I am going through a refinance right now for first and second on our house. I just ran some numbers and I'd like someone to "check my math". I can send an extra $1250 to mortgage each year (payments of $625 in Nov and Dec) or can invest the same in a taxable account the same two months.

(2nd) Mortgage:

55k, 7.410% apr. 30 yr fixed payment of $382.
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Invest (do not pay off early):

Mortgage payment of $382 for 30 years.
Costs $82,348 in interest payments over 30 years
Costs $1250*28 (first 2 years do not invest the money)= $35,000
"result" is $154,000 in investments after 30 years (plus paid off 2nd mortgage). Assuming 9% rate of return.

Pay down (do not invest until 2nd is paid off):

$625 payment in Nov and Dec each year (except first two years).
Costs $41,208 in interest
Costs $1250*16 yrs of paying down=$20,000
(2nd mortgage paid off in 16 years according to my calculations).
If I invest 12*381+$1250 each year from 16-30 ($5834/year) with same 9% rate of return
"result" is $187,000.

Am I missing something? I was expecting to see the "late investment" not exceed the "invest early".
When I went through same numbers for first, it made sense to invest (much lower APR), but with second I am seeing a different trend.

We are opening a Roth IRA for my wife in may, and we (I) had to go through selecting a mutual fund for her to start with.

I look at our Roth's as "One Entity". My Roth has 30k+ in it, invested in:

PRFDX (~6k) T Rowe Equity Income
PRWCX (~5k) T Rowe Capital Appreciation
RPMGX (~5k) T Rowe Mid Cap Growth
PRNHX (~5k) T Rowe New Horizons
PRIDX (~2k) T Rowe International Discovery
PREMX (~3k) T Rowe Emerging Markets Bond

This is about 45% large cap, 20% mid cap, 10% small cap, 8% International small cap and 17% international bond.

It was obvious to me the hole was "international large cap".

I then looked around for foreign large caps. T Rowe International Growth and Income made the short list. Glanced at two other T Rowe funds (Overseas and Global Stock), along with a few other good International funds (Dodge and Cox).

Dodge and Cox required a $1000 initial deposit with restricted automatic investing, so that "lost" the race with T Rowe. We are sending $300 to open the account and contributing $300/mo to open with Int'l GrIn.

TRIGX was chosen because it follows a good investment philosophy:

"Investment Objective
The fund's objective is long-term growth of capital and reasonable income through investments primarily in common stocks of mature, dividend-paying, non-U.S. companies.

Strategy
Invests in large-capitalization, dividend-paying companies outside the U.S. The stock selection reflects a value orientation. "

Has solid returns over mid term (month end/ quarter end):
1 Year 24.12% 29.92%
3 Years 21.55% 22.79%
5 Years 18.78% 17.93%
10 Years N/A N/A
Since Inception* 10.17% 10.24%
Inception Date December 21, 1998

And reasonable expenses
Expense Ratio As of 10-31-2006 0.91%

I am always interested when people post to discussion groups, asking about "which mutual fund to pick". Helps remind me to think about WHY I picked the funds I did.

Mutual funds in some ways are like shoes. To some people, they only need a few mutual funds and they are happy.

To other people, having many mutual funds is important for one reason or another. And why someone chooses a mutual fund will also change from person to person.

If you need to know, I own more mutual funds than footwear- I THINK. But my wife has more shoes for sure.

The important thing to remember is a mutual fund selection can last a lifetime. I have to buy new footwear once every 3-4 years.

Step 1- know your "asset" allocation and risk tolerance. This means know if you want large caps, small caps, international, bonds, money markets- and/or whatever you want to invest in.

If you don't want to do step 1, then buy a single mutual fund (one size fits all)... either a total stock market index fund or a target retirement fund.

Step 2- plug and play various funds into the asset allocation. Most research suggests return has more to do with the allocation than any specific fund inside the allocation. Meaning you could pikc from any of the 6-7 mutual funds a fund family has for Large Caps, and choose another fund for bonds. The mix of 80%-20% or 50%-50% between these two funds will have more impact on returns than which fund you did or did not pick.

