In the first half of the show, Victor explains the importance of keeping a close eye on your pay stubs. You want to make sure that your retirement funding is exactly how you had indicated you wanted it to be, your pay is being calculated appropriately, and always pay close attention whenever a big change happens in your life.
In the second half of the show, Victor compares and contrasts index and mutual funds. He goes over the specifics of each fund and gives his recommendation on which one he feels is better for retirement.
Make It Last with Victor Medina is hosted by Victor J. Medina, an estate planning and Certified Elder Law Attorney (CELA®) and Certified Financial Planner™ professional (CFP). Through his law firm and independent registered investment advisory company, Victor provides 360º Wealth Protection Strategies for individuals in or nearing retirement.
For more information, visit Medina Law Group or Palante Wealth Advisors.
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https://www.makeitlastradio.com/ep-97/
Click below to read the full transcription…
Announcer: Welcome to “Make It Last” helping you keep your legal ducks in a row and your nest eggs secure with your host, Victor Medina, an estate‑planning, elder law attorney, and certified financial planner.
Victor J. Medina: Everybody, welcome back to Make It Last. I’m your host Victor Medina. I’m glad you can join us for another fun and exciting journey down the road towards legal and financial retirement salvation. I’m here as your guide.
I’ve got a really exciting show for you today. I want to cover a couple of different things. We’re going to talk about specific kinds of funds into the 21st century and how you can use them in your portfolio.
The thing about it is the world that we live today is constantly changing, ample examples of these. If you go out and ask a family member from a prior generation, technology today might be one of the most evolving changes and even, I guess, Baby Boomers can attest to that.
I tell you, my mom, especially, and dad are really into their iPads and the way they consume information it’s completely changed their life. My mom, being from Puerto Rico, is so excited that she can read the newspaper on her iPad. It’s just crazy how much technology has evolved and changed the way that we’ve been doing things.
Even just the concept of the phone. 20 or 30 years ago, you might have been lucky enough to have a cell phone that could call and maybe text your contacts. In order to do that, you had to spell out the words using [laughs] one number for three letters. You could never use the number one. B was number two. Number two is also A and C. It’s crazy. Today, we’ve got phones that can do just about everything.
I know that I’m out with my son often. I’m like, “You have the entire encyclopedia of knowledge of the world at your fingertips. Stop watching a video of somebody else playing a game and maybe look that up.”
Not only is technology changing, but so are many other things in this world. Retirement is changing completely. As opposed to 20 or 30 years ago, today, retirement planning is much more prevalent, because pensions are becoming scarce or are scarce.
Social Security has got question marks around it. People are trying to get some security around their retirement and making sure that everything is in place. They have to change the way they approach it. You, the retiree, or pre‑retiree needs to be a lot more proactive and start building a plan for your retirement. That includes how you invest your money.
The prior shows, more recently, we’ve been talking about retirement theory, and haven’t gotten into the weeds of specific kinds of investments and things that should be in your portfolio. I want to talk a little bit about that today.
There are a abundance of different funds that are available. I think it’s important to choose the right ones in order to be successful. I want to talk to you today about two different kinds of funds, index funds and mutual funds, and how they may or may not be the right fit for you. Before we get into that a couple of high line items.
I mentioned before that we are making a shift in the logo and the branding of the radio show. I’m happy to announce a couple of things, the first is that our contract with WCTC has been renewed for another six months. We started these first three months in a bit of an experiment moving to an hour format as part of their Sound Advice programming.
Here we are on a Wednesday, in the middle of the day with some rebroadcasts on Saturday and sometimes in the evenings if there aren’t any summer Patriot games out there. The good news is that you, the listeners have really made it known that this is a good set of programming efforts for them, they’ve gone ahead and renewed us for another six months.
By the way, I’m not somebody that gets multiyear contracts, six months is as about as long as we go on these things and that’s great. We are really excited to do that. In line with that what we are going to do with this week, is we’re going to go ahead and release the new logo for the radio show.
If you are a podcast subscriber, if you’re somebody that gets this on your phone or if you would like to what you’re going to see is that the logo around that is going to be updated. We’re going to do away with the blue, it was a metal robot thing going on there.
We’ve warmed it up a lot, and we’ve got that consistent with some other branding efforts that we’ve got going on in my business life. Right now, the Make it Last monikers are all a part of the books that I’ve written and this radio show.
We’ve also done some rebranding around the financial services firm which has been renamed as Palante Wealth Advisors, and then we’ve done some logo on that. I’m not really going to announce that website yet, although that is really, really close.
The logo for the radio show is out, if you’d like to see that what you should do is you should try to subscribe to the show, then the more subscribers we get a little easier it is to track the information that is going out there. What episodes are you listening to the most, what do you like to hear?
