Thursday, June 16, 2016

"John Oliver Freaked Me Out!": Simple Rules for Keeping Retirement Investing Fees to a Minimum

In case you missed it, John Oliver recently had a piece on retirement funds and fees on Last Week Tonight! It's a great overview of the pitfalls that can completely screw over ordinary folks just trying their best to save for retirement:

Self-serving advice from financial advisers: The financial advice industry has shockingly little oversight; you really don't need any kind of certification to call yourself a financial adviser or analyst. Financial advisers often make their money from commissions on the financial instruments they sell you, which is a conflict of interest at best; at worst, they don't have your interest at heart in the slightest.

High fees on retirement investments: "Compound interest goes both ways," Oliver points out, noting that just as a small initial investment can grow big enough to retire on over time, so can seemingly tiny fees eat away at your retirement account to an extreme degree.

So. How do you keep your money as far as possible from fees and unnecessary, bad advice that you have to pay for, while still growing your retirement fund in the stock market?

It doesn't have to be hard.

Making financial decisions that affect your future can be daunting, and there's plenty of confusing info out there. I think they make retirement fund documentation intentionally confusing. That's why so many people turn to "experts" to make their decisions for them. They don't trust themselves. The trouble is that these experts often use the trust placed in them to their own advantage. If you're afraid to DIY, think of it this way. You may be a doofus with no training, but at least you're not a doofus with no training actively trying to swindle you.

DIY-ing is easier than it looks. It actually turns out to be so easy that I sometimes think I must have done it wrong. (And, full disclosure, maybe I did.) According to all the trustworthy sources I've read, there are really just a few key pieces of information you need to find out about a fund you are considering investing in. When I'm looking at a prospectus from a retirement broker, I throw out all the fancy jargon, graphics, and statistics, and ask myself just two questions: What's the index? What's the expense ratio?

What's the index?

First, I make sure that the fund I'm considering investing in is an index fund. Then, I try to make sure I'm investing as broad and diversified as possible (which might mean using more than one index fund).

Index funds are funds managed by a simple algorithm, or rule. (By the way, I'm using the term "fund" to refer to a mutual fund, or a bundled up group of stocks. Why bundle stocks? For diversification--so you don't put all your eggs in one basket.) The "index" is the rule that is used to decide which stocks to include. For example, the S&P 500 index is a list of 500 large American companies that are publicly traded on the New York Stock Exchange. You can also find index funds that index, say, every single publicly traded company in the country, or in the world.

Index funds don't seem glamorous because they can't hope to "beat the market." An index of the entire market can, by definition, only match the market. But matching the market is way better than most actively managed funds do. Actively managed funds can hit it big from time to time, but their wins are random and unpredictable, like a gambler's. Over time, simple algorithms consistently beat human being making illogical, emotional choices.

I keep it simple with just three funds: one index fund for the total U.S. market, one index fund for the total world (except U.S.) market, and one index fund for bonds.

What's the expense ratio?

Index funds typically beat out actively managed funds in the long term in sheer returns, and, crucially, they are also typically lower-fee. They can be; there's no human at the helm. You'll always pay some sort of fee, just for the administrative work of running the fund and keeping track of everything, and some index funds are more costly to run than others. (International index funds, for example, are often more expensive, presumably because of things like exchange rates and the cost of doing business overseas.) But there's no hotshot fund manager to pay, no group of top analysts throwing darts at stock market listings and driving home in their Jags.

Still, some companies will go ahead and charge all kinds of weird random wrapper fees and middleman fees, even for an index fund. So getting an index fund isn't a magic bullet. You still have to look at the expense ratio of the fund.

The expense ratio is always published somewhere in the documentation, and it's the annual fee the administrator (invisibly) takes out of your invested funds each year to pay for their own costs. It will be a percentage. I consider 1% to be pretty high. You definitely don't want over 1%. A fraction of a percent is ideal.

I've never found any company that offers lower expense ratios than Vanguard. John Oliver briefly mentioned Vanguard as a positive example of a company that offers low-cost, no-frills investment choices; they're the company I use, and I definitely recommend them. I am not being paid by Vanguard to advertise or anything like that--they don't need to pay for advertising, personal finance geeks like me offer them plenty of free advertising.

Information I ignore

Prospectuses are quick to tell you how the fund did last year (or some other, carefully chosen period of time). This is deceptive. Obviously all the funds they're trying to push did okay last year--the ones that didn't have been disbanded. Unlike in school, past performance doesn't indicate future returns. Actively managed funds aren't like students that learn and grow over time. They're more like gamblers that sometimes hit it big, and sometimes wipe out.

I also ignore any kind of chart or graph which purports to predict the future. You can't predict the stock market's future, and anyway, I'd hope my my money will grow in any investment fund. What I want to know is not that it will grow, but how much it will grow compared to my other options. It's going to be really hard to find any kind of investment that beats out a low-fee index fund, taking into account the difference in the amount invested after fees are taken out, especially over a long period of time.

What if I can't choose an investment firm or specific funds because I am locked into certain choices my company made for me in my 401(k)?

This is a huge problem that I have had before and will almost certainly have again (once I have a 401(k) again!) Once I had Vanguard, once, but it was my first real job and I didn't know enough to appreciate it!

It sucks, because you don't have much power in this situation. Generally, investing in a 401(k) is better than not, especially if your company offers an employer match. In that case, you have to do your best with the options you have. Sometimes employees can lobby accounting or HR to change investment banks--they may have made shitty choices out of pure ignorance--but this typically works best at a smaller firm.


When I am choosing funds, I ask just two questions:

What's the index? The fund must be an index fund. When thinking about my total portfolio, I want to make sure it includes U.S. and foreign total stock market funds, and some bonds (more as I age). For example, at age 30, my portfolio breaks down roughly like this:

50% Total U.S. Market Index Fund
40% Total International (non-U.S.) Markets Index Fund
10% Total Bond Index Fund

What's the expense ratio? All fees on each fund should add up to less than 1%, and the lower the better. Vanguard can often do much, much better. For example, here are the current expense ratios for the Vanguard funds that correspond to the above:

VTSMX Vanguard Total Stock Market Index (U.S. only): 0.16%
VGTSX Vanguard Total International Stock Market Index: 0.19%
VBMFX Vanguard Total Bond Market Index: 0.16%

No comments:

Post a Comment