Breaking Up is Never Easy – But is it Time?

The 5 and 7 Year Itches

One of my friends invests with Raymond James Financial. After reading about the merits of indexed investing, he’s going to ask his advisor what he thinks.

The advisor will suggest something like this:

“Look, index funds might be fine for part of the portfolio, but you need to adjust your risk. Plus, we can find funds that beat the indexes.”

One of the first things an advisor likes to assume is that the client doesn’t understand the concept of portfolio allocation. True, for most people, a portfolio with a 100% stock index would be risky—about as risky as having a portfolio with a handful of actively managed stock-based mutual funds.

But if the client understands “portfolio allocation”, the advisor will start to sweat…

At the investment seminars I’ve given, I’ve suggested that people keep things simple:

1. The U.S. market constitutes nearly half of the world’s total stock market valuation, so it should constitute nearly half of the stock market money in your portfolio.

2. The international market makes up the remainder of the world’s stock market capitalization, so it should constitute the remaining “equity” portion of a portfolio.

3. If the client is between the ages of 40 and 50 (and if they don’t have a pension) then they could take a page out of John Bogle’s book and have 40% to 50% of their portfolio in bonds. Respected professor, Burton Malkiel, suggests a similar bond allocation.

Just three funds would accomplish the task:

40% in a Vanguard bond index

30% in a Vanguard total stock market index

30% in a Vanguard international stock market index

People can argue the merits of whether the investor should have a higher U.S. representation, or a higher or lower bond representation or a real estate income trust component or even a precious metals component.

And that’s fine. There are loads of trains of thought to defend and attack the above position.

That said, it will be tough to find an educated investor (with a financial education) who will suggest that an advisor charging a wrap fee of at least 1%, and then buying actively managed funds for my friend, will come close to the returns of the above portfolio over a lengthy period of time.

My friend has his money in a taxable account, and this is where it will be even more costly for him to remain with Raymond James. Actively managed mutual funds are not very tax efficient, when held in taxable accounts. Index funds are tax efficient.

If the advisor is good and honest, and if my friend presents these arguments, then he’ll say to my friend: “You’re right. You really should change your account. I’m sorry. I really could have cost you tens of thousands of dollars over your investment lifetime.”

If my friend is curious to see how he would have done with the simple arrangement above, I’ve tracked the results of such an indexed portfolio.

He could do this, to make a comparison with his own portfolio. Look at where his portfolio value was 5 years ago, near the end of June, 2005 or the beginning of July, 2005. He could then look at his portfolio value today, and then subtract the contributions he has made to the portfolio over the past 5 years.

For instance, if his portfolio was worth $200,000 five years ago, and if he deposited $1000 a month, then we could look at his current portfolio value, subtract $60,000 in contributions, and see what his dollar gain had been. From there, regardless of what his value was, he could work out an overall gain or a loss.

If his account was $150,000 five years ago, and if it was worth $200,000 today, we would take today’s value ($200,000) subtract his monthly contributions (say, $60,000 total) and come up with a number amounting to $140,000. In this case, my friend would have lost money over the past five years. To find out the percent lost, you’d divide 140,000 by 150,000, to get .933. This means that his account would be 93.3% of what was deposited into it, for a loss of 6.7%

I’ll be honest. The picture probably won’t look pretty for any investor. The markets are lower today than they were five years ago. But he needs to have a look.

If he had invested in Vanguard indexes in 2005, as suggested above, and if he hadn’t changed a single thing about them (and hadn’t added fresh money) his $200,000 invested five years ago would be worth $204,806.79, for a total growth of 2.4%.

You can see the portfolio here, titled “5 Year Itch”

Portfolio: 5 Year Itch          
Date: 06/21/10 09:24 AM          
Ticker Company Name Cost Shares % of Total Current Value Gain / Loss Gain / Loss
VBMFX Vanguard Tot Bd;Inv $10.27 7,789.00 40.35% $82,641.29 $2,648.26 3.31%
VGTSX Vanguard Tot I Stk;Inv $12.60 4,761.00 31.22% $63,940.23 $3,951.63 6.59%
VTSMX Vanguard T Stk Idx;Inv $28.77 2,085.00 28.41% $58,192.35 ($1,793.10) -2.99%
        0.02% $32.92    
          $204,806.79 $4,806.79 2.40%

If he had invested in the same manner at the beginning of 2003 (my friend can do the same calculation from this date, if he wants) then his $200,000 would be worth $269,599 for a total gain of 34.78%.

