“Recession” … its a word that strikes fear in the hearts of investors both young and old.

Generally, when a recession hits, you know what you’re in for. The stock market tanks, your 401(k) loses value, businesses you know and love close, and major media is in a frenzy every day about the latest financial disaster to strike.

The NBER (National Bureau of Economic Research) defines a recession as “a significant decline in economic activity spread across the economy, lasting more than two quarters which is 6 months, normally visible in real gross domestic product (GDP), real income, employment, industrial production, and wholesale-retail sales. To date, there have been 47 recessions in the United States since the Articles of Confederation (1777).

While falling stocks and market turbulence can leave you uneasy about the security of your nest egg, the truth is: As an investor, you haven’t lived until you’ve navigated your way through a recession.

Anyone can invest during the good times. You throw money into your 401(k), it goes up, and everyone is happy! Nothing to it.

However, the part about investing that everyone forgets about is that with “reward” also comes “risk”. And when a recession hits, you know exactly what “risk” they were talking about.

When a recession hits, you need to adjust your mindset so that you don’t do anything irrational. You also need to remember that they are a perfectly natural part of our cyclical economy. Recessions are only temporary and generally only last for approximately 11 months.

Truth be told, if you keep these points in mind and act strategically, you can make the most out of a recession by buying the right kinds of assets. Here’s how to invest during a recession and treat it less like a hindrance and more like an opportunity.

Buy More Stocks

Before we can start making money during a recession, we need to first ensure that you’re not going to lose any money by doing something rash. Therefore, start by doing this.

Don’t Sell Your Current Stocks or Stock Funds

One of the worst things you can do during a recession is to sell any stocks or funds containing stocks. It can be incredibly tempting since it will feel like that’s the only way to prevent you from losing money. But I’ll urge you – don’t do it! Here’s why:

Think about the old investment mantra “buy low, sell high”. During a recession, the value of your stocks will most likely be depressed. So selling them will only make you “lock-in” to those low prices. We don’t want to do that.

Instead, leave your current allocation of stocks right where its at, and take these actions instead.

Invest New Money Into More Stocks

If there’s anything you do want to do during a recession, its to take advantage of those low stock prices and buy up as many good opportunities as possible.

The easiest way to do this will be to take your monthly automatic retirement plan contributions and increase your future stock allocations. For example, if your portfolio was 60% stocks and 40% bonds, change it to 80% stocks and 20% bonds. That way, you’ll be buying up even more low-priced securities than you normally would.

Increase Your Contribution Level Altogether

In fact, if you’ve got any money to spare, now would be a wonderful time to increase your contribution level altogether. Let’s say you’re contributing 10 percent to your 401(k). How about bumping that up to 15 percent?

Again, I know it will feel counter-intuitive. But think about how that would work. All the new money you’d be investing could be used to scoop up even more stocks at their temporarily discounted prices. As time goes on and the shares start to go back up in value, you’ll have even more of them than you would have had if you hadn’t increased your contribution level.

Re-balance Bonds and Cash in the Stocks

Okay, so I said to leave your stock allocation right where it’s at. By that, I mean don’t sell any of your stock funds. But that doesn’t mean you can’t sell some of your funds that are doing okay and then use the money to buy more stocks.

I’m talking about rebalancing your portfolio. Rebalancing is a simple practice where you reset the percentages of your stocks and bonds. Effectively, it takes money from the winning assets and use it to buy shares of the assets that have lost money. Even though that can seem counterintuitive, its a very healthy and effective way to force yourself to take advantage of the low asset prices.

Generally during a recession, bonds and even cash investments will tend to go up while the stocks go down. So if you re-balance, you’d be effectively locking into these increased prices (… the “sell high” part of the mantra from earlier …).

Stop Checking Your Portfolio

The greatest threat of sabotage to your investment portfolio is your own psyche. The best thing you can do to curb it during a recession is to just stop checking on your portfolio. Don’t look at how much its gone down because all this will do is to cause you to worry, panic, and probably do something that you’ll wish later you hadn’t.

Instead, disconnect yourself from daily market slides and bad news, and just to hold tight. Ride out the storm and wait for the storm to pass. It always does eventually.

Invest in Dividend Stocks

If its good opportunities you’re looking for when it comes to investing during a recession, then you need not look any further than dividend stocks.

Dividend stocks are the shares of companies that pay their owners a dividend or cut of the profits every quarter. In other words, for simply owning the stock, you’ll receive a payment. Dividend yields are typically anywhere from 1 to 4 percent annually with some paying even more.

Why Dividend Stocks are Good Deal

In addition to receiving quarterly payments whether the stock value goes up or down, there’s a lot to love about buying up dividend stocks during a recession.

Just like we talked about in the last section, anytime a reputable company’s share price is down due to the markets, its a good time to swoop in and buy as many shares for a bargain as possible. Dividend stocks are certainly no exception. In fact, every share that you purchase entitles you to more dividend payments, so the more the better!

Also, most companies that can pay out dividends are generally able to do so because they are making profits and have solid financials. Overall, that will help ensure that the company stays strong and will not be too adversely affected by the temporary market downturn. Together, this will give you confidence that the share price will eventually go back up and produce more capital gains.

Just be careful of companies that might try to inflate their dividend yield just to make themselves look more attractive. Usually, strategies like this are not sustainable and the company will either cut their dividend payments by the next quarter or run themselves deeper into financial issues.

Where to Find Good Dividend Stocks

Great dividend-paying stocks are not to hard to find. There are two go-to places to find them: The Dividend Aristocrats and Dogs of the Dow.

The Dividend Aristocrats are an elite group of companies who have not reduced their dividend payout in over 25 consecutive years. If you’re looking for safety and security knowing that the company will continue to pay its shareholders through thick and thin, then this a good list to comb through.

You might wish to buy the individual stocks of some or all of these companies yourself. Or, alternatively, you could make life easy and buy all of them at once by simply picking up the ProShares S&P 500 Dividend Aristocrats ETF from your favorite discount broker.

The Dogs of the Dow are the ten companies in the Dow Jones Industrial Index that have the highest dividend yield. The strategy behind picking these ones is that because their dividend yield is so high, it means that the current stock price does not reflect where the company believes it will be financially in the near future, and could potentially be a good deal. Within this group of ten companies is a subgroup called the “small dogs” where only the top five are considered.

There are some mutual funds and ETFs that invest in the Dogs of the Dow, but none of them are 100% all dogs. Since there are only ten stocks, it may be easier to just work with a discount broker and buy the individual stocks yourself.

Consider Real Estate

Stocks aren’t the only asset that usually goes down in value during a recession. Often times real estate can also become depressed during tough economic times. With the threat of job security, reduced net worth, and likely no increase in salary, many people stop looking for houses or simply let their house fall into foreclosure altogether.

While those situations are certainly tough for those people, it does create some lucrative investment opportunities for others with financial security. Here are a few strategies you may want to consider.

Upgrade Your Primary Home

Though it’s debatable if your home should be considered an investment, it’s without a doubt an asset. It’s something that has value when you buy and (hopefully) more valuable when you sell it one day.

Of course, not all homes appreciate at the same rate. For example, if you’re in a neighbordhood thats not as desireable as other ones, you might only notice your home increasing in value by a few thousand dollars per year. By taking advantage of the recession, you could leverage the depressed home prices as a chance to upgrade to a more prestigous home or area. Then you might see your home value increase more rapidly.

Consider Rental Properties

Ever thought about becoming a landlord as a side hustle? A recession is the perfect time to find a great deal on your first rental property.

Start by looking for single-family homes in your area where you’re familiar with the community and home prices. If you see an opportunity to buy a house at a depressed price, then start looking into what landlords in the area charge for rent. Put together a business case and see if it would be a profitable venture.

If you’re feeling very adventurous, you could always look for properties that are outside your town and in areas where you know there is a high potential for tenants or even Airbnb guests. For example, buying homes or condos in college towns or vacation destinations might help always keep your property in high demand.

Buy REITs

If buying real estate seems exciting but you’d rather not mess around with physical property, then you can still get in on the action by buying into a REIT.

REITs (real estate investment trusts) are companies that operate similar to mutual funds and ETFs where groups of investors pool their money together to finance various forms of real estate. These are generally much larger scale projects such as office buildings, medical facilities, warehouses, etc.

Other than being able to invest in real estate, the big attraction to investing in a REIT is that they produce relatively high dividend yields. REITs are required to payout at least 90 percent of their taxable income to shareholders.  Many go so far as to payout 100 percent. This means that similar to dividend stocks there is some assure that you’ll regularly be receiving payments, even during the market turbulance.

