Before you turn your savings over to a financial adviser or broker, you should have a clear understanding of his or her investment strategy. Here are seven questions you should ask your money manager.
1. What’s our plan? Most investors don’t have an investing plan. Without goals, it’s difficult to assess investment options. For most investors, the plan is straightforward: You want to accumulate enough money so that you can maintain your standard of living for as long as you live. If you have a spouse or partner, you probably want the same result for them. Ask your broker how he or she intends to meet that goal.
2. Why am I invested in actively managed funds? The majority of actively managed funds underperform their benchmark indexes each year. Over a ten year period, less than 5 percent of them equal or beat their benchmark returns. You would be far better off in a globally diversified portfolio of low-cost index funds in an asset allocation appropriate for you.
3. What’s the risk of my portfolio? Risk is measured by standard deviation, which measures the volatility of your portfolio. If your broker doesn’t know the risk of your portfolio, find an adviser who does. If you don’t know the risk of your portfolio, you have no business investing.
4. Can you predict the future? The only truthful answer is no. Ask your broker why you should consider his views on the direction of the stock market and the effect of current events on the stock market. Find out his views about what the price of a given stock will be in the future and his recommendation for the next hot mutual fund manager. All of these opinions involve the ability to predict tomorrow’s news. If his answer is yes, you know you have a big problem.
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5. What is the after-tax return of my mutual funds? Actively managed funds report pre-tax returns. However, they are very tax inefficient (compared to index funds) because of the higher turnover of their portfolios, resulting in increased tax liability to their shareholders. Your concern should be your after-tax returns. That’s all that matters to you.
6. Why am I holding individual stocks? Holding individual stocks can expose you to up to twice the risk of holding the index. Individual stocks have risks unique to them (like the death of the founder) which can be reduced or eliminated through diversification. You would be better off owning the index than concentrating your risk in any individual stock.
7. Why am I holding individual bonds? The same reasoning applies to bonds, with even greater force. Diversification reduces the default risk of holding individual bonds, by reducing risks unique to those bonds. You and your broker are not as skilled as a professional bond manager, who is responsible for managing a portfolio of billions of dollars of bonds. Costs and fees will be significantly reduced by owning a bond index fund. Actively managed bond funds, on the other hand, have an even worse record than actively managed stock funds.
Dan Solin is a senior vice president of Index Funds Advisors. He is the author of the New York Times best sellers The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, and The Smartest Retirement Book You'll Ever Read. His new book, The Smartest Portfolio You'll Ever Own, will be released in September, 2011.