The Five Rules of Investing Success

 2. Commissions and Inflation Matter

A recent study by finance expert Larry Swedroe determined that the expense of actively managed mutual funds which are the bulk of mutual funds (active managers attempt to buy and sell the right stocks at the right time) can be as high as 5 percent or more per year.  These often hidden costs come from operating expenses, cost of cash, commissions, market impact costs and taxes.

An annual drag of 5 percent or more on a portfolio’s performance coupled with an annual inflation rate of at least 3 percent as measured by the Consumer Price Index means that there is very little in most portfolios that is actually growing.

The situation gets far worse with insurance-based products such as annuities or variable life products (“cash value life insurance”) when you consider the fact that these fees are usually coupled with very high surrender penalties.  These surrender charges exist largely to fund the high commissions paid to the advisers.   Insurance products generally make for good insurance, not investments.

3.  Taxes Matter

In addition to typical high fees, actively managed funds often have very high turnover rates.  Indeed, a typical actively managed fund turns over more than once a year.  That means, hypothetically, if you purchase a fund on January 1, it is likely to have sold every stock in its fund by September or October of the very same year.  This turnover increases the transaction costs, the market impact costs, and just as importantly for nonqualified accounts, the taxes paid on any capital gains.  This is especially challenging with short-term capital gains taxed at higher ordinary income rates. Taxes can be a major drag on a portfolio’s performance.

The situation is made even worse with annuities which convert favorable long-term capital gains tax rates into higher ordinary income rates.  Despite this obvious shortcoming of annuities, these tax-nasty vehicles are actually sold to the investing public as tax-favored vehicles due to their tax deferral features.  Tax deferral can be accomplished at no cost to the investor by way of various provisions of the tax code (e.g., IRA, 401(k), 403(b))

4. Use passive investing

    Actively managed funds usually have very high fees or loads.  Another word for load is commission.  You can spot an actively managed fund by the letters A, B, C, and so on (e.g., “A Shares”).  These letters describe the commission that you pay and when you pay it.

    The opposite of active management is passive.  Passive management seeks to diversify within and among asset classes as opposed to picking the right stocks and the right time.  Passive management by its very nature has extremely low turnover; indeed, in some cases it takes decades to turn over a passively managed fund.  Lower turnover means lower costs.  Indeed, if your adviser has access to institutional as opposed to retail funds, the outlook is even better, as the cost of the funds gets reduced even further.  The more you save in costs, the more you make in portfolio returns.

    5. Carefully Choose your Adviser

    The vast majority of investment advisers are stockbrokers or insurance agents; some are also known as fee-based advisers.   These various brokers usually receive commissions for transactions (buying or selling securities, funds or insurance products).  Transactions generate fees, not performance.  Fee-based advisers receive both fees and commissions. The challenge with commissions, beyond the fact that they are generally high, is that they create unnecessary conflicts of interest between the investor and the broker.  Additionally, brokers are not registered with the Securities Exchange Commission (SEC), and their obligation to the investment public is one of only “suitability” standards, slightly greater than caveat emptor, or buyer beware.  The relationship is said to be commercial in nature.

    Fee-only advisers can have no conflicts of interest and cannot accept commissions.  As such, in constructing their portfolios, they usually utilize no-load mutual funds, which are often institutionally based and not retail.  Theirs is a fiduciary (highest duty recognized in law) and not a commercial (buyer beware) relationship with their clients.  Fee-only advisers have a duty to provide the optimal investment solution at the lowest possible cost.  Their fee comes from the value of the underlying assets under management and not a load or commission from a transaction.  Only if you do well, does the fee-only adviser do well.

    Stephen L. Hicks, JD, MS, AIF® and Roger L. Millbrook, JD, CPA/PFS, are fee-only fiduciary investment advisers and principals at Siena Capital Management, LLC., in Grand Ledge.   Both hold law degrees as well as other advanced degrees and designations in the area of financial services.  Previously, Hicks was one of five advisers on a nearly one billion dollar fund outside of Chicago.









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