Just like stocks, there are good and bad REITs. Be sure to always do your homework upfront and only invest in reputable ones with solid financial track records.

Build Up Your Emergency Fund

If the thought of sinking your money into anything related to stocks or real estate just sounds too risky, then there’s still one more thing you can do that will be incredibly valuable: Build up your emergency fund.

Most financial gurus out there agree that your emergency fund should be a cash-only account consisting of at least 3 to 6 months worth of living expenses. The idea is that in case something unforeseeable happens (… like a worldwide pandemic …) and you were to be out of a job for several months, you’d have a financial cushion to fall back on.

While most people know this is a good idea, they rarely ever actually do this. The thought of having that much money just sitting there inside a cash account earning less than 1 percent interest seems ridicoulous. However, I take a different persepctive.

You should think of your emergency fund as a self-made insurance policy rather than an investment. If the worst were to happen and you didn’t have an emergency fund, what would you do? Rack up your credit cards and take out personal loans at crazy high interest rates? Raid your 401(k) and destroy years of saving for retirement plus sabatoge all future compound returns? Or worse – miss your mortgage or utlitliy payments and get kicked out of your home?

With an emergency fund, you prevent all of that. That’s why its important to see it for what it is and all the financial burden it can save you if you take the time to build a sizeable cushion.

Plus, who knows … Our tolerances for risk and attitudes toward investing change and evolve just like every other part of our human psyche. If you spend the time now to build up a decent emergency fund, perhaps when the next recession hits (and yes there will be another one some day), you’ll be ready to swoop in and buy up those securities at a bargain!

Photo credits: Unsplash

The post How to Invest During a Recession and Actually Make More Money appeared first on My Money Design.

Recently while rolling over my old 401(k) to an IRA with Vanguard, I had to make a very big decision as to which way I wanted to go.  I could stick with their low cost mutual funds which I was very familiar with.  Or I had the option to pick commission free ETF’s.

Having six figures of retirement savings, this was in no way a decision to be taken lightly! Choosing the right type of funds could mean saving myself thousands and thousands of dollars in unwanted expenses or trouble later on when I’m ready to start making withdraws from my funds.

I’ve been an investor in mutual funds for over a decade now.  But ETF’s were interesting to me.  They seem to always be on the cover of every financial magazine, and lots of people in the early retirement forums always talk about having them in their portfolio.

Ultimately, between the ETF and mutual fund, which one did I pick to go with?  I chose to go with mutual funds. And here’s why.

In this post, I will explain some of the research I did, some of the pros and cons of both, and why I decided that mutual funds would be a better fit for me.

What Are Mutual Funds and ETFs?

I’m sure everyone reading this blog already somewhat understands what a mutual fund is.  A mutual fund is a collection of various stocks, bonds, and sometimes other assets all rolled into one financial product that you buy from a financial company (like Vanguard or Fidelity).  They can be actively managed or passive – meaning they are either managed by a fund investor manager or simply modeled after a standard index fund.

ETF’s, on the other hand, are more like the new kid on the old financial block.  Even though not as many people tend to invest in them as mutual funds, they are all the rage with new investors.  Since being introduced in the early 2000’s, the ETF market is expected to expand by as much as 15 to 30% over the next few years.

The term ETF is short for “exchange traded fund”.  You can think of an ETF as being very similar to a mutual fund. They, too, are also a collection of different stocks, bonds, and other financial products. The major difference is that an ETF trades like a stock.  It’s value fluctuates all day long, and so they can be purchased and sold at different prices throughout the open market.  Mutual funds, on the other hand, only change value and are traded once per day (at the end of the day).

So Which is Better – An ETF or Mutual Fund?

Like I mentioned, I ultimately decided to go with mutual funds.  Though ETF’s were very enticing, there were three main reasons why I liked mutual funds better.

1. Historical Data:

My first reasons is experience. Mutual funds have been around for almost 100 years; almost as long as stocks themselves. Some of the funds that Vanguard offers have been around since the time of the Great Depression. Their fund managers, investment practices, processes, and experience date back for decades.

More importantly, there’s oodles of data to prove it.  Since I am a long term investor and often filter out short term noise and market fluctuations, I tend to prefer stocks that have well over 10 years of data that I can look back at and compare against market indices.

ETFs, on the other hand, are a relatively new type of investment. Although things seem to be going well for them both now and for the foreseeable future, it remains unclear whether they will stand the test of time. Though they may have survived the past two recent recessions, there is no historical data necessarily to back up whether or not that particular ETF will perform well given 20, 30, 50, or even 100 years of market turbulence.

It’s like when something goes wrong in your office, and you have to decide whether you want to ask for help from the new hot-shot who just started last year, or the guy with a few grey hairs that’s been around for the last 20 years. Though both may have good ideas, when it comes to putting my money where my mouth is, I’m going to pick experience every time!

2. Bid-Ask Spread:

Secondly, with ETF’s, there’s a matter of something called the bid–ask spread.

The ETF bid–ask spread is the difference between the price you’re willing to sell at and what someone is willing to buy it for.

Even though by itself an ETF has a certain value due to the stocks and bonds it represents (something called NAV or net asset value), that still alone doesn’t justify what someone is willing to pay you for the ETF.  In reality, buyers could offer you a lot less.

This could be a problem with some ETF’s. Suppose you decide to invest in an actively managed ETF and market falls out of favor with the assets it represents.  You may end up having to sell your investment at a discount and not getting your full value.

With mutual funds, this is not a problem. Mutual funds are tallied up at the end of the day when the markets close. So in essence investors never really feel the same sort of pressures as they would with stocks or ETF’s of selling at a discount.

3. Expenses and Commissions:

Finally, the last thing to consider between mutual funds and ETF’s are the expense ratios and commissions.
Unlike with mutual funds, ETF’s charge a commission every time you buy and sell them (just like a stock).  Thankfully, with my Vanguard account, because of the number of investments I already have, it appears that if I did want to buy ETF’s they would be commission free.

One place where ETF’s are making an absolute killing and why they are so popular is their extremely low expense ratios. On average, their expense ratios can be lower than 0.1%. Compare that to the average mutual fund expense of 1.0% and that is a humongous chunk of savings that will result in a portfolio of thousands and thousands more dollars over time.

Again, with my situation and using Vanguard, the issue of expense ratios really isn’t much of an issue at all.  Of the six or so mutual funds I selected for my IRA rollover portfolio, the average annual expense ratio was 0.2%. If we were to do the math on that difference of 0.1% in expenses and compound my losses over the next 10 years before I plan to make an early retirement, that works out to just about $6,000. When we’re talking about six-figure 401(k)’s, that’s not really a ton of money to make much of a difference.

Conclusions

Do I think ETF’s can be a good products? Absolutely!  Their low cost approach and index-like models make them very strong contenders to be wonderful financial products in the future.

But do I want to gamble my entire retirement savings on them?  Sorry.  I’m going to stick with tried-and-true mutual funds and go with what I know works well.

I’m sure that given enough time, I may start to dabble in ETF’s and integrate them more into my different retirement savings funds. But for now, when it comes to mutual funds versus ETF’s, I’m going to stick with what I know and understand the best.

Readers – when it comes to choosing between an ETF vs mutual fund, which one do you prefer? What have been your pros and cons with using either?

Images courtesy of Andreas Poike | Flickr and Daniel Oines | Flickr

The post ETF vs Mutual Fund – Why My Money is with Mutual Funds appeared first on My Money Design.

If passive index funds are the way to go, then why does anyone invest in actively managed funds at all?

That was the question I received when I was trying to help someone pick some mutual funds for their 401(k) plan.  It’s definitely a good one to ask!

Over the years, a seemingly growing number of academics and financial bloggers have really been showing their love for investing with passively managed index funds (myself included).  With all the major advantages and benefits they point out, it sure seems like a no-brainer that this is the way to go.

Yet, when you take a closer look at where the money is actually going, it may surprise you to learn that the numbers paint quite a different story.

In the US, some $9.8 trillion in assets sit with actively managed funds.  How much are with passively managed funds?  Only $4.2 trillion.  This means that as a whole, 70% of all US investments are held in active funds.

As someone who personally believes in index fund investing and holds most of his retirement portfolio in passive funds, I have to ask the question: What’s going on here?  Do active fund investors know something that the rest of us don’t?  Is there something that passive fund enthusiasts are missing?

Or is there more to it than we know?  Could people be pouring their money into active funds and not even know it?

Let’s explore the facts from both sides of the passive vs active fund debate and see what we can learn from all of this.