If you don’t do that, you can always email us at feedback@makeitlastradio.com, and we’d love to hear what you think about that. If you go to Apple iTunes, if you can go to Spotify, any of those places, it will not be seeded with the new logo. I hope you enjoy it, hope to hear back what you think especially if you are a client of ours.
You can see how it can be consistent with the rest of the stuff that we’re doing out there, would love to hear what you think about that. One other thing, before we go into the topics about the different funds, I wanted to talk to you about probably something that you ignore routinely.
I know that I do. I read a blog post that really opened my eyes. This blog post was written by a friend of mine who runs a different financial services firm, a little bit more focused on younger people and also focused on women in tech.
Her name is Meg Bartlett, she is a CFP. She runs something called Flow Financial Planning. They don’t specifically focus into retirement planning here, but she wrote a really interesting post in mid‑February.
It got me thinking that this is probably something that I should share with you. What she did ‑‑ this is really, really helpful ‑‑ she focused on your pay stubs. If you’re still working, you probably completely disregard your pay stub on a regular basis. You may not, for instance, ever look at the pay stub itself as long as the amount that is being direct‑deposited into your account is consistent.
If that amount were to change, you’d probably pay attention to that, then ask HR why that is. The details on the pay stub itself, they go by wayside. I know that this is the case. It’s a little bit different for me as I own my companies, I don’t really get the same kind of pay stub that other people get.
I know that I’m always looking at the one that my wife gets. Her pay stub has a wealth of information. She is a public employee, she works for a school district. She has things like her union contributions, she has some mandatory healthcare deductions.
She has different information about contributions to taxes for unemployment and leave and disability. She’s got a lot of information in there. She also has some retirement planning information.
What Meg was highlighting in her blog post, was essentially that two of her clients had looked at their pay stubs and realized the deferral when paid contributions were going to Roth instead of a pre‑tax. That’s not what they had set up. They wanted to go into a pre‑tax account and even though they had filled this form out to make sure that it had changed.
It’s going to cause a lot of administrative headache, ‑‑ which is a pain ‑‑ it’s also going to create higher than planned for taxes. The 401(k) contributions into a pre‑tax account would have reduced the total amount of taxable income that they had. Here we are in the first quarter of what we’re doing in 2019. If you lost a quarter of contributions, you’re not going to be able to get that back. You’re going to be subject to higher taxes.
When she was going over this with her client, she was really surprised to learn that the reason why the 401(k) election didn’t take is because there is no checks and balances or any kind of integrated system.
If you wanted to change your 401(k) distribution, what you did was you had to go onto the 401(k) website, make the change, then in order for it to go to the payroll service, there was an email sent from the 401(k) system to the HR person who would then have to manually key it in to the payroll systems.
It was a very inefficient way of doing it, but it does set up this idea that in this world of managing your finances, it’s really only as strong as the weakest link. The email plus a manual data entry for 401(k) distributions is certainly a super, super weak link.
The real punchline that I’ve been hiding about the story is that both of these clients worked for tech giants. The idea there is they probably should have been a little bit more aware of it and set it up.
Even in a world where being efficient techs, start‑up, things like that is so much about using technology to our advantage, here we have this setup that is really, really at its foundation and its core. Something that is subject to a lot of problems because of the way that these weak links work.
Here we go, what can you do when you review your pay stub? I think that you should be checking a few things in here. The first one, clearly is your pay. What you want to do is make sure that, especially if you’ve recently gotten a pay raise or something along that, you want to make sure that your gross pay number is correct.
This can be an easily overlooked thing. If what you’re doing is just looking at your direct deposit and seeing, in fact, that it has gone up, if all you do is see it has gone up, you might think that the pay raise has been accurately entered.
What you should do is probably multiple the amount that’s in the gross times the number of pay checks that you’re meant to received. You can do this a couple of different ways. Sometimes, people get paid once a month. Then, you’re going to multiple your gross times 12. Sometimes, people get paid twice a month, on the 15th and on the 30th. In which case, you’re going to want to multiple that by 24.
Yet other places will pay you 26 times or every other week. If you do every other week, there are 52 weeks out of the year, then you’ll have 26 pay stubs. If you’re my wife, it’s even different than that. She’ll have a certain amount of payments during the school year. Then, she’ll have some lump sum payments that will be going out through the summer.
Then there are other tax‑related stuff that we need to calculate into there. For instance, you have a certain amount that you have to contribute towards Medicare, but it caps out. After that, if there’s a certain pay check within a certain month above that, your pay might go up. We’re going to get to that in a second.
First, just look at your gross pay and make sure that that equals what your arrangement with your employer is. The next one here is within your 401(k). Hopefully, you have a 401(k) available with your employer. If you do have one with your employer, then what you’re going to be looking for is making sure that the amount that you’re contributing towards your 401(k) is accurate.
