These are my top picks for innovations that most benefit personal investors.
#6: Decimal pricing. Do you remember when stocks were priced in fractions? Like 23 and 3/8? This was not cool. Not only was it clunky, but it meant that bid/ask spreads were usually stuck at 1/8 of a dollar per share, or 12.5 cents per share. Luckily, today most investments are priced in decimals. Some exceptions include bonds and the interest rates on most mortgages. How archaic!
#5: Free online investment info. Information used to largely come in paper form, and cost money. Or you could pay tons of money for Quotron… really not practical.
#4: Discount online brokers. My Dad used to pay $50-$100 per stock trade — over the phone with a broker. Today some of my ETF trades are free, many of my trades average about $1, and my most expensive trades cost $8.
#3: Exchange-Traded Funds (ETFs). ETFs fix most of the problems with mutual funds such as high(er) expenses and lack of intra-day trading. ETFs also open up a wide variety of investment options including access to commodities, leveraged funds, and precious metals.
#2: Index investing. Index investing brings two huge advantages. First, incredibly low costs. Second, maximum diversification. Index investing has, and continues to revolutionize the investing playing field.
#1: 401(k)s (and IRAs). Named after a once-obscure IRS code, 401(k)s, or 401Ks, offer investors decades of tax-deferred growth opportunity. IRAs offer a similar advantage. Finally Roth IRAs offer similar tax-deferral opportunities where the tax benefit is back-loaded.
My current employer is radically revamping its 401K plan. I have noticed that companies tweak their 401K plans about annually, and dramatically change them every 5-7 years. This time it’s big. One of the choices allows for both ETF and mutual funds purchases. The EFT option has me excited.
So far in my career I have worked for three Fortune 500 technology companies. Long story short, I have two 401Ks and a couple IRAs. Between them I have about 8% invested in ETFs and the rest in mutual funds. After the 401K redux, I’ll likely have about 30/70 ETF to mutual fund mix. I’ll keep my asset allocation largely the same, but I’ll work out a bit of math here and there to do so. Some mutual funds stay, some funds go, some switch to higher expense-ratio versions, and some are frozen from new money after a certain date. Over time my retirement assets may approach a 50/50 ETF-to-mutual-fund ratio.
A similar 401K change may be coming your way soon. The booming ETF trend is continuing unabated with over $1 trillion dollars in assets under management in 2010; some predict that doubling by 2015. Why? 1) Institutional investors like ETFs, 2) retail investors like ETFs, 3) exchanges like ETFs, 4) brokerages like ETFs. Generally for the same reason: lower costs.
The upside of more options is access to better options and greater potential for diversification. The downside is trading fees for ETFs… $7.95 under the new 401K paradigm. Wise, infrequent purchases can mitigate trading costs. This requires a bit of financial planning, but is not really a big deal for serious investors. And there are ~25 ETFs that trade for free. One can invest in them every paycheck (like buying EEM for free) then periodically, every 6 months or one year, bite the bullet to sell EEM (for free) and buy the better ETF VEU. Brilliant — low fees and true dollar-cost averaging. [Not my idea, but a good one.]
In summary, fear not the change to more ETF-centric investing. Your particular company may pull a fast one on you… but in many cases not. Read ALL the fine print before determining the case. I’m glad I did, and I sense greater investing opportunity.
In my blog post Financial Toolkit: Indexing the World I discussed 5 ETF building blocks for diversified investment portfolio construction. In this financial blog post I’m going discuss a hypothetical investing situation:
Deborah is a 40-year-old woman with a $100,000 401K who just changed jobs. She transferred her 401K to an IRA, and has $100,000 now sitting in cash. Deborah’s new job pays $60K/year and she plans to contribute $10K/year to her new 401K. How might she invest her IRA funds?
As a proponent of diversified index investing, I suggest the following category questions… What percent 1) Domestic vs. foreign? 2) Stock versus bond?
I put forward the suggestion that Deborah’s choices in regard to these two questions will predict 80-90% of the performance of her chosen portfolio. (Don’t believe it, then read this asset allocation paper sometime when you are afflicted with insomnia.)
Let’s say Deborah decides that a 80/20 domestic versus foreign allocation, and 60/40 stock versus bond allocation are right for her. Working out the math that’s $80,000 for US investments and $20,000 for foreign investments. Applying the second stock vs bond ratio to each yields the following: $64,000 for US equities, $16,000 for US bonds, $12,000 for foreign equities, and $8,000 for foreign bonds.
The US part is pretty easy to achieve. Plunk $64,000 in a low-cost, broad-market ETF (or mutual fund) like SCHB, and $16,000 into a total (aka aggregate) bond ETF like BND. The foreign stock component is easy too; but $12,000 into VXUS. Only the foreign bonds require two ETFs because there are no foreign total bond ETFs (to my knowledge); thus I suggest $4000 in a foreign government-bond ETF like IGOV and $4000 in a foreign corporate-bond ETF like IBND.
There you have it. A simple example of asset allocation.
My personal opinion is that an initial asset allocation process can be very simple and effective. Notice that I was able to avoid several secondary asset allocation measures such:
- Value vs Growth (stocks)
- Large-cap vs Small-cap (stocks)
- Sector allocation (stocks)
- Developed vs Emerging markets (stocks and bonds)
- Short-term vs Long-term (bonds)
- Average Maturity or Duration (bonds)
- Government vs Corporate (bonds)
- Investment-grade vs non-investment grade (bonds)
- Average credit rating (bonds)
All of these “secondary asset allocation factors” can be side-stepped by purchasing “total” stock and bond funds as outlined above. Such total (or aggregate) ETFs seek to own a slice of the total, investable, market-cap-weighted investing universe. Essentially, a total US stock fund seeks to own a piece of the whole US stock market. Similarly with a total US bond fund, etc.
In summary, if you have a diversified, low-cost investment portfolio, the two biggest ratios to know are domestic/foreign and stock/bond. [If you don't have a diversified, low-cost investment portfolio you might want to think about changing your strategy and your financial adviser!]
I recall something I read several years ago. I’ll paraphrase…
If you’re going to pay for investment advice, start with good tax advice.
I was listening to an estate planning program on PBS while working in the garage. The speaker charmed his audience with anecdotes and analogies. His advice was decent enough:
- Pay attention to the beneficiary forms for your investments. Especially for 401K and IRA accounts. These trump wills and have important tax advantages upon death.
- Spouses should consider bequeathing some assets to non-spouse heirs to benefit from the $2M estate tax exclusion. (Note: I’ve not fact-checked this amount).
- Consider life insurance and annuities. Life insurance for tax-free inheritance, annuities for the possibility of living much longer than you expect (say to 100).
- If you don’t plan, guess who is likely to take most of the estate…. the government and the nursing home.
First, these are valid points. Second, this type of planning ranks right up with dentist visits, cleaning the bathtub, and proctology exams on the fun scale.
Nonetheless I’ve seen first-hand the impact of helpful decisions (smart IRA beneficiary choices) and unhelpful ones (no will, hard-to-find financial information, social security snafus, nursing home challenges).
If you wish to leave the most to your grandchildren, heirs, charities, then estate planning is a must. Boring, yes. Important, yes!
Additionally, tax planning is helpful not just for the deceased, but for the your day-to-day life. I’ll touch on that in my next blog.
Looks like some senators are talking about radically changing the 401(k), eliminating tax breaks, and possibly leading to the ultimate demise of the 401(k). Spooky stuff, and hard to find much info about at this time. Here’s the best info I’ve located so far.
Feel free to comment with additional info and links and I’ll keep following these disturbing developments.