Step 3- if you want to interrogate a fund, I suggest looking at the following criteria:

a) will this fund be held in a taxable or tax advantaged account (IRA's, 529's and 401ks are tax advantaged).
b) what are the top HOLDINGS of the fund.
c) what percent of fund is in top 10 holdings (if 25%, this fund in concentrated, if 10-15%, the fund is diversified). This tells how much risk you are taking with fund compared to similar funds.
d)what is 10 yr and 5 yr history?
e)what are expenses (.75% or less for managed, .15% or less for an index fund).
f) how does fund rank relative to comperable funds?

Came home a few days ago and there were 2 credit card bills waiting.

One was from a business trip my wife took. Bill was $1200 and needless to say her expense check was slightly more than half the bill.

One was from a soccer purchase I did last October and I gave my wife the cash to pay the bill off.

Because she does the checking account month to month I did not see these bills until this week. OUCH.

Add to that our bank was charging us $5 for each of my 7 mutual fund purchases in my IRA, plus a $15 excessive transaction fee which I just caught.

I went ballistic on Tuesday. The wife was not happy at how upset I got over what she called "little" things.

Since then, called the bank and they waived all the fees.

Tapping into emergency funds to pay off the credit cards. I am more relaxed now, but I didn't sleep too well until this was taken care of.

Next step is use the "calculators" on whichever fund company you choose to determine an allocation. If you want to do a quick one by hand, I created my own calculator below.

The allocation will be % stocks, % bonds, % cash. It will further break this down to % large cap, % small cap, % foreign, etc...

The allocation is "created" based on you honestly answering questions.

Simple questions like:

How long do you have to retire?
If you invested in soemthing and it lost 10% in one year, what would you do? Lost 10% in one day, what would you do?
If you invested in something and it lost 25% in one year, what would you do? Lost 25% in a day what would you do?

The reverse is also useful... 10% yearly gain... 10% daily gain... 25% yearly gain... 25% daily gain.
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Here is a simple way to allocate (if you want it)

Start with a

score1 of 0
score2 of 0

score1 is "minimum" % stocks you want.
score2 is "minimum" % bonds you want.


What is your age?
What age do you "expect" to retire? If you do not know, use 68.

What is difference of two above? This is "time".

For each decade in "time", add 20 to your score1. Round up for score one (so 11 rounds up to 2 decades).

If "time" is less than 20, then subtract time from 20. This is score2. Do not round for score 2.

The next step is what "return" do you want.

decide if you want more or less than an 8% return.
for every 2"points" you want above 8% return, add 20 to score 1.
for every 1 point at or below 8%, add 20% to score2


4 examples of calculator:

Ex a) 30 yrs to retirement, want a 10% return.

3 decades*20%=60%
10% return adds another 20%

This situation requires a minimum of 80% equities. How you allocate the other 20% is up to you.

Ex b) 30 yrs to retirement, want a 12% return.

3 decades*20%=60%
12% return adds 40% (4 points above 8% return, 4/2=2*20%=40%)

This situation requires 100% stocks to come close to a 12% return each year. This can be done for short amounts of time, I would not expect 12% returns to sustain over more than a 5-10 year period.

Ex c) 15 yrs to retirement, want an 7% return.

score1: 2 decades*20%=40% minimum equity
score2: time is 20-15=5%, plus 8% return adds 40% more to this (20% for 8% and 20% more for 7%)

So mimumum allocation for this example is 40% equity and 45% bonds. The last 15% can be moved to equities or bonds as you see fit.

Ex d) 15 yrs to retirement, want a 11% return.

score1: 2 decades=40% equity
10% return adds another 20% (within 2 points of 8%)
The additional 1% from 10 to 11 needs another 20% equity.

score1 total is 80% equity.

score2: 20-15=5%. 5% is the minimum amount of bonds.

The conclusions:

The longer you have, the more equities you should hold.
The shorter time you have, the more bonds you should hold. Anything less than 20 years to retirement should have a minimal amount of bonds (with this position growing larger closer to retirement).

If you want more than a 10% return, GOOD LUCK. 8% return is quite doable. 11% is pushing it. Using bonds for anything 8% or less is to increase probability of getting the desired return without adding on too much risk.

Long term return of equities is between 9-10%. There have been 10 year periods where equities have only returned 7%.