Again, you’re going to want to look at that contribution and multiple it times the number of pay checks that you’ll be getting. Question for you is if you’re under the age of catch‑up contributions, do you get to $19,000? That’s the maximum contribution.
If you are over the catch‑up age, then you’re going to want to add another essentially $6,000 to that. You just want to make sure that you’re getting to the max or you’re making sure that your number is safe with that.
Next thing you want to do is make sure that your 401 contribution is going into the right kind of account. If you’re lucky enough to have your employer have both a Roth and a pre‑tax account, make sure that it’s going into the right account. The Roth account will allow this money to grow tax free and the withdrawals be tax free in the future.
But you’ll be paying taxes in the on the entire amount of your wage income. There’ll be no deductions for how much you’re contributing to the Roth because those don’t come off of your taxes. If you want to lower your taxes and defer both the growth and the taxes on that money to the future, then you want the pre‑tax account.
If you think that you’re contributing after tax money, is that reflected the right way? Also related to the 401(k) is if your company offers a match. Are you getting that match correctly calculated? Years ago, I remember working for a law firm and checking a pay stub and realizing that I essentially had maxed out my 401(k) too early in the year.
I missed out some company match because of the way they had it structured. You just want to make sure that that is the right way. Next thing you want to do is you want to be reviewing your taxes. How much tax is being withheld? Do you have the right allocations?
There were a lot of people who were a little surprised this tax year in the way that they were getting their taxes done and when they owed a certain bill. Although the tax rates had changed, they had not at all altered their withholding. That really affected whether or not they owed money or not.
If you only withheld 22 percent and you’re in the 30 percent bracket, you might need to start to pay estimated taxes. By the way, this is the same if you’re receiving bonuses. Bonuses are typically taxed as supplemental income at a tax rate of 22 percent.
The companies do have the option of withholding taxes at a rate tailored to your circumstances. It might be better for you to withhold that at a higher rate if in fact that income will be taxed at a higher rate, so that you don’t have to dig into your pocket towards the end or have to pay estimated taxes in the next year.
There are a couple of other things that you should be looking at. Your employee benefits. If you’re contributing to a health savings account, is that the right amount? The maximum that you can put into a FSA is $2,700 and dependent and cure is $5,000. Is that set up correctly? If you’ve got any paid time off being calculated, is that being done the right way?
Again, you just want to check all of that stuff including things like your federal unemployment tax, Social Security tax, Medicare tax. Just make sure that that hasn’t fallen victim to some manual entry problems. The last thing is how often should you check your pay stub?
One of the things you should definitely do is look at the first pay stub of the year. That’s not necessarily because your pay is going to change from one calendar year to the next. When you do get your first pay stub as of January, these are going to be the things that set up for this tax year.
You definitely want to be looking at that early in the year so you can correct any problems before they grow into something much bigger. You want to look at it any time you make a significant change to your employment benefits and your setup. For instance, anything related to your deductions, 401(k) changes, benefits elections because of a qualifying event like having a baby or getting married.
If you are ever expecting to get reimbursed by your company, that would be an opportunity to check your pay stub. If you’re getting an extra pay check for the month, that would be one that you’re going to want to take a look at. My wife who gets paid every other week, sometimes gets three checks in a month, depending on the way that lines up.
That third check is always going to be higher because she’s not contributing in that check to some of the federal taxes. We want to check to make sure that that’s the case. That would be the schedule that I would recommend on it in having you look at the pay stub. It is something, as I said to you, it’s very overlooked. I’m depending on the sophistication of the payroll department that you work for.
You can get this stuff emailed to you. That’s the way that I do it. I have my wife’s pay stub emailed to me. I set it up, so I put me email address in there. Every other week, it just gives me an opportunity to quickly review it. It’s a PDF. I open it up, make sure the numbers are pretty consistent.
After a while, some of this stuff just fades into the background and you’ll notice a change the same way you’ll notice if there’s something wrong with the address that your mail was sent to. You pick up the letter and you’re like that’s not right, those kinds of things.
You definitely want to be looking at that and essentially going into the setup with your eyes open, making sure, in fact, that you’ve got everything set up the right way.
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Victor: That’s not the main thrust of what we’re going to be doing today, but it is a good segment for us to go through because, again, it’s something that it’s very overlooked. When we come back from the break though, I do want to talk to you about the way funds have changed in the 21st century.
We’re going to focus in on index funds and mutual funds and how they may or may not be right fit for you, specifically in retirement. We’re going to describe all of that and give you the full education, the full lowdown on it when we get back from this quick break. Stick with us. We’ll be right back.
Announcer: Imagine, if the attorney you trust to protect your legal interest could also be trusted to protect your retirement wealth, one trusted adviser to all fiduciary roles, Victor J. Medina. Mr. Medina is an estate‑planning and certified elder law attorney with a national reputation. He is also a certified financial planner professional.