First – Why Has Investing In Passive Index Funds Become So Popular?

I think it’s appropriate to begin any conversation about index fund investing with the man who popularized the idea: John (Jack) Bogle.

In 1974, Bogle started the company The Vanguard Group and offered the first index fund publicly available.  At the time, it was called “Un-American” and nick-named “Bogle’s folly”.  But eventually, things caught on.  Vanguard is now the world’s largest provider of mutual funds.  There is even a cult-following of financial enthusiasts who call themselves the BogleHeads.

Bogle’s Philosophy

The rationale behind investing in index funds can best be summed up from something said by Jack Bogle during his speech at “The World Money Show” back in 2005:

“Most people think they can find managers who can outperform, but most people are wrong.  I will say that 85 percent to 90 percent of managers fail to match their benchmarks.  Because managers have fees and incur transaction costs, you know that in the aggregate they are deleting value. The investment business is a giant scam.”

Wow, those are some pretty strong claims!  Let’s break this down into a few key take-aways:

“85 percent to 90 percent of managers fail to match their benchmarks.”

In other words, professional money managers whose sole job it is every day to understand the finances of the companies they pick and invest our money in can’t out-smart the market.

Furthermore, if you read between the lines of this statement, what Bogle is basically saying is that if the pros can’t even pick the right investments, then how can we ever expect to do so?

We can’t.  And neither can most pros.

Therefore, we could all expect to save ourselves a lot of time, trouble, and effort if we just invested in an index fund instead.

“Because managers have fees and incur transaction costs, you know that in the aggregate they are deleting value.”

It is certainly true that active funds cost more than passive ones.  According to an article from The Balance:

• The average Large-Cap Stock Fund costs 1.25%
• The average S&P 500 Index Funds is priced at just 0.15%.

(… Actually, the Vanguard 500 Index Fund Admiral Shares offers the lowest known expense ratio of just 0.04% (if you invest $10,000 or more).  That’s literally only $4 in cost for every $10,000 you have invested!)

So what’s the big deal with fees?

0.04 and 1.25% may not sound like two numbers with a big difference.  But when you look at how they can compound and impact your earnings over time, the results are HUGE – as in six-figures HUGE!

Just doing a simple projection of $10,000 per year invested for 30 years with 7% average returns, you can easily determine how much you’d lose to fees: A difference of $181,963 to be exact … Yikes!

Why are active fund fees so much higher?

Because paying someone (or group) to “actively” manage a fund costs more.  You’ve got salaries on top of more overhead with trading costs, research, analysts, and so on.

Right or wrong, at the end of the day, this just means more money coming out of your pocket!

So in summary, Bogle feels you’re getting hit from both ends.  Not only are you not making as much at the top with the kind of returns that passive funds produce over the long term, you’re also getting chopped down from the bottom with higher fees.  He paints the picture as pretty much a lose-lose situation.

So if Bogle’s statement is true, then why do SO MANY people still invest with actively managed funds?

401(k)’s Are Littered with Actively Managed Funds

Do you have a 401(k)?

If you do, go to the section where you pick your investments and tell me what you see?

If you said “a whole bunch of actively managed funds”, then I’m afraid you’re not alone.

In my own employer’s 401(k) through Fidelity, we have 57 funds we can choose from.  Only 4 of them are passive.

I’ve heard this same complaint from many different people across the Internet.  In some cases, their plans offer NO passive funds at all.

Is This a Coincidence?

I don’t think so – not by any means!

The total size of retirement assets in the US was $25.3 trillion at the end of 2016.  This works out to 34 percent of all household financial assets in the United States.

Defined benefit plans such as 401(k)’s work out to $7.0 trillion of this pie.  If the average actively managed fund charges just a 1% fee per year, this works out to $70 billion in revenue annually.

1% might even be putting it lightly!  At my previous job, one of the funds in our 401(k) plan charged over 2.0%!  That’s complete B.S.!

To put it simply: 401(k) plans are a big business!  This is why most of them are made up of actively managed mutual funds – because they can charge more for them then passive funds.  And the more they charge in fees, the more money they make.

This is one of the major reasons why 401(k) plans are often vilified by the public.  It’s questionable whether some of the funds they offer are really even any good or not.  Are they simply there just to collect a cut of the high fees?  Who’s best interest is really being served – the investor or the financial company?

This reminds me of a wonderful story that beautiful sums up the situation.  It comes from a book called Where Are the Customers’ Yachts? by Fred Schwed, and was published over six decades ago.  Here is the story as paraphrased by The Motley Fool:

“The title came from a story about a visitor in New York more than a century ago. After admiring yachts that Wall Street bankers and brokers bought with the money they earned from giving financial advice to customers, he wondered where the customers’ yachts were. Of course, there were none.”

But if some 401(k) plans do contain passive funds, then why wouldn’t people choose them?

Again, let’s use my own 401(k) plan as an example.  With all things being equal, when the average US retirement saver goes to pick his funds, there’s a 4 in 57 chance or 93% probability that he will choose an active fund.

According to a wealth adviser from this article with CNBC, this is unfortunately what A LOT of people do – randomly choose their investments.  The sad position that we are in is that the average American saver is not necessarily educated enough about personal finance to really know what makes one fund choice better than the other.

Over the years, I can’t tell you how many people I’ve personally talked to who have picked the funds in their 401(k) plan without any discernible reasoning whatsoever.  Maybe it was strong returns the year before, a high Morningstar ranking, a nice sounding name, … any number of variables.  But few of them ever on the basis of whether the fund is actively or passively managed.

In other words, “the deck is stacked” in favor of active funds.

While this might be a major factor for the common investor, what about everyone else?  What makes up the other trillions of dollars being poured into actively managed funds?

I believe the answer is quite simple.

People Want Actively Managed Funds

Believe it or not, there are a staggering number of people out there in the world who simply do not want to settle for “average returns”.

They want to do better!  And if that means paying a little extra for an actively managed fund, then so be it!

Index Investing is a Relatively New Concept

Is it really so crazy for people to have this “beat the market” mindset?

When you put this in perspective with how Americans have been investing over the last few centuries, I think it makes a lot of sense.

• 1792 – In the United States, the first major stock exchange, New York Stock & Exchange Board, is created.  Investors can now pick which companies they believe will succeed and become the most profitable.
• March 21, 1924 – The first modern-day mutual fund, Massachusetts Investors Trust, begins.  Investors can now easily diversify and let a fund-manager do all the hard work of picking the best stocks to make them wealthy.
• December 31, 1975 – John Bogle creates the First Index Investment Trust (later renamed the Vanguard 500 Index Fund) one year after starting The Vanguard Group.

Relatively speaking, index investing is a “new” way of thinking.  For literally hundreds of years, it’s been engrained in the minds of both professional and casual investors that getting rich means picking the right stocks.  They have high-hopes and intentions of putting their money into something (or with someone) that will deliver above average returns.

(Coincidentally, this is also why more financially affluent investors choose to go with hedge funds.  Again, they are doing so on the promise, or hype, that they will receive above average returns.)

So are those who invest with actively managed funds just being foolish?

A closer look at a few results may not seem to suggest so.

Active Funds Don’t Always Fall Behind Passive Ones

Bogle’s comment is that most actively managed funds fail to beat their benchmarks.  Keyword being “most”.

To be fair to any of the “good” active managers out there, their priorities are not always the singular goal to simply “beat the market”.  The most responsible ones will also find ways to minimize risks during periods of economic turbulence.

This two-prong approach is how some funds are able to beat their benchmarks for periods of 10 years or more.

Vanguard Example:

One good example of this comes from Andrew Hallam on the site Asset Builder.  He points out:

“Vanguard’s Windsor fund is an active fund that has beat a passive fund in a 39 year stretch.  If $10,000 were invested in it from August 1976 until March 3, 2015, it would have grown to $967,947 versus $581,814 for Vanguard’s S&P 500 index.”

Hallam then goes on to list several other Vanguard active funds which have beaten their index over a ten year period from 2005-2015.

For US Large-Cap, active funds beat the index funds 7.74% vs 7.69% after tax.

This was also true for International stocks: 5.17% vs 4.35%.

(Of course, to be fair to the passive funds, Mid-Cap, Small-Cap, and Bond indexes beat their active fund counterparts.  All-in-all, the numbers were relatively close.)

T-Rowe Price Example:

Of course, those are very specific time-periods.  T. Rowe Price did a little more comprehensive approach of active versus passive funds in their post “Long-Term Benefits of the T. Rowe Price Approach to Active Management“.