Long term returns of bonds is between 4-8%. There are periods where bonds do well for extended periods. It is possible to "time" these periods... entry point will be important (for example right now is a bad period to invest heavily in long term bonds). Low rates, inverted yield curve.

The next step will be dividing equities up to large cap, small cap, international etc...

If you know you want to save for retirement, and know how much you want to set aside, and think you want an 8,9, or 10% return starting now until the daay you retire, you have done 75% of the work.

You have researched "saving", you know you want to invest. The devil is always in the details.

The "last step", IMO, is choosing an asset allocation. The good news is this is flexible. There is not one right answer.

The bad news is this step is quite flexible. "Paralysis by analysis" may result.

Do a little research, make a decision, and use the flexibility to adjust as you learn.

Step 1) Choose a mutual fund company.

suggestions:
a) T Rowe Price
b) Vanguard
c) Fidelity
d) Dodge and Cox

go to the website of each company above and look around. This might be the easiest way to decide.

a) T Rowe Price is best known for their low cost managed funds. T Rowe has been around a long time, and has some mutual funds which are more than 30 years old!

All T Rowe funds are no load. You can open an account in any fund for $0 IF you commit to using the automatic asset builder service (which contributes $50/month minimum).

b) Vanguard is best know an an "index" house. Meaning their "better" funds generally track an index of some type. This yields average performance at a low cost.

The fund "minimums" at Vanguard are much higher than T Rowe. But research this on your own, I only know this based on what I read on discussion groups.

c) Fidelity has the largest offerings of any mutual fund company in the world. Some of it's index funds are cheaper than Vanguards. Some of it's managed funds are more expensive than T Rowe. But if you want a fund which invests in XYZ, more than likley Fidelity has a good choice of how to invest in XYZ.

I do not know fund minimums for Fidelity.

d) Dodge and Cox. D&C is a much smaller version of T Rowe Price, IMO. Managed Value funds which perform quite well.

Fund minimums for an IRA at Dodge and Cox are $1000.

Choosing a fund company has some inertia to it. You can switch houses "anytime", but you might have short term trading fees and more paperwork than if you made a decision based on the fund house.

After creating a "retirement plan", which is built on achieving a certain income level from a certain savings level (see previous blogs for this), a next logical step is measuring if you are "on track".

One technique I use frequently and quicly is the rule of 72. Take the interest rate on an investment. Divide this into 72. The result is the number of years it will take that investment to double.

4 examples
12% interest return. 72/12=6. 12% return takes 6 years to double.
10% return. 72/10=7.2. 10% return takes 7.2 years to double.
9% return. 72/9=8. 9% return takes 8 years to double.
6% return. 72/6=12. 6% return takes 12 years to double.

Backwards check. $100 invested
yr 1 $110
yr 2 $121
yr 3 $133
yr 4 $146
yr 5 $160
yr 6 $176
yr 7 $193
.2 years=$200 (money doubled)


So a way to check retirement. Take the amount needed to retire. If you have not calculated this, use "Current Income/.04" as calculation of what you need. See previous blogs for explanation on this.

My example: Assume you need $1,000,000 ($1 M) saved.

Half this ($500,000) do you have this saved yet?

If not, half it again ($250,000). Do you have this saved yet?

If not half it again ($125,000). Do you have this saved yet?

If not, half it again ($62,500). Do you have this saved yet?

If not half it again ($31,250). Do you have this saved yet?

If not, half it again ($16,625). Do you have this saved yet?

When you do the above, count the number of "halfs" you did. Each time you divided by half, add 8 years to your current age.

This will suggest when you could retire with a 9% return on your investments.

As you save more, especially at younger ages, this equation will look more favorable on your situation.

If you have a retirement plan, and want to check progress, there are many ways to do it.

I am not advocating this as the best way, only way or even a reasonable way... this is something to think about.

When you withdraw money during retirement, there are several forces working "against" you.

1) You are spending money you have saved
2) The markets returns are not predictable
3) inflation can do damage over time even if you account for #1 and #2. Inflation is the "increased cost of goods and serviced". Milk which was once $.99 a gallon now sells for $2.39 a gallon. That's inflation.
4) at some point a person loses their earning power. A person's ability to work and earn more money might be single biggest factor in retiring. If savings tank, and you cannot earn more money, what will you do?