You can see the portfolio here, titled “7 Year Itch”

Portfolio: 7 Year Itch          
Date: 06/21/10 09:23 AM          
Ticker Company Name Cost Shares % of Total Current Value Gain / Loss Gain / Loss
VBMFX Vanguard Tot Bd;Inv $10.38 7,600.00 29.91% $80,636.00 $1,748.00 2.22%
VGTSX Vanguard Tot I Stk;Inv $7.72 7,772.00 38.72% $104,377.96 $44,378.12 73.96%
VTSMX Vanguard T Stk Idx;Inv $20.07 2,989.00 30.95% $83,422.99 $23,433.76 39.06%
        0.42% $1,122.93    
          $269,559.88 $69,559.88 34.78%

If my friend has been lucky, his performance will be similar to the indexes. If he hasn’t been lucky, his portfolio will lag the indexed portfolio considerably.

If he wants to increase the odds of future success, he’ll index the entire account, with stocks and bonds, and he’ll use a Vanguard representative to help him set up his account with the above allocations.

Then he’ll do nothing but wait, and contribute fresh money.

If he wants professional tax advice, he’ll pay out of pocket for that, and save himself a bundle in the hidden fees (and the not so hidden fees) currently charged by his advisor.

Andrew Hallam

I’m a financial columnist for Canada’s national paper, The Globe and Mail, as well as for AssetBuilder, a financial service firm based in Texas. I’m also the author of Millionaire Teacher: The Nine Rules of Wealth You Should Have Learned in School and Millionaire Expat: How To Build Wealth Living Overseas. My mission is to educate, motivate and inspire people on basic retirement planning and best practices for investing, using evidence-based strategies. I'm happy to comment on your questions.

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8 Responses

  1. DIY Investor says:

    Nice analysis. It is obviously easy to pick funds that have beaten the market over any particular time frame. This is what a lot of advisors will do for you and charge a lot. The difficulty is in picking the funds that will do well going forward. After fees etc. you are trying to pick one of the 10 black balls out of a jar with 90 red balls.

    Smart money for retirement is in low fee. low turnover indexed funds. And the good part is that a lot of people can learn it themselves. The industry works hard at keeping the facts from people and it is playing havoc with their retirements!

  2. Hey Andrew,

    Great post! I am actually not currently invested in the US market at all; I have a decent chunk of my money in Canadian equities and the rest in international. Most of this is through my RRSP where I actually have limited choice in terms of funds, but I do get a company match. I avoided the US market due to reading a lot of Peter Schiff and the like, but should the Canadian dollar resume its upwards trend I might want to go into it at some point. Over the next two years I should be able to start building up an unregistered portfolio again 😉

  3. DIY Investor and Kevin,

    Thanks for the comments. Robert, I just received a card from John Bogle (who is likely one of your heroes as well) and he continues to "champion the cause" of encouraging lower fees in the fund industry. With some luck, I'll be able to hook up with him for lunch next summer. I narrowly missed seeing him this month. I arrived in the Valley Forge area a few days after he started his annual mountain retreat "working holiday". I don't think that guy ever rests. He's amazing.

    Kevin, the best thing about investing in the U.S. market (well, I think there are a few things) but one of them is the fact that 30% of the revenue going into those NYSE businesses is coming from overseas. With the world's globalization, there's so much more emphasis on a global market nowadays, rather than a specific market, like the U.S., the EAFE etc. If the U.S. dollar falls further, U.S. business earnings will increase because of it, because the 30% of international revenue going into NYSE businesses will reap higher EPS levels. I like to think that we can take advantage of some of that "dollar dropping" fear as well. When we buy Coke or JNJ, for example, we're buying businesses with quoted prices in U.S. dollars, but if, say, Coke's case volume remains the same, but the dollar slides, Coke's earnings per share will rise. If the public isn't aware that Coke is far more of an international than a U.S. company, then it will hammer Coke's price. That's when you walk in with those strong Canadian dollars of yours, to buy.