Their study examined performance over rolling 1-, 3-, 5-, and 10-year periods (rolled monthly) from 12/31/1996 through 12/31/2016. Returns were net any fees and trading costs.

What did they find?

“Half of the funds (9 of 18) outperformed their benchmarks over every rolling 10-year period, while two other funds outperformed in at least 98% of their rolling 10-year periods.”

Berkshire Hathaway Example:

Okay … Okay … So Warren Buffett’s Berkshire Hathaway isn’t technically an “actively managed” fund the same way a mutual fund from Vanguard is.  But here me out.  In essence, buying this stock works out to be pretty much the same thing: You put up the money, Warren Buffett and Gang pick the companies for you to invest in, and you all get rich!

How rich?

In a 2016 article from Yahoo Finance:

“Since 1965 to December 2015, Berkshire’s shares have returned 20.8% per annum for a cumulative gain of 1,598,284%, compared to an overall gain for the S&P 500 with dividends included of 11,335%.”

When compared to the roughly 10% return of the S&P 500, 20.8% is not too bad at all!

Not All Active Funds Are Expensive

If high fees over 1% are one of the main criteria that makes actively managed funds “bad”, then would you still feel the same about them if you found some with really low fees?

Do those exist?

Of course they do.  Part of Vanguard’s success was built on the reputation for having some of the lowest fees in all of investment service industry.

How low are we talking?

According to their own site, Vanguard’s average expense ratio is 0.18%.  That’s quite a bit different from the average industry rate of 1.25%.

Furthermore, their active fund average price works out to just 0.14% higher than what they charge for the Vanguard 500 Index Fund (admiral shares).  Using the same 30 year projection we did before, that only works out to a difference of $23,275; a lot less than the $181,192 we calculated with the industry average.

Bottom-line: With fees that low, it completely levels the playing field.  Now you can make your decisions based on performance and asset allocation.

Asset Allocation Goals

One of the big criticisms of index fund investing is that it does not necessarily coincide with the specific asset allocation goals and risk profile that some investors hope to maintain.

For example: X amount in a certain group of stocks, Y amount in certain type of bonds, etc.

Sure … you could just buy other index funds in an attempt to create the type of profile you’re after.  But now you’re doing all the juggling to make sure those funds are properly maintained and balanced every year.

This is yet another reason why some people choose to pick actively managed funds over passive ones.  They WANT someone to manage this asset allocation balance and risk for them.

And as long as we can find a fund that A) the performs well over time and B) carries low expenses, is would this really be such a bad purchase?

Two examples I can give you are two of Vanguard’s old chestnuts: The Wellington and Wellesley funds.  Both are well-known balanced funds offering specific types of asset allocation.  The Wellington is about 2:1 stocks to bonds with diversification across a number of prevalent sectors.  The Wellesley is 1:2 stocks to bonds with a focus on dividend paying stocks with a proven historical track record.

When you account for both stocks and bonds, each of these funds has beat its composite benchmark over the long haul.  And with expense ratios of 0.25% and 0.22% respectively, this is still only a small price to pay above what investing in a simple index fund can do for you.

What Can We Learn From All of This?

In summary, I believe we can conclude the following.

Yes, there are a lot of clear benefits to choosing passively managed index funds over active ones.  Their long-term performance and low costs combined with their simplicity make them a terrific staple for any level of investor.

If you want to keep things simple and invest without the fuss, then just go for all passively managed index funds.

But be careful not to paint all actively managed funds as “bad”.  Not all of them are.

True: It sure seems like a common complaint of many funds being offered in 401(k) plans across America is that they do not perform well and charge outrageous fees for the brokers who offer them.

But that doesn’t mean that there aren’t any “good” opportunities to be found with actively managed funds.  Like all investments (stocks, real estate, business, etc.), you have to put in some work and effort to find the right ones.  This would mean doing some research, learning about what the fund consists of, how it has performed against its benchmark over long-term, what kind of fees it charges, and what kind of diversification it can offer you.  In the end, it may just end up being a good fit for you and your money.

Readers – Why do you think people continue to invest in actively managed funds?  Can you think of any other times when there can be an advantage to what they have to offer?  How can aspects to both management strategies be used to create the best investment profile possible?  Fair warning – please keep the discussion constructive.  Any comments that attempt to bash one side or the other will not pass moderation.  

Images courtesy of Flickr, Flickr, and FreeDigitalPhotos

The post Why Do More People Invest In Actively Managed Funds vs Passive Index Funds? appeared first on My Money Design.

You might think you need to be some kind of stock-picking wizard, or that you need a “guy” to manage your money for you.  But in reality, that’s often not the case at all.  Study nearly any early retirement story and you will find that the truth is painfully very simple:

To get rich faster, you need to save more money.  A LOT MORE money!

So then: Why does everyone focus on investing over the actual act of saving?

While investing is a VERY important part of growing your wealth and eventually turning it into passive income, there is a limit.  As we’ll talk about more later in the post, history has taught us that there is an upper limit to what the average person can expect for a return over the long haul.

Perhaps we tend to put too much emphasis on our investment returns because we fool ourselves into thinking that we’re smarter than we really are.  That we’ll somehow notice something that no one else has.  TV shows lot Jim Cramer and article headlines like “The Hottest Stocks of the Year” on the cover help to perpetuate these illusions.

… But sadly, its all nonsense.  It’s all just clever marketing noise designed to sell us something and distract us from what we should really be focused on: Investing in simple index funds and then figuring how to pour as much money into them as possible!

In this post, I’m going to contrast how simply saving more money can triumph chasing unrealistic returns any day. In addition, I’ll show you how there’s a very easy way to replicate that extra 1 percent return that you’re trying to get.

The Real Way to Get Rich Quicker

Let’s create a very simple example.  Pretend you’re agonizing over which funds to pick for your 401(k).  You know from reading this blog (and others) that an index fund will return roughly 8 to 10 percent per year on average over a period of 30 years or so.  Let’s go with 8 percent for this scenario.

Like most novice investors, let’s say that you think you’re pretty clever and can out-smart the market.  In essence, you’re going to try to get one more percent beyond everyone else for a 9 percent total annual return!

To round out the example, let’s also assume that you make an average of $50,000 per year, and you’re saving 10 percent of your gross income.  That’s $5,000 per year or $192.31 per bi-weekly paycheck.

The Baseline Portfolio

To begin, let’s see what would happen if you took my advice and kept your money in an index fund.

Assuming an average earnings of 8 percent per year, by the end of 30 years you’d have $566,416.

(We’re going to ignore inflation to keep things simple.)

+1 Percent More Return!

Now what would have happened in this same scenario if you were able to find that “magic” fund or combination of funds that somehow produced one extra percent return?

In this case, that 9 percent annualized growth would have developed your nest egg into $681,538.

Not too bad!  That’s $115,122 extra.

But there’s just one problem …  That “magic” fund or combination funds doesn’t exist!

You Can’t Do Better Than an Index Fund!

We know from the teachings of Jack Bogle as well as several other studies that most fund managers (often quoted as 90% of them) fail to ever beat the market average.  This is because of two main reasons:

1. They can’t always predict which stocks will do better over the long haul.
2. Even if they could, the high fees they charge will reduce your net earnings down below that of an index fund.

In almost every situation, the common investor was simply better off to go the easy route by just investing in a market index fund and not bothering to fuss over any funds at all.

So where does this leave us?  Is there no way I can grow my portfolio up to $681,538 like we did in the second example?

Of course there is.  We simply need to save more!

The Solution: Save Just 2 More Percent

Take a look at how the math works.  By increasing your contribution rate from 10 to 11 percent, your savings increases from $5,000 to $5,500 for the year.  Saving that extra $500 is effectively like getting an automatic 10 percent return on your original $5,000 principal.

Of course, that’s only true for the first year.  Because of the way that compounding returns works, when we extend this study all way up to the full 30 years, we can see that we actually would need closer to a 12 percent savings rate to achieve a portfolio of $679,699 with the original 8 percent growth assumption.

(This results in only $1,838 less than the 10 percent savings growing at 9 percent growth scenario; close enough for me.)

Awesome!  Rather than chasing unrealistic returns and taking unnecessary risk, we were able to replicate those returns by simply saving a few percent more per year!

Now watch what happens when you increase your savings rate to 20 percent!  By doing so you’re putting away $10,000 per year in this example.

The result?  Your nest egg grows to $1,132,832!  Now you’re buiding wealth fast!

Focus on What You Can Control

Don’t get caught up in the numbers.  The real message we’re trying to convey here is this:

Saving is controllable.  The market is not!