I will use 3 examples of people using different withdraw rates. I will assume all people live 30 years after retiring.

Example A, person has saved $500,000 and withdraws 3% of assets in year 1.

3% of 500k=$15,000.
every year after, this person increases withdraws 3% (to account for inflation).

Assuming a 6% gain each year in retirement, this person would NEVER run out of money. The 3% withdraw rate is quite conservative and each year this person has more money than they had the previous year, except for first two years.

Example B. Person saved $750,000 and withdraws 4.5% of assets. 4.5% of 750k =$33,750. Every year this person increases withdraws 3% (to account for inflation).

Assuming a 6% gain each year. After 30 years, this person has less than half of the $750,000 left. The point being between a withdraw rate of 4.5% and inflation of 3%, the compounding effect will significantly reduce assets.

Example C. Person saved $1 M and withdraws 5% of assets. 5% of $1 M is $50,000. Every year this person increases withdraws 3% to account for inflation.

Assuming a 6% gain each year. In 29 years, this person ran out of money. They spent their entire savings in 29 years.

The risks I am trying to illustrate is what percent can you take out. 4% is usually used as the "planning figure". If you are 30, 20 or even 10 years away, use the 4% number as the target.

There are several things you can do to adjust for withdraws and prevent running out of money in a 30 or 40 year retirement:

1) Only take out the "3% inflation" factor in years market went up (in a down market, keep spending in line with previous year (when market goes down).
2)Purchase an annuity to replace a portion of your "fixed income". The annuity guarantees money for life.
3) Delay SS payments to age 70, to maximaze that benefit, knowing that SS will "never" go away.
4) reduce spending


There are risks with "drawing down" principle, here are risks, not mentioned yet

1) If market drops within first 2-3 years of retirement, this is single biggest risk not mentioned (if market drops 20% in any of above cases, only to "come back in years 5,6,7,8 of retirement, all of situations above would have drastically worse results.

2)High inflation would destroy all of these simulations. I listed example for mild planning, not trying to illustrate what would actually or never happen.

3) Investing to get a 6% return during retirement involves being around 40-60% invested in equities (probably). Getting a 6% return from a conservative investing tool (bonds, money markets, CDs) is not an easy thing to do, and these conservative instruments will lose to inflation most of the time (3% yield from a CD with 4% inflation means you "lost" 1% of money).

One additional point, there is a technique called "Monte Carlo Analysis" which will do most of this for you. Runs through random market patterns, inflation patterns and such to see if "amount", "withdraw rate" and "years to live" last your projected lifetime.

How to create a retirement plan.

Primary question will be "what is your picture of retirement".

Could be "stop living at work and start working at living".
Could be stop doing what pays the bills and start doing what stimulates the brain
Could be to travel the world

Could be combinations of above or things not mentioned.

For this discussion, I will assume you will spend a similar amount of money in retirement as you do while working.

I will assume a person makes $55,000 for this discussion

Objective #1. Determine how much you need.

ex A: If you want to retire early, take your current income and divide by .03. $55,000/.03=$1.84 M. Once you reach $1.84 M in this case, you can retire early.

ex B: If you want to retire in your 60's (closer to standard retirement age), take current income and divide by .04. 55,000/.04=$1.375 M (about 500k less than above).

ex C: If you choose to retire late (past age 70), take current income and divide by .05. $55,000/.05=$1.1 M. 700k less than early retirement.

The point is you can save yourself money by working later in life.

The .03, .04 and .05 is "withdraw rate", which will be discussed later. This % is defined as the % of nest egg you withdraw the first year of retirement. The lower the %, the more conservative the retirement plan.

Objective 2, learn to adjust "what you need". If you can "live on less" in retirement, you can make more assumptions. Live on less because you have a paid off mortgage, you moved to a condo for lower bills, you retired early, but chose a second job to pass time away... these factors allow you to reduce the 55k (used in example above). A traditional assumption is a person can live on 80% of their income in retirement.

so the calculations above:

55000*80%/.03=$1.47M (saved 400k)
55000*80%/.04=$1.1 M (saved 200k)
55000*80%/.05= $880,000 (saved 300k)

Issue 2- saving enough for the "retirement plan".

