak on TV shows, and give out tantalizing "investment secrets." Until you feel yourself knowledgeable and willing to speculate along with them, don't listen.

The reason is that your chances of signing on with these "smart managers" or the "outperforming funds" ahead of time are much less than 50-50. It is not for nothing that every mutual fund prospectus warns: "Past performance is no guarantee of future performance." Unless and until you really know what you're doing, and feel comfortable speculating, avoid people who tell you how smart they are with investments, especially the professionals. Chances are, they were just lucky for a while. Their luck may end when you invest with them.

Another risk is that these lucky and/or smart professionals may actually leave the fund they have long been associated with; they may go to another fund, retire from the business, or die. As a result, the person you pick to handle your money one year may not be the person who invests your money the following year. So there is always some risk in choosing a particular person, as opposed to a fund with a clear and adhered-to objective.

And be wary of slick brochures filled with charts and statistics. It is comically easy to lie in the investment industry. With over 5000 mutual funds and many fund categories, so much data are generated that, by selecting statistics carefully, one can show a large number of mutual funds are "the best" at some point in time.

When someone or some company is pushing a particular mutual fund with statistics or graphs, keep in mind that the numbers may mis-represent the truth in some fashion, either the fund's actual performance or the fees you will pay to get in or get out. So be wary of the advertising and the colored brochures. A large part of it is pure hype. Don't lose sight of the fact that investment products are like anything else - cars, washing machines, computers. You need the products, but you also need to do a little investigating before you buy anything.
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What Should You Do With Your Money? Part 3

Now what about life insurance? I doubt there is a physician alive who hasn't been approached by life insurance agents to buy policies with a built-in investment. Unless you are a true mavin on life insurance, and know as much or more than the insurance salesman, run. RUN, RUN, RUN.

When buying life insurance, pay only for the insurance you need, never anything extra as an investment unless you know exactly what you are doing. The "investment" will mainly end up in the insurance salesman's bank account, not yours. Buy only term life insurance. Lots of companies will sell it to you, and it's cheap. Always pay only for the insurance, not for anything else. If you are "sold" life insurance with a built in investment you will be at a tremendous disadvantage, compared to investing the cost difference in a broad-based index mutual fund.

In addition to the extra costs, insurance companies make it very difficult to exit any investment; they always tack on huge extra fees for quitting an investment, far greater than most mutual funds can get away with. Investing with an insurance company is a guaranteed way to weaken your investment return and to limit your options should your investment goals change down the road.

* * *

Now I recognize that many physicians have advisors and brokers and insurance agents whom they rely upon, that many physicians simply don't want to make investment decisions on their own. If so, fine. They are willing to pay for advice and the hand-holding that goes with it. (Actually, the situation is apt to be a bit more complex. I believe most physicians simply don't realize the extent to which high fees and sub-par performance erode their investment return year after year after year. Being busy practitioners, they may buy on recommendations from an advisor, and never read the prospectus or look at their investment returns critically.)

If you are not committed to a sales person for one reason or another, and are willing to investigate investing on your own, you should receive impetus from one salient fact: full service brokers and fee-based financial advisors exist only because they charge much higher fees than firms that sell true no-load mutual funds, and those higher fees do not, on average, buy higher returns. Professional advisors and brokers will siphon off at least 1-2% of all the money you invest into their pockets; that is 1-2% above and beyond the basic cost of the products they sell. And this extra 1-2% (again, above the basic costs of the investments themselves) goes on year after year after year after year, as long as you hold the investment with or through the people who sold it to you.

STOP AND THINK ABOUT THIS FACT.

Let's say you are nearing retirement and have $1,000,000 in all your retirement accounts (including 401(k), IRA, etc.). Let's say you have it invested with a full service broker in a recommended mutual fund; the broker's hidden fees, the front or back end loads, the cost to maintain your account and so on and so on come to a "modest" 1.5% a year, which is typical and "not high." That 1.5% is based on the retirement fund's asset value, of course, not what you originally put in the account. That means that every year, without fail, you have to write your broker/advisor/planner a check for $15,000. "What?" you say. "This isn't true, I don't write a check at any time!" Hah, hah. The joke's on you. You do pay the $15,000, just as if you wrote out a check for that amount. It is just deducted off the top, month after month after month, so you don't notice it. If you were sent a year-end bill for $15,000, for seemingly no work on your agent's part, you would quickly pick up the phone ask, "Hey, what's this for?" And need I remind you that you would get this bill no matter how much the account gained during the year. You would get the same bill if the account lost money. No matter what, the broker/agent/planner would still get his her $15,000; you would get nothing. That is, until you wise up and quit paying something for nothing.

This 1.5% fee is conservative, actually. Many managed accounts have fee structures that come to 2-3% of the account's total assets; on each million dollars that comes to $20,000 to $30,000 every year. And for what? For investment performance that is about 90% guaranteed to not do as well as an unmanaged mutual fund. Yes, if people had to write out a check to their brokers/financial planners for the actual fees, the industry would probably come to a grinding halt in just a few days. But because you don't actually write out a check, and the fees are deducted off the top, no one (well, almost no one) complains.

Likewise, any insurance sold with an investment attached is always going to be more costly than without the investment.

Again, all this fee-gouging is perfectly legal, but you don't need it; with just a little research you can save a lot of money. Take time to become more knowledgeable. Read the materials sent out by any of the four companies listed above. That information, plus perusal of books listed in the bibliography and the personal finance magazines, will certainly make you feel more comfortable with investing over time. More importantly, this information will also give you a handle on important aspects of total financial planning, which includes far more than simply investing, but tax and estate planning as well.

Don't rely on brokerage-sponsored seminars as a method of learning how to invest. Some seminars are good, particularly when sponsored by no-load mutual fund companies (whose product lines tend to be superior to those peddled by full-service firms, in part because of lower fees). When "free" seminars are run by full-service, commission-based companies, whose sales staff's livelihood depends on commissions, watch out! Subtly or overtly, you will be pressured to buy something.

The sales people will likely not try to sell you anything at the seminar, but rest assured that the phone number you provide will be used. You will be solicited, they will ask to meet with you, the pressure will be on. You might even feel an obligation to buy their products; after all, they gave you information at the seminar, and perhaps food and drink as well. Resist any temptation to buy until you have investigated the product, and compared it with similar products sold without sales people. Don't be afraid to say no. You don't owe them anything.

On the last page of this section is a Summary of Generic Advice for young professionals; heed it wisely.

WHAT TO DO WITH YOUR MONEY - BIBLIOGRAPHY

But before the Summary, a few books. There are literally hundreds of books on personal finance and investing (about 1000, in fact). To view a large selection, browse the personal finance section in any large bookstore. Or, to view a large selecton of titles, type in "investing" in the Amazon.com home page search engine. The books listed here, in alphabetical order by author, are especially recommended. Links are to the individual book's web page at Amazon.com. If you come across another work you found particularly helpful, please let me know.

martin@lightstream.net