Through his law firm and independent registered investment advisory company, Mr. Medina provides 360∞ Wealth Protection Strategies for individuals in or nearing retirement. His unique approach offers advantages to high wealth individuals seeking conservative advice and a professionally managed approach to their retirement wealth.
To learn more, call 609‑818‑0068. That’s 609‑818‑0068 or listen to the newest episode of Make It Last radio, Wednesday mornings at 11:00 on 1450 Talk Radio.
Investment advisory services offered through Palante Wealth Advisors, LLC, a New Jersey‑ and Pennsylvania‑registered investment advisor.
Victor: Hey, everybody. Welcome back to Make It Last. We spent the first segment talking about examining your pay stub, but what I wanted to talk to you about were two very popular funds available to you. I want to help you better understand them.
We’re going to focus on index funds and mutual funds. I want to help you think about your money at this stage of your life and which might be a better option for you. Maybe you use neither and that’s fine, too.
All I want to do is help educate you, so that you have a better understanding of the two. Then we can go from there. We may open up a conversation. I will let you know sort of what we advise and why we advise them in one particular direction or another. I wanted to first give you that education.
People, I think already, know a lot about mutual funds. They’ve been around since the early 1900s. They started out becoming very popular in the 1980s and 1990s when they started generating good returns for investors because what they essentially did was to allow young investors to invest in a basket full of stocks so that it could be diversified.
Index funds on the other hand, may not be as familiar to people as the mutual funds. They haven’t been out as long and therefore, they’re not as widely used. They are becoming appealing to many people today. I want to help you show some of the reasons why.
Then maybe contrast that with some reasons why you might still want some mutual funds. We are going to go through the difference between them as we go through that.
Index funds are becoming increasingly popular. They have different benefits than mutual funds and the idea there in terms of the ins and outs of it is I want you to understand the way the index funds are set up, and how in the same way you need to know about mutual funds, you need to know about index funds before you purchase them.
The problem I see though often is that people come into my office, and I ask them about how their money is invested, and they’ll often tell me that their advisors invested in places that they think they should have their money, but they don’t have any idea what those funds are or even what those funds do.
For all they know those funds could be in current fees and risking their portfolio. That may be something that they don’t want at all. It strikes me as really quite interesting, I don’t know if you’ve ever been to the symphony. I am a bit of a musician. I really enjoy classical music and I enjoy going to symphonies in particular.
The way that they’re crafted, the different movements, so on and so forth, but if you’ve ever been to the symphony or maybe even to an opera, anything where people are playing live classical music, if you get there early you’re going to witness something that is quite amazing.
First thing that will happen is you’ll have somebody playing one tone that everyone will tune to. Then what will happen is people will tune to that and it will sound great, it will sound fantastic because they are playing one note in tune and they’re professional musicians. The tone of it is absolutely gorgeous.
When they’re done with that they’ll start practicing all kinds of stuff. The violin will be doing one thing and the trombone will be sliding all over and it sounds like absolute chaos. It becomes overwhelming. You can’t distinguish one player from another, it goes crazy in terms of the noise that’s going on in there.
Until finally the conductor comes on stage, and they will quiet all of that down. The conductor will raise his or her arms with a baton in hand and will start to conduct. All of these things that were making these crazy sounds now make beautiful, beautiful music.
That’s very similar, I think, to the way that people collect their investments. Then, when they buy them, they’re perfectly in tune. It’s one note playing, and they understand it. It sounds great. Then, as they grow and get a number of things together, you can get all of the noise.
People have an opportunity to make a decision about whether or not they’re going to be the conductor in their own life trying to make all of this stuff work together or whether they’re just going to sit back and enjoy the music. My goal here is really to get you to understand that, in retirement, you should really just be sitting back and enjoying the music.
That’s the goal of what you’re doing. Let a conductor do what the conductor does so that you can just be the benefactor of all of the organization that goes into that. That’s no better example than in picking your investments, specifically the kinds of different funds that you’re in. Look. If you have questions about your account or you want a second opinion, then you can contact my office.
We can help you walk through that. We’re reachable at 609‑818‑0068. You can schedule a complementary consultation with us. You just call 609‑818‑0068, and we can do that. I think that it’d be important because a lot of people come in without a plan. A common mistake that people make going into retirement is not having a plan.
Whether you think your money is invested in good places or not, I’m encouraging you to take a second look. Retirement is one of the most important milestones in your life. You want to make sure that you’re completely prepared for it. Don’t procrastinate any longer. Take action. You’ll be happy that you did. Certainly, give us a call at 609‑818‑0068. We can help you. Let’s dive into the show.
Let’s talk about index funds because we said that those were a couple of the ones that were growing in popularity but not as well‑known as mutual funds. The first index mutual fund was created in 1976 by John Bogle, who was otherwise known as the founder of Vanguard. This particular fund that was first launched is known as the Vanguard 500 Index Fund.