This depends on current age, retirement age, % of income you save, and how aggressive you invest.

3 examples (all with people either making 55k, or thinking they will be making 55k the year they retire). All examples assume a 10% annual return.

ex 1: A High School student (age 16) making 10k. saves 5% of his earned income in a Roth IRA. Assume this person skips college and works the day they graduate.

5% of 10k=$500.

At age 72, this person has the 1.1 M needed to replace 100% of a 55k income. They saved only $28,500, and have a total savings of $1.1 M

At age 69, the person in this example has enough to replace 80% of 55k.

If you add Social security into this situation, this person could retire in their 60's with their savings replacing 50-60% of income, and SS supplementing the rest.

ex 2: A college graduate which does not start saving until age 25. Make 40k coming out of college. Saves 10% of income (10% of 40k=$4000).

Somewhere between aged 64/65 this person will have enough saved for the early retirement option ($1.8 M).

This person contributed $164,000 to their retirement fund.

ex 3: a couple which did not start saving until their 40's. They make 68k, but have decided they can retire spending only 55k per year (55k is 80% of 68k). They save 20% for retirement once debts are paid off at age 45. 20% of 68k=$13750/year.

Between aged 68 and 69, this family would have saved their goal. ($1.3 M).

They saved $343,000 to reach this goal.

ex 1: set aside 28500 to have $1.1 M
ex 2 set aside $164,000 to have $1.8 M
ex 3 set aside $343,000 to have $1.3 M

ex 1 return (1.1M/28,500)=38X return
ex 2 return (1.8M/164000)=10X return
ex 3 return (1.3M/343000)=3X return

The time one's money was put to work is the biggest factor to achieving goals (this is "the power of compounding"). Time can be overcome with a higher savings rate, or resetting goals "lower" for retirement.

There are 2-3 threads going with pay down mortgage or investing... and when it "makes sense" to pay down mortgage.

All calculations were done with a spreadsheet downloaded from microsoft. I modified sheet, some, but all this could be done with standard sheet and somewhere to write down if then answers.

Issue #1, being debt free has a psychological value, and this post is not meant to demean, replace, or suggest what that value is.

Issue #2, paying down a mortgage is "risk free" rate of return. Whatever loan rate is (5%, 5.75%, 6%) is the lowest risk investment you have, assuming savings accounts, T Bills and other fixed income securities yield less than the interest rate on mortgage.

The numbers

100k mortgage, 6% interest rate. Payment is $599.55. First month is $99.55 principal and $500 interest. Total 30 yr interest payment is $115,838.19. Loan repyament period is 360 months (30 yr fixed).

Situation 1. pay extra $50 each month. Overall interest reduced to $91,268 (saved about 14k), repayment period shrunk to 295 months (saved 65 months*599.55=38970.75 of loan payments.

Total extra payment was 295*50=$14750.

situation cost $14750 over 295 months to save $63,540 over 65 months.

situation 2. Pay $100 extra per month for first 10 years. Overall interest reduced to $82,974.02 (saved $32864). Repayment period shrunk to 286 months (9 months shorter than above). Saved 74 months*599.55=$44,366.70 in payments.

Total extra payment was 120*100=$12,000 (2750 less than situation above).

situation cost $12000 over 120 months to save $77230 over 74 months.

Meaning the extra payments were fewer, cost you less out of pocket, and saved you more money. This is because these payments were applied eariler in loan period. Early repayments count more than later repayments.

situation 3. Person pays $200/month starting in year 20. overall interest paid is $109,846 (27k more than previous situation, 6k less than standard 30 yr fixed). repayment period shrunk to 323 months. This is nearly 40 months more than previous situation.

The extra payment in situation 3 was $16,800 (the highest of the 3 situations). Because the extra was paid at the end of the loan, it did not "compound" in reverse as much as lower payments applied earlier.

Does anyone out there have an HSA with a high deductable health plan?

Second question- does it work well?

Third question- do you have kids and how old?

The best retirement "plans", from a financial perspective, are the ones with flexibility. Flexibility comes from account types (and the rules/ advantages of those accounts).