While we can ”assume” that the markets will grow at an 8 percent annual rate, this is merely an average figure over time.  Depending on a great number of variables (most importantly years invested), you could end up with a totally different rate of return.  (Check out these averages on the S&P 500 Wikipedia page.)

To paraphrase investment legend Benjamin Graham: No one ever really knows what Mr Market is going to do next.

Saving, on the other hand, is known.  It’s absolute.  If you decide to save 10, 12, or even 50 percent of your money, that’s a sure thing that is about to happen.  While your money may tend to fluctuate up and down depending on which investments you have and how they are performing, overall you’ll always have more money to work with than if you tried to rely on investment returns alone.  This is a very important concept to understand in the accumulation phase of retirement planning.

Conclusions:

• Investing is important.  But don’t get caught up.  Make life easy and pick a balance of stock to bond index funds that you’re comfortable with.  Set it once and then check on it once per year.
• Use the rest of your time to focus on HOW you’re going to SAVE MORE!  Saving more is the part of this equation that you can control.  Therefore, it’s your key to building up your wealth as quickly as you want to!

But I Can’t Afford to Save Any More?

Ask yourself: You “can’t” save anymore money, or you “won’t”?

… Notice there’s a difference?

Saving more is a bit like exercise.  You have to put in the work and stay disciplined if you want to see results.  There are no quick, over-night solutions!

Anyone can save more money if they put their mind to it and make an effort really optimize their expenses.  The trick is to focus on one at a time and follow-through!

Just this year to save money, we’ve already:

• Refinanced our house (after just one year),
• Lowered our property taxes,
• Reduced our cell phone bills, and
• Lowered our auto insurance costs.

On top of all of those, we’re already working on next year by eliminating as much of our vacation costs as possible through travel hacking.  We’re taking advantage of credit card sign-up bonuses that we can use for free flights and hotel stays.

Find more of these kinds of money saving tips in my ebook: Save MORE, Earn MORE!: 21 Easy and Practical Ways to Save More Money for Your Retirement and Other Financial Goals.  

Again, all it takes is focusing on one bill per month and developing a plan for how you’re going to reduce the cost.  Though it may take a few emails or phone calls to make it happen, you’ll be happy when those savings start to add up, and you can use them for the things that really matter!

Readers – Which do feel will make the richest the quickest: Trying to boost your returns or your savings rate?  Which one do you tend to dwell on more and why?

Featured image courtesy of Flickr | Chris Potter

The post What’s the Fastest Way to Get Rich? Simple: Save MORE! appeared first on My Money Design.

For anyone who doesn’t remember, the 3 Percent Signal was an interesting concept where you effectively buy or sell shares of an ETF to effectively lock yourself into a 3% gain per quarter.

I, unfortunately, somewhat fount this strategy to be a bust when I tried to validate it by reproducing the results.

At its basic level, I do believe there is some merit to a “buying or selling stocks when the price is low or high enough” theory. After all, isn’t it all just math; small gains here and there that add up over time?

Perhaps so. But the problem that I’m sure you and I both have is knowing exactly when is the price truly low.

“Low”, of course, is a matter relatively.

It’s very simple to look at the current price of an investment, look at its history, and see that it is in fact “low” and perhaps a good opportunity to be purchased.

But is that really enough to “beat the system”? Could beating a market index really be that simple?

Building My Test – The 10% 12-Month Signal

I decided I would test that theory (on paper at least).

With the same Excel spreadsheet I had used for the 3 Percent Signal fresh on my PC desktop, I decided I would concoct my own hypothetical “signal” scenario. This would was just about as easy as it is ever going to get: Buy when the investment is 10% or more lower than 12 months ago. Let’s call it the “10% 12-month” signal.

I decided to test this using the same vanguard small cap NAESX mutual fund that I tested in the 3 Percent Signal.

The “Signal” process would go like this: Every month that the fund drops 10% or more below its price from exactly 12 months ago, I’ll buy $1,000 worth. If it’s less than 10% or gains value, I will do nothing.

As a benchmark, I’ll compare my results to that of someone who simply took that same amount of money and on Jan 1st bought however many shares they could purchase. So for example, in 2001, if their friend using the Signal strategy invested 5 times at $1,000 each for a total of $5,000, then this guy in auto-pilot mode would simply also match that investment of $5,000 on January 1st, 2002. We’ll call this the “No Signal” approach.

What Happens After 15 Years?

To start our analysis, I decide to look at data from the years of 2000-2015.

At first glance when you look at the two graphs, you notice … nothing profound.  Although the Signal strategy tends to do a little better than the No Signal one, they seem to follow the same market trends up and down.

Zoom in a little bit more on the last year of the two graphs. Notice that the “Signal” one (red) is just a bit higher than the benchmark (blue); about $7,414 more ($80,492 vs $73,078).

While $7,414 is not exactly a ton of money, it is a difference to note. When you quantify the return on investment over the past 15 years, you get an annualized rate of 11.3% with the Signal and 10.5% with No Signal. That’s practically almost a full percent more!

Could we be on to something?

Knowing that the small cap index is considered to be somewhat “risky”, I decided I’d try the same process on the S&P 500 Index.

Unfortunately, the end results were not quite as well spread. Between the two strategies, there was actually a decrease of $1,674 when you used the Signal strategy. So not only is the difference not distinct, it’s also not to our benefit.

What Happens After 30 Years?

Let’s turn our attention back to the small cap index.

Could that spread of almost 1 percent between the two strategies continue on if we continued this study with 30 years of data?

I again ran the simulation and, unfortunately, the spread closes. This time, the Signal strategy ends with $13,765 more than the No Signal strategy. But over 30 years, that is not a very significant amount of money; only $436,134 vs $422,369. The annualized rate of return calculates to almost identical: 9.7% vs 9.6%.

Even though we already know the S&P 500 will not work, I did the same calculation with 30 years of data as well. The two strategies again will give you almost identical results: $128,614 vs $125,185. So, again, there is almost no difference whatsoever.

Conclusions

With those 4 simulations, I believe I can safely conclude that trying to time your investments based on buy and sell signals for stocks has almost no benefit at all over the long term. You’d do just as well to go into auto-pilot mode and buy whatever assets you plan to buy on January 1st versus all the trouble of watching the markets month-to-month and trying to out-smart the system.

To remain humble in this investigation, there are a few things I think I could do to further develop it. I only ran one block of 15 years and one block of 30 years. Perhaps if I chose rolling data sets from several rolling years of 15 and 30 year periods, I might uncover occurrences where this strategy worked.

The other thing I could do is investigate other types of investments. The small cap index and S&P 500 index are relatively popular ones and easy for people to relate to. But they are not the only two investments in the world. There may be other examples to explore.

Readers – How many of you have tried your own “signal” experiments? What kind of successes or failures have you had with trying to detect such patterns?

Featured image courtesy of Flickr | Thomas Hawk

The post Do Buy and Sell Signals for Stocks Really Exist? The 10% Experiment appeared first on My Money Design.

I’ll admit it – this book was scratching me right where I itch!  I’m a huge sucker for mathematical-based approaches to investing and optimizing your personal finances.  (When I say that, someone like Michael Kitces or Wade Pfau comes to mind.)  If you’ve got the right numbers and figures to provide as evidence for your strategy, then I’ll have no trouble giving your research an honest, worth-while listen.

More so, even though I recognize and believe in the power of index fund investing, I’ve often thought to myself that there has to be other, more strategic ways of coming out ahead of your peers.  Take, for example, the simplicity of compounding returns.  Isn’t this just a mathematical way of growing your money way above and beyond anything you could ever save on your own?  Perhaps there are other similar strategies – it doesn’t hurt to dream, right?

Honestly, when I got all done reading The 3% Signal, I was ready to sign on the dotted line!  Having just sold our old house, we’ve got a nice little bit of cash sitting in our savings account.  I’ve been gung-ho to start putting it to work!

But before we jump into the 3% Signal strategy with both feet first, I have to ask the all-important question: Does it really work?  I mean, like, really work?  I’ve read plenty of other books in the past that made some pretty amazing claims about grand returns you’re going to make using their advice.  But when I looked under the hood a little bit more carefully, I didn’t like what I saw.

The 3% Signal strategy deserves no special treatment.  Just because the author offers us his back-test data does not necessarily mean we have to accept it at face-value. At this stage of my investing career, I rarely do anything with my money any more if I can’t first put some realistic numbers into Excel and convince myself that the plan is going to work first (or not).

(On that note, a quick side-story: Last year, I was actually all set to buy my first rental property!  BUT, after running the numbers, I ended up not moving ahead with it.  I decided there were other, better opportunities to make a higher return more quickly.)