Its call letters are VFINX. It’s a fund that is very popular today. Now, for those of you that are completely unfamiliar with what an index fund is, it’s basically an investment fund within the mutual fund family designed to track and mirror a key benchmark indices, such as the S&P 500, the Russell 2000, or other indices. They can be made up of stocks, bonds, or other investments.
The idea is that they’re there to track a particular index. That’s why they are called index funds. They track the underlying index, which means that they invest in the same stocks as a given underlying stock‑market index would be made up of.
For example, if the index fund was following the S&P 500, they would invest in stocks such as CVS, Facebook, Goldman Sachs, Ford, and many more because their job is to track the benchmark index and own the things that would be in the S&P 500. Because they track this index, they typically rise or fall at the same percentage as the index.
While it’s not always the case because there’s some tracking error, if the S&P, for instance, dropped five percent, the index fund would likely drop the same amount. If the S&P goes up 10 percent, the index fund might do the same. Since these index funds simply track and mirror a particular index, they are considered passive investments.
Simply what this means is that they’re not actively trading or doing a lot of changing. They are trying to guess what will be happening in the future and then beat the market by actively moving in and out of various funds or securities in order to do that.
Also, because they are considered passive ‑‑ or that is to say that they don’t do a ton of trading trying to eke out an advantage over the market ‑‑ they tend to have a lower operating cost as compared to other funds.
If that operating cost is known as an expense ratio, which is another form of a fee, typically an index fund can have a fee that ranges from 0.05 percent to maybe about 0.1 percent, so either five hundredths of a percent or a tenth of a percent. Some of these index funds can have a higher fee than that, but we’re talking about an average.
Another advantage of an index fund is that it allows an investor to put money in large global stocks without having to invest in them individually. Like a mutual fund, it’s a basket of different securities.
It’s a great way to diversify your portfolio rather than just investing in a few individual stocks. If you ask me my recommendation on this, I believe that being in an index fund is superior to being in very specific securities or owning individual stocks. That’s a clear advantage I think in my book.
Now that we understand index funds, let’s give a little quick history on mutual funds. They were created way before [laughs] the index fund. They were around since the 1700 or 1800s because really, conceptually, all it is is a basket of securities held mutually by all of the owners. They pool their money.
The first modern‑day mutual fund was known as the Massachusetts Investor Trust, call signal MITTX. It was created in 1924. As of mid‑2018, mutual funds accounted for close to $19 trillion in US assets, making them one of the most popular investment vehicles available.
That makes a lot of sense because, again, most people don’t have the capital to be investing in multiple different securities and owning enough of them individually in order to represent a well‑diversified portfolio. Where we get a separation between the mutual fund and the index fund is that some mutual funds may be actively managed.
It’s like a little bit of a hedge fund in the sense that you’re pooling your money with other people. You’re giving it to a manager that is going to be making decisions on your behalf about what securities to buy or sell without any strict guidelines to be following a particular index. They are going to have their managers actively pick investments and essentially try to out‑guess the market.
The complexity comes in that not all mutual funds do that. Many of them do. Many of them do, but not all of them. Unlike the stricter definition of the index fund, which is just go passively follow that index, the mutual fund can be either one of them. Either one of them can be actively managed or can be passively managed.
Really, it’s hard for an investor to understand which kind of mutual fund that they’re in. They’d have to go and review the prospectus and really understand that or have an advisor that is sharing that information with them, which many of them don’t. Mutual funds have different objectives than index funds.
As I said, index funds just simply have the objective to match essentially the returns of the benchmark index by owning the same securities. Mutual funds, on the other hand, generally aim to beat the returns of a benchmark index. It’s harder for mutual funds to do this because they tend to charge higher fees.
A mutual‑fund fee can average between one and three percent, with some reports claiming that the average is about .84 percent. That’s much higher than the index fund. You have to really get something that performs higher in order for a fee like this to be attractive. Mutual funds tend to have three different kinds of fees.
They have front‑and‑back‑end loads, which is an industry term for a fee that goes into purchasing one. Many mutual funds will charge a fee to get into the mutual fund. That’s called an A share. Other mutual funds may charge a fee on the backend or on a consistent regular basis. That might be a B or C share.
In addition to the sales charge that goes in, there’s also an annual charge, which is part of the fund expenses. Those are an expense ratio. These are the fees for annual operating expenses expressed as a percentage of the assets. You’ll see that .84 is something that’s charged essentially every year in order to operate this. It’s like a hurdle.
Your money has to make more than the returns on that because that’s the fee that’s coming out every year regardless if the fund performs better than expected, worse than expected, not at all. Then there is also a turnover ratio. A turnover ratio is a percentage of the mutual funds’ holdings that have been replaced and are given here.