Each account type could be considered "a leg to stand on". The more legs you have, the better.

Every US citizen has the basic leg of social security. The worst case is your retirement savings has only one leg. I consider Social Security to be a "bond like conservative investment". This allows me to invest other areas more aggressively (and take on risk) because I know I have this one leg to fall back on.

The next most common leg is a 401k. The "rules" of the 401k suggest that the withdraws will be taxable. For my wife and I, this means this leg is taxed at 25% or 28% federal tax bracket. Ohio will take some more, we get whats left.

If someone has a pension, that is another leg. I do not have a pension, if I did, I would look at it similar to Social security. It's a conservative tool, so other investments should be more aggressive.

Roth IRAs are another leg to stand on. The rules/advantages of a Roth IRA suggest that qualified withdraws are tax free (YEAH!). Meaning whatever is taken out will not get taxed at all. The more a person can rely on the Roth, IMO, the better. The primary issue here is the only way to get a Roth is to save the money yourself. The above mentioned legs (SS, pension, 401k) get contributions from companies and the government... a Roth needs to funded by the individual which wants to use it.

Annuities are another leg. I see value in supplementing social security with more GUARANTEED income. An annuity is something you "buy" from a life insurance salesman. It is best, IMO, if a person buys an immediate annuity when they retire (and not invest in a variable annuity for 30+ years with high costs). Variable annuities are probably one of worst investments around (for retirement planning), but immediate annuities clearly have a place if someone wants to reduce the risk of running out of assets during their lifetime (the advantage of the right annuity contract would be an income stream for life, none of the other legs, except social security, can offer this feature).

Taxable accounts. If a Roth IRA is maxed ($4000/year for 2007; $5000 a year starting in 2008), a person could invest additional money in a taxable account. Gains in this account would be taxed at 10%/15% long term capital gains rates. This is a lower tax rate than the 401k plan.

The goal is to create as many legs as possible.

Other legs not mentioned including being debt free, owning house (not having a mortgage) and being in good health.

The priority of each leg depends on tax bracket now, tax bracket in retirement, how long you expect to live, and how much money you want to pass onto your kids.

1) Avoid account fees.

T Rowe Price charges $10/year for IRAs under 5k. Each mutual fund is a different "account", so if a person owns 6 fund under 5k, they will be charged $60.

If you ASK, T Rowe will tell you that the $10 fee is waived if you have 10k total in all IRAs.

2) Avoid frequent transactions. If using brokerages (to buy stocks, ETFs or mutual funds from other companies), there is a transaction charge each time you buy or sell. Solution- accumulate money in a savings account all year, then have only 1 purchase transaction per year.

If you get clever, you could save money over 2 years time, and in any of the first 4 months (before April 15), you could buy 8k worth of investment for same transaction cost... making sure 4k gets allocated to prior year and 4k get allocated to current year.

3) Avoid transaction fees on mutual funds. Sme funds charge a "short term" redemption fee. If you rebalance, and need to sell a fund (in a 401k or IRA), make sure you have held the fund long enough to avoid these charges.

If buying mutual funds through a broker, there are frequently 12b-1 fees, sales loads or other charges. This is money out of your pocket. Find no load mutual funds (all T Rowe Price funds are no load).

4) Avoid buying expensive investment products such as variable annuities. If you need an annuity, it is best to invest outside the annuity (in a mutual fund), then sell the mutual fund and buy an immediate annuity. The immediate annuity will have charges, but it's a one time thing when you create the annuity contract, not ongoing fees during the investment phase which drags returns.

If "volatility of returns" is a measure of risk, I can illustrate some examples of why less volatile investments can be quite beneficial.

Assuming a nearly 100% equity portfolio in both cases.

Index

2006 15.64
2005 4.77
2004 10.74
2003 28.50
2002 -22.15
2001 -12.02
2000 -9.06
1999 21.07
1998 28.62
1997 33.19


consider the negative returns (-22%, -12% and -9%) in 3 consecutive years.

$1000 would have shrunk to $900 in 2000. The $900 would have shrunk to $800 the next year. Then shrunk to $620 in 2002.

