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Educate Yourself

There is a world of investment knowledge out there.  Knowing some of the basics is crucial to your success.  I’m not going to pretend to know all of it, not even close!  However, I do know a thing or two!  This post isn’t meant to give a crash course in how to invest.  There is a plethora of information at our fingertips.  As an advisor and former stockbroker, it used to be that we had the most current information available through our quote terminals and research departments.  That’s not the case anymore.  Now it’s information overload.  If anything, it can be paralysis by analysis.  For every pro we read about there is a con.  For every pundit who says the market will go up there’s one who says to bury canned food and ammo in your backyard.  Rather than getting someone into the next big thing (how the industry used to be), I view my role as helping folks not shoot themselves in the foot, make good financial decisions, and wade through the clutter of the information.

Knowing risks involved is rule #1.  In previous posts and just in general, we know the US stock market has historically gone up in the long run.  But, stocks are still considered an aggressive investment.   If you are investing in aggressive instruments, make sure you can weather the ups and downs.  As of this writing we’ve experienced a 5% pullback in the Nasdaq 100 Index in the span of roughly 2 weeks.  That’s manageable.  What if it continues to fall until your $100k becomes $80k?  Can you handle that?  You should also ask yourself what the purpose of the investment is.  Are you saving for a house, new, car, retirement, or are you just hoping to hit it big by choosing the next Amazon or Microsoft?  If it’s a certain goal and the market suddenly pulls back, you may need to postpone that purchase.  A good rule of thumb Ilike is to have 3-6 months’ worth of expenses sitting in a money market.  Beyond that, I’d suggest keeping anything you plan on spending within the next 2-3 years in something secure.

The second thing I implore people to think about is whether they want to hire a professional to help them.  Like I mentioned, all the information and more is available at your fingertips.  But, if it’s not in your wheelhouse or you find yourself stuck, maybe you need to seek professional help.  If you do, interview different advisers.  Treat them like a trade’s person: get three quotes.  See who you like the best and check their history at brokercheck.com for complaints and work history.  See if their clientele is similar to you.  If you’re high net worth, do you want to work with someone whose average account size it $20k?  I think working with a fiduciary is important.  It’s one of the reasons I set up my shop, so I could be held to a legal standard as a fiduciary.  A fiduciary has the legal obligation to put client interest ahead of their own.  Financial advisors who aren’t fiduciaries must follow a suitability standard.  This means they must only sell products which they believe will suit the client.  Generally speaking, fiduciary advisors cannot or don’t charge transaction fees or commissions.  You pay them a flat fee for service either as a percentage of assets under management or an hourly rate.


Paying someone a percentage of assets may cost a lot, say 1%.  On a $1,000,000 portfolio that’s $10k per year.  Look at the alternative though.  A non-fiduciary will likely charge commissions and/or use expensive mutual funds.  With a fiduciary using exchange traded funds or low cost funds you might be looking at 0.15% in underlying fees.  A financial advisor using the suitability method might use similar investments except that the funds charge a higher annual fee and, in many cases, an upfront sales charge between 1%-5.75%.  In addition, the underlying fees are generally much higher than 0.15%, likely closer to 0.6% and higher.  This is a drag on performance.  If you just want an advisor to run transactions this MAY be a better way to go, but usually clients want more.  Remember, we have everything we need at our fingertips.  Investors can run trades on their own at a far lower cost.


One of the dirty secrets of financial services is that non fee-based advisors tend to gravitate toward products that generate the highest commissions.  Advisors aren’t going to make much money charging a few hundred bucks in commissions to execute a stock trade.  Plus, it’s really hard to diversify by buying individual stocks.  As an advisor just using a suitability method, they’re going to make a lot more money charging 5.75% up front coupled with ongoing revenue from mutual funds.  The other product that you’ll catch these advisers selling are variable annuities. 

These are heavily sold by commission sales people.  If you go to one of your strip mall investment shops, they will undoubtedly try to sell you on one of these.  I’ve reviewed countless portfolios that have these in them, and it’s always a head-scratcher.  Well, not really.  It’s evident that the advisor was trying to make a few bucks.  Advisors get paid handsome commissions and they have annual ongoing fees of 2% plus and backend sales charge if you sell before a certain number of years.  Anything with high fees I don’t like.  In my previous life I inherited a book of business from a retiring broker.  Many clients had variable annuity products with a “5% guaranteed rate of return” with a potential for market performance.