These trading costs are passed onto you, the investor of that particular mutual fund. We’ve gone ahead and we’ve highlighted for you a little bit of an explanation of what an index fund is and what a mutual fund is. I’ve already told you that I believe that an index fund is superior to holding individual stocks.
What do I think about the difference between a mutual fund and an index fund in which you hold? What do we encourage for our clients?
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Victor: Well, the first answer to that question is we absolutely do not encourage our clients to hold actively managed funds. We don’t believe that active management works. By the way, the research backs us up on that. I don’t think that that will ever be the case. Now we get into the difference between passively managed or what we call evidence‑based mutual funds and index funds.
Which one do I prefer? Well, I’ll tell you when I come back from this quick break. Stick with us.
Announcer: Life is better when you have your legal ducks in a row. One area attorney can help you get your financial ducks in a row as well, Victor J. Medina, fills dual fiduciary roles, an estate‑planning and certified elder law attorney, and also a credentialed certified financial planner professional.
Through his law practice and independent registered investment advisory company Mr. Medina serves high wealth individuals seeking conservative advice and a professionally managed approach to retirement wealth management.
To learn more about Victor’s 360∞ Wealth Protection Strategies, call 609‑818‑0068. That’s 609‑818‑0068 or listen to the newest episode of Make It Last radio, Wednesday mornings at 11:00 on 1450 Talk Radio.
Investment advisory services offered through Palante Wealth Advisors, LLC, a New Jersey‑ and Pennsylvania‑registered investment advisor.
[background music]
Victor: Hey, everybody. Welcome back to Make It Last. We’re spending today talking about the difference between index funds and mutual funds. We want to help you understand which of either of them should you be holding in your portfolio as you especially get towards retirement.
Now that we’ve spent that first segment informing you on the background information for both index fund and mutual funds, I want to spend some time pointing out some key differences. Before I do that, let’s talk about how they are similar. Number one, they are typically both comprised of a basket of securities that include stock bonds and maybe some real‑estate holdings.
Number two, they are both substantially less risky than investing in individual stocks and individual bonds because, by definition, they are diversified by holding lots of different things. We can get into an academic discussion about whether that diversification actually matches what is true diversification, but just on its face, holding more things than the individual stocks is going to get you better diversified.
Here’s where we get to things that might be different. Investment goals. An index fund’s general objective is to match the returns of a particular index that it is tracking or mimicking. That seems to be common sense, it’s called an index fund.
The difference with that in a mutual fund is that the mutual fund aims to beat the returns of their comparable or related benchmark index. Not only do they need to beat the index, but they need to beat the index by a cushion to overcome the extra fees that are in there. It has to not only, just casually, outperform that index, it’s going to have to do it beyond the operating expenses that are in there.
The next level of difference is the level of management. One of the main differences between an index fund and a mutual fund is their style of management. Here, we have to further separate out mutual funds because, as I said, you can have mutual funds that are actively managed and those tend to be more expensive, which I’ll get to in a second.
You can also have a mutual fund that is more passively managed, or in my world, what I would call it is evidence‑based. We are going to talk about our specific investment strategy in a second, but you need to understand, as I was saying before, that the mutual fund landscape includes funds that are both actively managed and passively managed.
There is a difference, whereas all of the index funds are passively managed, the mutual funds is mixed. You have to understand which one that you have.
The next level of difference are investor fees because mutual funds are a little bit more that their management style is less robotic of just tracking an index. It’s going to have higher fees. Those fees can include the expense ratio that you are charged every year, the sales loads that are charged to get in and out of the funds, the turnover ratio, which is embedded in there.
Again, the idea is, depending on the way that mutual fund is structured, it can have significantly higher fees. Again, it doesn’t have to, but most investors don’t know which kind they have.
John Bogle, when he originally created the index fund, did it with the idea that the index funds can perform similar or better than the way a mutual fund was for a fraction of the cost because it was getting away from the active management. By tracking an index, the cost will be lower.
By the way, these costs can really eat at your investments because, if you have something that has very high fees that are in there, it can really erode how much your fund grows. By the way, and not in a way that is readily apparent because it’s not always the case that the fund, for instance, is losing money on the basis of it having to charge a fee.
There could be many years in which it’s making money. You really don’t understand the way that it’s doing that or the way that the fee is impacting that because it’s just like a little bit of a boat anchor around it. Let’s use some numbers to get an example. Let’s say that you had $100,000 invested and your account earns six percent for 25 years.
If it was zero fee on that and it was just compounding growth and you never touched it, it would be worth $430,000. If you added to that account, by the way, it would be significantly higher. Let’s just say you put a $100,000 in right now. When you put it in there and you just left it alone, it grew six percent for 25 years. 430 grand. That’s great.