That is nearly a 40% loss over 3 years. Quite volatile (relative to highs of 28-33% 3 times)

Choosing a fund which is 100% stock, but managed (so as to prevent steep losses).

returns of

2006 19.14
2005 4.26
2004 15.05
2003 25.78
2002 -13.04
2001 1.64
2000 13.12
1999 3.82
1998 9.23
1997 28.82

$1000 in 2000 would have increased to $1130 in 2000, to $1140 in 2001, then dropped to $993 in 2002. By not having the negatives, it can maintain princpal balance and still be 100% stock.

The reason for the difference in returns is the managed fund would NOT hold stocks which did not have good prospects on the way down, as well as the managed fund can buy stocks because their valuations look "cheap" based on recent stock events.

It does cost more money to not lose as much... keep in mind all returns listed (by law) are net of expenses... so the expenses are factored into the above returns.

My point is that indexing has downside risk. it is possible to invest in a portion of the index, with less risk and higher expense, and approach the returns of the index.

Over the 10 years listed above the top fund (VFINX) returned 7.55% with a high year of 33% in 1997 and low of -22% in 2002.

Over the 10 years listed, the second fund (PRFDX) returned 9.61% with a high year of 28% in 1997 and low year of -13% in 2002.

Other funds with similar styles to PRFDX (conservative equity investing, but nearly 100% equity):

DODGX (Dodge and Cox stock)
FEQTX (Fidelity Equity Income)

Examples like these are another example of being 100% stock and having less risk than someone which might be 80-20.

Downward risk/ defensive investing is a long time strategy which works for many people.

Risk is defined as various things.

To some it's loss of principal.
To some it's "change" in principal (volatility)
to some it's variance of returns
to some it's variance of expected return.
to some it's the cost of investing (cost of mutual funds).
to some the time something is invested is a risk (time)

inflation is a risk as well meaning if someone avoided the risks above, their risk just changed to inflation eating away their returns from bonds/cash.

In the lengthy discussions on indexing yesterday, many people cited cost as a risk (meaning my funds were more expensive and posed a risk to making money).

My view of risk is volatility of returns (especially negative returns).

If someone takes on more risk, they should be rewarded with more gains (given enough time).

Indexing by definition is risky. There is inherent volatility within indexes. Returns vary significantly (10% average with a range of -25% to +33% for last 10 years). Highly volatile. The issue with volatility/risk is it takes more time (adds another factor into risk) to recover the losses.

I will list an example later.

Costs do not indicate risk or performance. Costs are part of equation (all things being equal, lower cost has better return). What smart fund managers do is manage risk as much as they pick stocks. This risk could be managed by going to cash, could be timing buys at low points of market, could be avoiding bad investments all together. The reduction of risk "has a cost", and if the reduction of risk yields positive returns when an index is going down, then the additional expense (to me) is well worth the cost.

indexing works GREAT in up markets, and performance will be better than strategy I am suggesting (defensive equity funds). These gains reward the indexer which took the ride down.

A discussion yesterday on "indexing" a way of investing meant to minimze fees and give an investor the return of a given index deserves a discussion.

Issue 1, investing is NOT a religion... yet some people swear by indexing more than they go to church.

Issue 2, make sure you understand the index (NEVER invest in something you don't understand). The popular indexes used are S&P 500 (large cap stocks), Wilshire 5000 (the top "5000" companies in the country), the Wilshire 4500 (the top "4500" companies with EXCEPTION of the top 500-S&P 500), and the Russell 2000 ("2000" small companies).

Issue 3 managed funds will compare themselves to an appropriate index. Fees matter. Some managed funds charge .69% (T Rowe Equity Income) and .73% (T Rowe Captial Appreciation)expense ratios. Index funds charge ~.35% (TRP equity index) to .18% (Vanguard Index 500) to .07% (Fidelity Spartan 500).

Issue 4. RISK. Risk can be defined as volatility- the liklhood returns will vary significantly. If a person accepts risk, they are accepting variance of returns. If a person wants less risk, they are usually willing to sacrafice the high end to avoid the low end.
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I want to combine these issues, concetrating on S&P 500, the most popular index.

Do you know why a company is in the S&P 500? If you believe investing in only things you understand, but cannot answer this question, it appears you do not practice what you preach.