In this post, I’m going to share with you my personal analysis of the 3% Signal strategy (which we’ll abbreviate from here on out as “3Sig”).

Can You Really Artificially Lock Into a 12.6% Return?

The first thing that struck me about the 3Sig strategy is that, on the surface, it offers to lock you into a return of 12.6% every year.  That’s what 3% per quarter (as the strategy calls for) is when you compound it throughout the year.

But here’s the thing that bothered me:

1. If there’s a bond portion, that’s not getting 12.6% year. So the total return has to be lower.  Kelly’s data in Table 15 (p. 89) suggests its 9.1%.  But what if its less?
2. If you infuse cash every so often (as Kelly offers both data with and without), then the overall return should again be lower because that cash hasn’t had sufficient time to compound. Again, Kelly states in Table 15 that it should return a whooping 10.4%!  But this seems too good to be true.

And one more thing:

3. Why is the data only from December 2000 to June 2013? (I’m assuming Kelly really means 1/1/2001 to 7/01/2013.)  Is the last 12.5 years really enough time to make a sound judgment as to the effectiveness of this strategy?

I decide the best way to tackle each of these suspicions was to download the same data he used (available on Yahoo Finance) and try to recreate the results in Table 15.

If I’m successful, then I should be able to use other sets of data that go even further back.  That way I can back-test this plan by +20 years.

So how did that all work out?

My 3% Signal Results (Using the Same Data as Kelly)

After working out an extensive Excel spreadsheet taking into consideration small nuances of the plan such as the “30 down stick around” rule and the rebalance to 80/20 when your bonds get above 30%, I was able to come up with some results.

Here are my results compared to Kelly’s Table 15 results:

• With no new cash invested, Kelly got $29,760 with the 3Sig plan and $27,289 with a traditional buy and hold strategy using only IJR.
• My calculations under the same conditions came close: $31,009 with 3Sig and $28,907 with just IJR.

Not a horrible comparison, but not exact either.  In both cases (Kelly and me), the 3Sig strategy came out ahead.

Now, here’s where it gets interesting.

When you DO add in cash every time your Bond fund runs out of money, Kelly and I get very different results:

• Kelly got $85,721 with $27,249 in cash injected into the plan. Again, that’s a return of 10.4%.
• My 3Sig calculations resulted in $48,536. I only added $9,532 of new cash into the plan.  And my return was 9.6%.

Naturally because you have to have the same amount of cash to make this an apples-to-apples comparison, my calculations for the Index alone plan with cash infusion do not match Kelly’s results:

• $52,739; a 10.5% return
• Kelly’s $78,105; a 9.3% return

This is interesting.  The results of my calculations seem to suggest almost the inverse of Kelly’s findings!

I can only think of one logical reason why this could be:

• One of us is wrong.

Admittedly, it could quite possibly be me.  My calculations are based on my understanding of Kelly’s method to the best of my understanding.  By the way, if anyone would like a copy of my Excel document to try to work with me on this and investigate these findings further, feel free to email me.  I’d love to get a second opinion.

If I am wrong, then is this strategy really so simple and straight-forward?  I’m an engineer who deals with data all the time.  If the 3Sig strategy is really so easy to use, then I should have had no trouble reproducing it with little effort.

What Happens When We Add More Years of Data?

Okay, so let’s table the fact that Kelly and I got different results.

Let’s now address the issue of Kelly’s data being only from the last 12.5 years.  Quite frankly, one clip of data that is only 12.5 years is just not enough evidence for me to hang my hat on.

Kelly says he only used this time frame because that’s how far back the ETF’s go.  Okay.  I’m going to work around this by using two similar mutual funds that go back even further:

• Small cap stocks = Vanguard Small Cap Index Inv (NAESX)
• Bonds = Vanguard Interm-Term Bond Index Inv (VBIIX).

Using these funds gave me data that goes all the way back to 1994.  Working my way up to 2016, this gives me 21 years of test data.  Not a huge amount of data, but certainly better than 12.5 years.

Again, using the same rules that Kelly outlined, I came to the following conclusions:

• When extra cash was added, the Index only approach beat the 3Sig approach $123,383 vs $109,553. It does a pretty good job up until the great recession of 2009, and then it never quite keeps up pace; trailing by almost $20,000 at times!

• When no extra cash was added, the two strategies basically start to mirror each other. $67,801 3Sig vs $67,294 Index.  This is because without any new cash, the bond eventually runs dry.  Then you’re effectively left with a 100% stock fund; the same thing as the Index approach!

Again, in both analyses, we see that the 3Sig method doesn’t necessarily give us any specific advantage.  In fact, in the cases where extra cash was added, we actually end up with lesser balances!

What Can We Conclude About All of This?

So is there any benefit or merit to using Kelly’s 3Sig strategy?

In short, yes.

Although you don’t necessarily end up with more money, there is one thing to be said about this approach: It does produce stability.

Let’s say you were in the retirement phase of life and living off of your investments.  How would you feel about your money fluctuating wildly up and down with all the noise of a small-cap index fund?  I know I would not feel good about that!

In contrast, the 3Sig strategy does help to reduce (but not eliminate) these wild spikes in losses.  We as humans are emotional based, and some stability can do us good.

So in summary:

If you’re in the accumulation phase of life, you’re probably better off just going with the Index approach.  The bumps and blips you’ll feel along the way may be rough at times, but you’re more likely to end up with more capital when all is said and done.

While you’re in the retirement phase of life, the 3Sig approach may have more usefulness now that cash preservation may be more important than capital building.

Technical Notes:

On the issue of adding additional cash every time your bond fund runs dry, I didn’t really agree with the way that Kelly presented this data.  In the Table 15 (p. 89) where he compares the plans, in Plan 1 he assumes you started off and invested on Day 1 all of the cash ever needed over the course of the 12.5 years.  This is unrealistic, and I believe Kelly even dismisses this idea later on in the text.

Take Kelly’s Plan 3 for example.  In this one, all the cash that is added throughout the course of the 3Sig plan (Plan 2) is totaled, divided over the 50 quarters.  This, again, is unrealistic.  For a person just starting this plan today, how do you know how much “extra” money you’re going to need in order to make an accurate comparison 10 or 20 years from now?

Therefore, for my calculations, I took a slightly different approach.  And I believe that my method actually does a better job of giving a true Apples-to-Apples comparison.

In my analysis, every time you added in additional cash to the 3Sig plan for a specific quarter, you also bought the same number of additional shares in the Index Only approach for that quarter.  This way, fair-is-fair.  Each quarter, you’re not adding cash to one plan but not the other.

I also believe this small change contributed very little to the differences in results I calculated versus Kelly.

Readers – What do you think?  Are you sold on the 3% Strategy, or do you believe there is more to this investment strategy?  What other investment strategies have you investigated on your own only to find very different results than what the author had presented?

Photo credit: Flickr

The post Does the 3% Signal Investment Strategy Really Work? appeared first on My Money Design.

MMD: Today we have a mega guest post from fellow personal finance blogger ARB.  Take it away!

Hello, readers of My Money Design! I am ARB, the Angry Retail Banker!

Over on my blog, I offer what I call “An Insider’s Take On Retail Banking”, which means that between bouts of raging out and threatening my entire customer base with physical harm, I talk about both life as a branch banker and ways for you to maximize your banking relationship.

I am here today to talk about absolutely none of that stuff.

Before you all hit the back button on your browser and type “funny cat videos” into a Google search, know that I’d like to discuss an awesome form of passive income that I think doesn’t get covered a whole lot.

I’m talking about Peer-to-Peer (or P2P) lending and I will be addressing some of the common arguments against it.

What Is P2P Lending?

I actually first heard of P2P lending right here on My Money Design and have been smitten with the concept ever since.

While I’m sure the veterans of the passive income community already know what P2P lending is, let me take a moment to explain the basics to the uninitiated.

P2P lending is a form of loaning money that bypasses the banks and other financial institutions almost entirely.

Instead, borrowers looking for loans are matched with individual investors looking to lend out their own money with interest. Essentially, individuals act as banks and make a profit in the same way that the banks typically do.

The two major P2P platforms in the United States are Prosper and Lending Club, the latter of which saw Google as a major investor before becoming a publicly traded company.

Both borrowers and investors (or lenders, I should say) would sign up for an account with either or both platforms.

Borrowers would then submit their loan applications while lenders would transfer funds to their accounts. Once the borrower is approved for the loan, it becomes visible on the site to the lenders.

Lenders go through the list of available loans and decide which loans they want to fund and how much of each loan they want to fund (as little as $25 per loan).