Now let’s assume that you’re sitting in a mutual fund where the operating expenses are about two percent a year. If you were in that kind of account, after 25 years the same account would be worth only $260,000. Think about that for a minute. That is $170,000 less simply because you paid a fee that at the time you may not have thought would’ve made a difference but definitely will over time.
People I think don’t often realize how much a little upfront fee can mean in the long run. Now, I want to be clear. I’m not assuming that all mutual funds charge two percent a year or any for that matter. I’m not assuming that all index funds, and really none of them, charge zero. I just want to help you understand that a small percentage can mean a lot over time.
If I’m driving an aircraft carrier and I make small course correction with a slight tenth of a degree left or right, I am going to end up a hundred million miles off course. I’m definitely going to be not where I expected. That will be the same thing. You might be thinking, “Well, what if the mutual fund outperforms the index fund?”
Remember, one of the things that it’s trying to do is essentially be able to do better than the benchmark index. If they outperform, then they can overcome the higher fee. Sure, academically, that’s the case. If you do your research online, there are various studies that show that higher cost mutual funds generally underperform the lower cost funds.
A big reason for this is because the fund managers of these mutual funds that charge a higher fee have a very difficult time adding enough value to overcome the additional expenses because they’re engaging in the same game that I told you was nearly impossible.
They’re trying to time the market, they’re trying to outguess the market, they are trying to be able to pick a selection of securities that are going to outperform, know information that somehow isn’t knowable.
It’s very, very difficult to do that. We can’t predict the future. As much as I have tried to buy a working crystal ball for my office, the truth of it is, I don’t have one that works that way. This is only a hypothetical example. It doesn’t represent a real life scenario. It definitely should not be construed as specific advice designed to meet the particular needs of you and your situation.
I’m just giving you some numbers for you to understand the way that fees work. Index funds have been increasing in popularity. According to Moody’s investor service, index funds are believed to grab more than about half of the assets in the Investment Management Business by 2024.
Also according to Moody’s, by the way, investors are increasingly buying relatively cheap funds that mimic benchmarks and getting away from active portfolio managers who look to beat the market. Again, as I mentioned, often come up short.
A large reason Moody’s believes that index funds are becoming the forefront of investing is because investors are becoming more and more aware that mutual funds typically don’t outperform their benchmarks and yet, they’re charging higher fees.
This proliferation of information, the Internet of things, the ability to go out and research that has illuminated some of the problems with that industry of actively managed funds. People now understand that they should not be paying more for performance when that performance isn’t based on any evidence. It’s just based on this portfolio manager’s belief that they can outperform their market.
The idea there is that many times they can’t. I know there’s a very popular story about a portfolio manager that had outperformed the index, I think 13 or 14 years, their benchmarks. If they had retired at that point in time, they’d be legendary, but they went for year 15. When they did, they lost a ton. They kept losing after that.
People that had been chasing this performance as though they knew that this person had the magic elixir, lost a ton of money because it is difficult ‑‑ if not impossible ‑‑ to be able to outperform the market regularly.
You might be wondering yourself, by the way, can you invest in an index funds in all of your accounts? The quick answer is more than likely yes. If you’ve got a 401(k) or a company plan through work, it may be the case that you can find an index fund is an option to invest in. Many of these plans are now offering lower cost investments like index funds. You have that available to you.
When you get through thinking about these investments, you need to seek out an advisor who specializes in retirement planning and can offer you vehicles like the index fund. If a mutual fund is what makes more sense to you, they can offer that also. Not just these two funds, but the financial universe to provide you with exactly what you need to be successful in retirement.
As I mentioned before with my little story about the symphony, there’s a place for every instrument that’s out there. You may not want everything being played by the oboe. It’s an interesting sound, but not everything needs to sound like “Peter and the Wolf.” By the way, that is a really nerdy music reference [laughs] to just a very small sliver of the audience.
The idea is that there’s a time and place for all of these options and what you want is the conductor that is able to select from the right instruments to make the most beautiful music possible with your retirement. I think that’s where the value of an advisor is.
I promised to tell you what I thought that we should be doing with your retirement. It may surprise you because the majority of the assets that are invested for our clients in the market. We do investments that are part of the different insurance solutions within annuities.
Life insurance and long‑term care is part of it, too. In the world of the street, mutual funds versus index funds, we actually tend to favor passively invested or evidence‑based, objective mutual funds. We do that with a very particular company whose model and philosophy is very, very similar to the way that an index fund works.
What they do is they basically say, “It’s probably right for you to own as much of the market as possible because that’s how you’re going to be diversified.” There are ways of tilting your portfolio that, over time in history, you can outperform just at the market. This is going to go a little gear‑heady into this. Just keep track with me on this.
The evidence suggests that over time small cap stocks or smaller companies will outperform larger companies, that more‑profitable companies will outperform less‑profitable companies. Companies whose price is lower than ones that are higher, so their value stocks versus growth stocks, tend to outperform the market as well.