My understanding is a group of people which work for "standard and poors" (S&P) decide the 500 companies which are proxies for the whole market. Not the 500 largest, not the 500 fastest growing, not the 500 best values, but some random group of 500 stocks.

The index does change year over year. Companies get dropped and added as S&P people see fit. These people at S&P have no vested interest in anyone in an index fund making money.

Most S&P 500 index funds own all 500 stocks in the index. The mutual fund is broadly diversified (owns 500 stocks, most managed funds own 100-200 stocks). They own the bad ones (like Enron), they own companies in bankruptcy (like Dana, Xerox, Ford, GM) until the companies are removed from the index.

This is "downside" risk. If a person owns an index fund, they own these companies "on their way down", with no mechanism to dump the losers.


It gets much more cloudy with Wilshire 5000. For one thing, the Wilshire 5000 index has more than 5000 stocks in it. WHAT? Yes, it has ~5700 stocks in it last I looked. Second is a Wilshire 5000 index fund will NOT own all "5000" stocks. It will own a SAMPLE of the 5000 stocks. Index has 5700 and fund owns less than 5000. WHAT GIVES?

Two problems with this. First is if index has more the 5700 companies, couldn't the people creating the index make a decision as to what to remove? Second if the fund manager now has to make a decision as to what he does or does not buy (he cannot buy 5700 stocks, it would be WAY too costly), what does he decide to buy and WHY. Why is not listed in fund prospectus. Invest in what you understand.

So in reality a wilshire 5000, wilshire 4500 or russel 2000 index fund is being "managed", a person is choosing what stocks in the index to put into the fund which is owned by a customer.

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Control and Accountability. Those are probably two words most people want in most things in life.

This is why I choose managed funds. My fund manager is accountable to me. I have control over the types of companies I invest in based on the fund manager I choose.

The risk of a managed fund is if the manager misses a "good stock" on it's way up. The advantage of a managed fund is the fund manager does not have to ride a stock on it's way down.

Xerox is a good example. it was a high flying stock in the 90's. High dividend, high yield. excellent performance. I used to work for Xerox, and also owned the stock (XRX). My father even retired from Xerox. Then speculation started about bankruptcy. Any managed fund in their right mind dropped the stock like a bad habit. price dropped. Then Xerox filed for bankruptcy. Stock dropped again and removed it's dividend (Xerox had previously reduced it's dividend prior to this when bankruptcy speculation started). An index owned the stock all the way down. Xerox is still part of S&P 500... so it brought the return down... where as most managed funds probably sold it.

The goal of managed funds is to reduce risk by not taking the ride down.

The examples I like to use are PRFDX and PRWCX. I will compare to VFINX (Vanguard 500 index, largest mutual fund in the world, I think).

PRFDX is T Rowe Price Equity Income
PRWCX is T Rowe Price Capital Appreciation


PRFDX expense ratio is .69%
PRWCX expense ratio is .73%
VFINX expense ratio is .18%

The question is, does .5% expenses get an investor out of the down cycle?

PRFDX returns

1997 28.82%
1998 9.23%
1999 3.82%
2000 13.12%
2001 1.64%
2002 -13.04%
2003 25.78%
2004 15.05%
2005 4.26%
2006 19.14%

PRWCX returns
1997 16.20%
1998 5.77%
1999 7.07%
2000 22.17%
2001 10.26%
2002 0.54%
2003 25.47%
2004 15.29%
2005 6.85%
2006 14.54%

VFINX returns
Year VFINX Category Diff
1997 33.19
1998 28.62
1999 21.07
2000 -9.06
2001 -12.02
2002 -22.15
2003 28.50
2004 10.74
2005 4.77
2006 15.64

note that 10 yr returns for each fund are
PRFDX 9.99%
PRWCX 12.26%
VFINX 7.55%

It's cool the two funds I mentioned beat the index, that was NOT the goal. The goal was an 8% return (which both exceeded) WITHOUT THE RISK. Look at the lows.

2001 and 2002 in particular. 2005 as well. The goal is to reduce risk, not beat the index. Beating the index is a measurement (if returns were significantly lower than the index, one could argue that less risk yielded a much lower return).

I will post a blog on risk tommorrow.