Once a loan is fully funded and distributed, the borrower repays the loan via monthly payments that cover both principal and interest. Those payments are distributed to the investors who funded the loan.

Pretty much it’s regular people lending money to other regular people. You can imagine it as yourself taking on the role of the bank, or as being a bond investor where the bonds represent real people rather than governments, municipalities, or businesses.

Either way, expect that at least one out of every three people you try to explain P2P lending to will look at you and un-ironically ask you if you are a loan shark.

Why Should I Be Interested In P2P Lending?

Is my word not good enough for you?

Alright, how about the fact that most experts believe you can earn a 5-12% return on your investment in P2P lending. Now understand that this is not a hard number or a guarantee; your results will depend on the loans you choose, your loan filters, your risk tolerance (you want the riskiest loans or the safest?), and the state of the general economy.

I’m not telling you what you will or won’t make. But it seems to be the average for many institutional investors and industry experts and it seems to be the average whenever I do loan back-testing (more on back-testing later).

Now, there will be a downward trend in the ROI (Return On Investment) of every portfolio. A new portfolio hasn’t had a chance to experience defaults yet. But even taking this into account, looking at all of Lending Club’s loans issued since 2009, we still see a ROI of 8.68%.

Not bad, huh?

Compare that to your savings account getting you 0.01%.

And P2P lending is gaining grounds amongst some personal finance bloggers who are letting the results speak for themselves. Mr. Money Mustache, for example, has seen returns so far of about 12.22% as of this writing. I credit the mustache for his success.

But Mr. Money Mustache isn’t the only wildly popular, immensely successful, and amazingly good looking blogger to enter the P2P sphere. I’m, of course, talking about me. I said “amazingly good looking”, right?

For those of you who must know how much I’m making, I started with Prosper a little over a year ago and Lending Club a few months after that. My Prosper account has returned me about 9.93% for all the notes that are over ten months old (thus properly weeding out the defaults from the ROI), while my younger Lending Club account (invested entirely in low grade, high yield loans) as a return of 12.84% after taking defaults into account.

Of my 164 Prosper loans, only 7 are late and 2 have been charged off (with 13 being paid in full already). On the Lending Club side of things, I’ve got 237 loans with 4 of them being late, 1 still in the grace period, and 1 charged off (14 of them have been fully paid). While I expect the default rate to increase as time goes on, that’s definitely not the risky “Vegas gambling” many people see P2P lending as.

Now the worst, most dishonest thing I can do is sit here and tell you that you will make a ton of money because I’m doing good so far, but I just want you all to get a feel for what the general returns have been since 2009. I truly doubt a mature portfolio will see consistent 15% annual returns, but I do believe that P2P lending can offer you better returns than even my beloved dividend stocks, though with much greater risk (so I do recommend keeping only a small portion of your greater investment portfolio in P2P loans). I have companies that pay 3% in dividends; I have loans with interest rates over 20%.

Taxes On P2P Lending:

For those of you who forgot, MMD wrote a nice little eBook recently called Save Better (which everyone should go and buy already) in which he taught you all the ways you can save money on your taxes. One of the ways to gain a tax advantage was by investing in stocks for the long term. Dividend and capital gains taxes are lower than the ordinary income tax rate that your paycheck is taxed at.

But what about your P2P lending returns? How are they taxed?

Unfortunately, your returns are taxed as normal income, and if you’ve ever found yourself complaining about how much the government takes out of each paycheck (like I do every two weeks), then you are going to find this to be a major downside to this form of investment.

Fortunately, both Prosper and Lending Club allow you to open up an IRA with them, greatly minimizing your tax burden. And like stocks, charged off loans in your taxable account can be written off as losses, according to this post on Lend Academy, a popular P2P lending blog.

P2P Lending In Your Area:

Funny thing about P2P lending. Not all states allow it.

I’m not going to go into why certain states have still not allowed P2P lending (why does any politician support or oppose anything? Votes and money), but some states allow you to enter the P2P lending world, and other states do not.

What’s crazier is how complicated these restrictions are. It’s not simply a matter of the whole asset class being allowed or blocked. Rather some states allow you to borrow but not lend, and some states allow you to do business with one company but not the other.

A potential investor may find themselves allowed to borrow from Lending Club and Prosper but not actually lend money out themselves. Another person may find themselves limited to doing business with Lending Club but not Prosper.

As far as investing goes, 28 states allow you to invest in Lending Club while 31 allow you to invest in Prosper. The breakdown for Lending Club is as follows:

If you live in a state that doesn’t allow P2P lending at all, then you’re pretty much out of luck.

But what about you non-’Muricans that don’t live here in ‘Murica?  You might want to check out what P2P lending companies exist in your country.

Europe has a number of different P2P lending companies headquartered in the United Kingdom, France, Spain, and Germany, of which some of the best ones are listed in this Forbes article.

P2P lending has also broken through the Great Firewall of China. There the amount of money that has been issued in loans has increased by 300% since the same point in time in 2014.

The Asian Banker actually takes the time to list all P2P lending services by country. This asset class is not just limited to the Western world; these markets are also in Australia, Hong Kong, India, and South Korea. No word on when North Korea will be getting in on it (probably never).

The Arguments Against P2P Lending:

Now that I’ve educated you on a few aspects of P2P lending, I want to really get into the meat-and-potatoes of this article.

You see, every type of investment has its risks, and P2P lending is no exception.

The biggest risk of a P2P loan is that of a loan default. A person might lend money to a borrower only for that borrower to never repay the loan.

But you could say that about any type of investment. Stocks could go up and down, or the company can go bankrupt. Bonds can also default. Not all bonds are as safe as the U.S. Savings Bond. Real estate investment income can erode due to vacancies, maintenance, and deadbeat tenants.

I could literally go down a list of passive income ideas and come up with a reason to avoid every single one.

I’ve heard a lot of arguments over time about why “you shouldn’t be lending money to random strangers over the Internet”. Some arguments against P2P lending were very well crafted and thought out. Others, not so much.

I’m not going to sit here and try to convince everybody that P2P lending is the best investment or form of passive income for you. Nor am I going to analyze whether P2P is a viable threat to the banking industry or compare them to traditional bank products like I did awhile back with prepaid debit cards. That is all outside the scope of this article.

Instead, I will opportunistically and shamelessly promote my blog using someone else’s resources in order to drive … I mean … address some of the arguments that I have heard against P2P lending and offer my counterarguments.

Argument #1: “What happens to you if the borrower defaults!? These loans don’t have any collateral!”

Do you know how many times I’ve seen this excuse presented as “The Big Secret The P2P Lending Platforms Don’t Want You To Know” or something like that?  The notion that these loans are backed only by the good faith and credit of the borrowers?

This message is presented in this hushed whisper of a tone, like a crazy living-off-the-grid survivalist who is trying to tell everyone that bank tellers are calling the police on their customers without Obama overhearing and personally ordering a hit squad to cover his tracks.

It’s absolutely true what they say. These loans are backed by absolutely zero in collateral!

There is no home, car, or any other hard assets to recover in case the borrower doesn’t pay back the loan. And if the borrower defaults, you lose the money you lent that person.

But that’s just like a regular credit card or bank loan!

The fact that you don’t lose your home if you default on a bank loan doesn’t deter Bank of America from offering them, does it?

The fact that the bank can’t debit your bank account to pay unpaid credit card bills doesn’t stop Chase from getting you to apply for them, right?

And the banks seem to be making quite a bit of money off unsecured loans. They are certainly making record profits, according to this Wall Street Journal article from late 2014 which also pointed out that banks’ outstanding loans have topped $8 trillion (yes, I know much of this is mortgage lending) since research firm SNL Financial first started tracking them in 1991.

Banks are able to withstand loan defaults of tens of thousands of dollars per borrower not just because they already have billions of dollars in assets, but because each loan is such a tiny part of their overall loan portfolio that the loss of the entire principle of one loan is completely covered by the interest payments on the rest and then some.

You should do the same! Don’t loan $15,000 to one borrower. Loan the minimum of $25 to as many different borrowers as possible.

In the end, the cost of a borrower default will be greatly minimized and your losses will be nearly non-existent.

Even the lending platforms themselves recommend this tactic. And make no mistake; it is the single most important thing you can do to protect yourself.

Prosper’s website even states that since 2009, every investor who has purchased at least 100 notes (loans) has had a positive return on their investment.

Using the website Nickel Steamroller, which allows us to see the actual results (including ROI and default rating) of past loans, we can see that even a portfolio with only the riskiest loans gives us a positive ROI.