5% guaranteed minimum with market-like upside sounds great!  There’s a huge catch though.  The way these things work is that there are two sets of values, the cashout value (CV) and the guaranteed minimum withdrawal benefit (GMWB).  The CV is the actual value of your investments, or the amount you can withdraw as a lump sum.  The GMWB is the higher of a 5% return or your CV.  The GMWB can only be paid out in installments of 5% of the value after a certain time period or starting at a certain age, usually 10 years or age 65.  That means if you’ve accumulated $100k you’d get $5000 per year.  Conversely, if you invested $100k at age 55 and got 5% each year until age 65 when you were going to withdraw, it would look like this:

Starting Value: $100k

GMWB Value after 10 years: $162,889

Annual payment for the rest of your life: 5% X $162,899= $8,144.95

 

Can anyone honestly say that they know for certain $8,145 per year in 10 years is still what they want to do?  No, they can’t.  Also, $100k is a lot of money.  Will $8,145 per year make that big of a difference in your retirement?  I doubt it.


If you’re following along closely, you should be asking “what about the market rates of return; markets over the long term typically do better than 5%?”   It may be anecdotal, but not one single annuity I inherited from the retiring representative had a cashout value higher than the GMWB. I had about 20 of these and each had been held for 8 years or more.  The problem is the fees.  Looking at an old statement, the underlying investments charges were around 0.7%, the annual contract fee was 1.4%, there was another 0.3% as a rider fee, and there was a $30 annual fee.  It’s hard to beat the market when you are paying 2.5% in annual fees!  In this specific case the annuity was purchased in 2004 for roughly $51k.  It was invested moderately the entire time and is now worth $67k.  That’s a 1.37% annual rate of return over that timeframe.  For comparison, the Vanguard Wellesley Income fund (VWIAX) which is similarly invested had a 6.37% return since 2001.  To be fair there are a few things that could impact this: ongoing contributions, a 3 year difference in time frames… But a 4% annual rate difference over 20+ years…?  Again, this might be anecdotal, but this was a common theme when looking at annuity statements.


When you get pitched one of these products they sound too good to be true, much like a time share.  Even many advisors who sell these don’t truly understand how they work other than the slide deck they’ve reviewed prior to your meeting.  The bottom line is that when the word “guarantee” makes an appearance, you’re paying for it somehow.  Annuities are hybrid insurance products.  Insurance is also known as risk transfer.  To transfer that risk there is a big cost.  Insurance companies know this.  It’s why they are profitable, and massive.  They know that if they focus on long term returns they will generate more than enough to cover any claim.  This is what you should do, focus on long term returns.   What can you do instead of a variable annuity?  Buy bonds!


You could have a lower cost diversified portfolio, like the Vanguard Wellington, and historically do much better due to the lower costs.  Sure you will experience the fluctuation and could lose money.  As long as you focus on the long term everything should work out just fine.  However, I see it time after time where people bring in statements ant they have $20k sitting in an annuity doing nothing and it’s not going to have a material impact on their future anyway.


To be clear, I’m only talking about variable annuities here.  Fixed annuities may fill a spot in your portfolio for guaranteed income.  Those are simple, you pay a lump sum up front for a guaranteed income stream the rest of your life.  The last type of annuity you might run across is an index annuity.  The jury is still out (by me) whether these are worth it.  They are complicated products with a lot of fine print which always makes me nervous.  But, they do offer a compelling case.

Let’s reel it back in.  I really went on an annuity tangent here which covers a lot.  My first suggestion to educate yourself was to know the risks and invest for different goals accordingly.  Number 2 is to hire a professional if you need the help.  But that dovetails into a third point which is to have your interests aligned and know how your advisor gets paid.  Then #4 is steer clear of variable annuities.  In my opinion there is no reason to use them, ever.  There’s so much more to get into regarding investment education, but I think these basics are a good starting spot.  If you agree or disagree or would like my opinion on other things, send me a note to jon@jzwealth.net.  When I was a kid I loved the cartoon “GI Joe”.  At the end of each episode they had some sort of public service announcement where the kid would say “Now I know.” The soldier would reply “and knowing is half the battle.”

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