By the way, there’s a similar sort of assessment on bonds, and the evidence backs that up. Because this is such a long‑term view, the operating expenses for these funds tends to be very, very low. They are nowhere near high as a couple of percent per year. The operating costs for these funds tend to be a tenth of a percent, 0.2 percent.
The hurdle that it has to overcome relative to the index fund is not very great. It might only be two‑tenths of a percent greater than an index fund. There are advantages that we have calculated to being there. First is being in an index fund. I’m going to completely confuse you by letting you in some of the risks that are associated with an index fund.
One of those risks is that an index fund just blindly follows the index. What that means is a couple of things. The first is that the cost of trading on that can be higher. Some of the indices, specifically the Russell indices, all reset the stocks that make up their definition of that I think on June 25th or something like that.
What that means is that the trading cost and the cost to buy those securities goes way, way up because everybody has to be buying everything new that’s in the index and selling everything that’s old. You don’t get a great deal on that. Blindly following an index can lead to a little worse result than being a little smarter about what you own and how you buy it.
The other thing about it is that index funds in and of themselves does not mean you have a strategic approach to your investing. Within even the world of index funds, what ends up happening is that people end up buying an index fund simply because it’s called an index fund. They don’t realize the index that they’re tracking.
If you are essentially trying to mimic a well‑diversified portfolio, it still becomes difficult. If you just go out and try to buy one index or another index and try to layer them together without some better education or experience in this level, you may not be adequately representing the total amount of the market that you need to own in different asset classes.
You still have to apply that in there. I don’t want index funds to essentially just be like the same equivalent of well‑diversified. No, you probably shouldn’t have 100 percent of your money in S&P index fund. That’s really, really risky. That’s not a good idea.
If you are questioning what you’re owning and what you’re doing with it, one of the things you should be seeking is professional advice. Find that conductor in your life that can help make beautiful music of your retirement portfolio.
If that’s something that you would like help with and specifically with us, you can give us a call. Again, the number for the office is 609‑818‑0068. We’ll give you a complimentary consultation to come and do that.
In the first meeting, we want you to come in with any questions or concerns you have and actually bringing in some of your investments if you have questions about that. We’ll tell you why your oboe sounds out of tune [laughs] if that’s really what’s going on. By the way, I’m really laying in on the oboe players.
They are a different bunch. You’ve heard the instrument. It sounds a little weird. It’s this double‑reeded instrument. It’s not anything normal. I was a trumpet player when I was growing up. That made sense to me. The oboe? No sense. I don’t know why I want something buzzing wood inside of my mouth all the time, but that’s what those people do.
I could extend this analogy and really make the variable annuities the oboes of the world and really make my oboe‑playing friends not happy. Anyway, if you want to know why your specific investments are working or not working in that, you can definitely reach out to us to be able to learn why that is the case. We can help you understand that. It would be our pleasure to do so.
Couple of things that are coming up just in terms of wrapping up what we have going. First, new logo. Absolutely new logo coming in for the show. If you’d like to know more about that, you can go ahead and subscribe to the podcast. You’ll be able to see that. I’ll be in and around the neighborhoods giving different presentations.
I’ll be at the Pennington Presbyterian Church in Pennington, New Jersey, part of their older adult ministry giving a talk there on how to get your ducks in a row. I’m going to be in a Conversation of Your Life panel on April 16th.
That’s going to be held as part of some of the Mercer County stuff that they’ve got going on as well, so if you’d like to know how to get your affairs in order if you’re getting older. By the way, one of the things that we do for our clients ‑‑ so here is a great reason to become part of our client family ‑‑ is we’ve got a lunch‑and‑learn going on in our office April 29th.
One of the things that we’re going to do in addition to bringing in lunch is we’re going to be talking about how to plan for next year’s taxes. We’re going to try to give that advice to our clients ahead of time. They just filed on April 15th. What can we do to get ahead of the curve on this and be able to do that?
Then finally, we’ll want to start to announce this early, but we’re going to be holding an official open house welcoming us to our new home at 230 West Delaware in Pennington, New Jersey. That’s going to be on Saturday, May 11th.
It’s going to be a lot of fun, so you may want to put that on the calendar as a save‑the‑date. New logo, index versus mutual funds, how to check your pay stub, a really fun‑filled radio show with a ton of great information.
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Victor: If you like the show, one of the best things that you can do is share this information with a friend. Point them towards the radio show. Have them listen at 11 o’ clock on Wednesday mornings. Have them subscribe to the podcast. If you see the new logo, we’d love to hear what you think about that. All right?
This has been Make It Last, where we help you keep your legal ducks in a row and your financial nest egg secure. We’ll catch you next week. Bye‑bye.
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