    Eventually, there's always a long term correlation between business earnings and business prices. It's the nice short term discrepancies that we can take advantage of—whether buying indexes or individual stocks, short term prices aren't very rational.

    But I have a feeling you know all this anyway. Perhaps other readers, I hope, are going to think about it.

    Thanks again for the contributions guys,


  4. Relating to the above post, we ran the numbers on my friend's Raymond James account. Here's the story:

    Five years ago he was with TIAA Cref–a fabulous non profit fund company servicing, mostly, people working in the educational field.

    A Raymond James rep suggested that he could do a lot better for my friend. And get this. The guy charges 1.75% annually as a wrap fee. My friend didn't know much, so of course, five years ago he switched from TIAA Cref to Raymond James.

    Anyway, I made a few comparisons. How would he have done if he left his money with TIAA Cref instead of switching, and how would he have done with Vanguard?

    His Vanguard results are in the post above: his 5 year return would have been just over 2%.

    His actual Raymond James account's return has been -17% over the past 5 years (as an overall drop) and if he stayed with TIAA Cref (and kept his money exactly as it was allocated 5 years ago) he would be down about 9%.

    Over the long haul, I don't think the TIAA Cref account would normally perform too far behind an indexed account, because their fees are low.

    But that Raymond James account is destined to be a loser, thanks to those high fees. I found that two of his funds had expense ratios combined with 12B1 fees that exceeded 3% annually. Then there was the 1.75% advisor's wrap fee on top of that.

    I'm never sure whether financial advisors like that are just mean, or unknowing. What do you guys think?

  5. Another great post Andrew! To answer your question, FAs maybe more unknowing or totally brainwashed, by the institutions they work for and products they push. I would never say a for-fee FA is like this. They're for-fee for a good reason 🙂

    Andrew and others – do you think long-term there is still a very strong upside in investing in the U.S. market? I'm not talking about holding JNJ, KO, PG or about a dozen others, I'm speaking of the market as a whole. I'm not convinced. I don't own XSP or another similar U.S. ETF. for a few reasons. I would need to be convinced.

    Your thoughts?

  6. Hey Financial Cents:

    One of the things I love about blogging is hearing different opinions on markets and strategies. For what it's worth, here's what I've done with my money.

    I have money in Canadian short term bonds, but other than that, I don't have any other Canadian exposure. You guys might think I'm completely nuts, but I don't own a single Canadian stock or a Canadian index.

    My largest position, by far, is in Berkshire Hathaway shares. So I sure hope the U.S. economy has plenty of long term upside. I've been a Berkshire bottom feeder for years—buying shares when thinks look bad, overall, and getting them cheap. You guys might think I'm really crazy for this, but when Buffett dies, the shares will go on sale and I'll buy more(even a 25% discount would mean that you'd get the insurance business for free, because at 25% off, it would be selling at less than book value)

    What do you guys think about the U.S. economy, as it relates to buying U.S. stocks as long term holders. Do you guys think I'm a wacko? I don't mind if you do!



  7. Mich @BTI says:

    Hi Andrew,

    Nothing is wrong with your approach regarding US equities, you have a plan and you are executing it as you see fit. My situation is the opposite of yours in terms of Canadian holdings, i am currently holding 100% Canadian equity as you can see from my portfolio.

    IMO, because i am invested in the energy sector i already have exposure to all the economies out there (demand for oil) with the safety and the stability of Canada. I don't have to invest in a Chinese company in order to get a piece of the growth in China, by growing they will consume more oil and result in higher profits to the Canadian oil producer.

    That is not to say that investing in companies overseas is not lucrative. For me it comes down to not having enough time to research everything so i concentrate on 1 sector that offers me exposure to multiple economies. After all he who wishes to hold everything ends up holding nothing.



  8. Hey Mich,

    I never thought about how investing in the energy sector is like investing in the world, but I think you're right.

    In a similar vein, I see investing in American businesses like investing in the world as well. As developing markets grow, they seem to have an insatiable thirst for our name brand products—or at least Western name brand products. This is one of the reasons I think the U.S. market has some amazing wheels beneath it.

    Very interesting point about investing in the Canadian oil industry. I think you're right!

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