More than “positive”, if you had started in 2009 blindly throwing your money Prosper’s riskiest loans with no regard for the purpose of the loan, the borrower’s credit score, income, number of recent credit inquiries, etc., you would have had a staggering 12.61%  return on your investment (with at least one year in there passing the 17% mark)!

More importantly (with the exception of 2010 and 2011), the rate of defaults has steadily decreased since 2009.

Now this doesn’t mean that you should go out and pour all of your money into the riskiest loans than P2P lending has to offer. I am simply showing you the numbers (actual real-world results, not just theoretical models or future predictions) that show the power of diversification, which in turn shows that the risk of borrower default is not something that should scare anyone away from this form of investing.

Even if 20% of our hypothetically lazy and careless lender’s loans had defaulted because he was targeting “the riskiest of the risky”, he still would have made $12.61 for every $100 invested as long as he simply diversified and invested only the minimum amount spread out across the maximum number of loans.

Argument #2: “You’re not investing! You’re just gambling! You have no way of knowing if these random people will pay you back!”

It’s true that past performance is no guarantee of future success, and that even with the numbers I quoted for you, it’s still possible for any individual loan to default.

You don’t see past the numbers on the screen. You don’t see the borrower behind it. Who knows if “bob_almighty111” is going to pay back that $25,000 loan?

Lots of things can happen. What if Bob loses his job? What if Bob is a deadbeat? Are you a deadbeat, Bob?

First, Prosper and Lending Club are major companies that deal in consumer lending. Don’t you think that they have strict underwriting guidelines that they follow?

Lending Club goes over their basic requirements here, and it’s pretty much the same criteria that the banks use.

Peter Renton, a respected member of the P2P community and the owner of the popular P2P lending blog Lend Academy which I mentioned earlier in this article, detailed in 2013 some of the changes in Lending Club’s underwriting requirements.

While these changes make it easier for borrowers to get approved for loans, it does so in a way that doesn’t increase the lenders’ risk, showing the care and effort Lending Club puts in their analysis of both individual loan applications and historic trends.

Prosper had a more storied history.

Remember how I wrote before that all their lenders since 2009 made a positive ROI if they diversified? Well, Prosper was around before 2009. The Prosper of old was a wildly differently run business than the Prosper of today. We are better off for it. The old Prosper, or “Prosper 1.0” as it’s commonly called, pretty much handed out loans to anybody who asked nicely, which is what my customers seem to think my bank is obligated to do (pro-tip: Having a checking account with over $1,000 does not guarantee you a loan).

This led to default rates reaching obscene levels of roughly 35%. Eventually they got busted in 2008 for selling unregistered securities and had to be reorganized into what is now informally called “Prosper 2.0”, complete with SEC regulation and everything.

So now operating within a proper regulatory environment and maintaining an underwriting process that doesn’t involve the words “yes to all”, Prosper’s ability to filter out the bad loans from the good has been almost immediately visible.

Their investors are earning positive returns and they have an A+ rating from the Better Business Bureau.

But why take anyone else’s word for it when you could be your own underwriter?  … Sort of.

I mentioned a couple paragraphs back a site called Nickel Steamroller, right? Right.

And as I very briefly mentioned, that site lets you back test actual loan results, complete with filters. This means that you can actually apply certain sets of criteria, plug in the data, and see how well real loans that fit that description did in earning their investors a return during a certain time period.

For example, you want to know if lending to the state of California would increase your loan defaults. Or perhaps you are looking to see which loan purpose will net you the highest return.

You can apply filters such as credit score, home ownership, open credit lines, loan grade, literally anything. You can search for how loans that fit that criteria did during a time period of your choosing.

This isn’t how some analysts or a computer program think such loans might do. These are actual results of real loans and what they made for real investors.

Gambling is throwing your money on red and hoping for the best.

Gambling is putting all your money into one or two loans and hoping that you see that money again. But with the ability to back test loans—to look at loans of different criteria and see their real world results—you can effectively do your own “underwriting”, formulate your own strategy, and know what loans are more likely to be paid back and what loans are more likely to fail.

Again, you have no way of knowing if any individual loan will be paid back, and it is true that defaults are just part of the game.

But knowing that certain types of loans in certain areas for people underneath a certain credit score have historically had high rates of default allows you to lower your own default rate by avoiding those loans.

You’re not just closing your eyes and throwing your money at random people when you have real world data that tells you which groups of borrowers have paid back loans in the past and which ones have a history of taking lenders’ money and running.

Argument #3: “Has this asset class been stress tested? Who knows what will happen if another financial crisis strikes!?”

Oh yes, P2P has been stress tested.

This has been stress tested through more financial crises than you think. And it has survived the worst of the worst. Forget the Great Recession, this asset class has survived the Great Depression!

How is this possible, you ask? Are all bankers mighty and omnipotent time lords?

Yes, yes we are, but that has nothing to do with P2P lending. Again, I point you right back to my first counterargument as we look at the borrower’s side of the equation.

Before, we looked at one aspect of P2P loans that were similar to bank loans; the lack of collateral. Not all bank loans involve collateral such as your home and car.

Credit cards are a prime example of unsecured debt, or debt backed by nothing but a borrower’s credit history and promise to repay.

But let’s take a closer look at the actual loans offered by Prosper and Lending Club and see what else is similar.

Let’s see: P2P loans are fixed rate, unsecured loans offered with three to five year terms. The loan amounts range from a couple thousand dollars to $35,000 and are paid back in monthly installments with principal and interest being applied to every payment.

Hmm … these don’t sound similar at all to bank loans. No, instead they sound exactly the same!

Literally, the only differences between a basic personal loan from a bank and a P2P loan is that the bank directly profits in the former while individual investors directly profit in the latter, and I have to deal with angry customers wondering why they haven’t been given a closing date yet in the former while I don’t have to deal with the general public at all in the latter.

… Wait, I think I figured out why I like P2P lending so much.

The banks are still here, still offering these loans, and still making money on them.

In my eyes, P2P lending isn’t really a new asset class at all.

It’s not some exotic new thing that even the most seasoned financial advisers have trouble understanding. They aren’t mortgage backed securities or anything like that.

They are the same simple, easy to understand fixed rate bank loans that people have been dealing with for decade upon decade upon decade upon decade. They have been stress tested to Hell and back and they have passed.

The only thing new is that you have a chance to earn money from these loans rather than Jamie Dimon (Chase’s CEO).

Argument #4: “The people applying for these loans must be some serious deadbeats! If they had good credit, then why wouldn’t they just go to the bank like everyone else?”

P2P lending is just starting to dip its toes into the world of mainstream finance, but it’s not there yet. It’s still a brand new asset class as far as your average investor is concerned.

Most people have never heard on it and have to have it explained to them, while everyone knows about the stock market or buying rental property. And when the average person needs a loan, the first thing they do is go to their bank. Or their parents.

I have seen many people imply P2P loans to be “the back channels of lending”, as if the borrowers were dealing with shady loan sharks in the basement of a Mafia-owned bar. They ask why would someone go out of their way to borrow money at ridiculously high interest rates (Lending Club’s highest APR is over 26%, while Prosper loans can hit the 35% mark) from a lender that no one’s ever heard of when there is a reputable bank on every street corner that they can deal with (and speak to a lending professional as well).

The thing is that many of those reputable banks have very strict underwriting criteria. While they have been loosening their requirements, those underwriting requirements became much stricter in the years immediately following the financial crisis and still have not returned to those levels.

I fully support the tightening of lending standards since banks can only afford so much risk on their primary method of making money (sorry, increasing the amount of deposits is worthless as far as increasing revenue goes since banks don’t make money that way), but that means that it is really hard for Bob the Borrower to get a loan.

But while the big banks are only dealing with borrowers that have perfect or near perfect credit, Prosper and Lending Club will deal with people that aren’t quite at that level but can demonstrate that they will be able to pay back a loan.

Someone who has been successful at making timely credit card payments at 30% interest should be able to pay back a debt consolidation loan at 15%, even if they don’t have the best credit or income. The P2P platforms have their underwriting guidelines, but they are less strict than the banks and will lend to people with subpar credit if those people demonstrate the ability to pay back their debt. They will deal with Bob when the big banks won’t.

But okay, so P2P platforms are geared towards riskier borrowers then? That sounds, well, risky.

Sure they can justify charging these people higher rates, but it sounds like an investor is playing with fire by de facto dealing with only subprime borrowers.

And if P2P lending is going to become mainstream in the investing world, it has to become mainstream in the lending world as well. It has to do that first. Which means attracting prime borrowers.

Why would someone with perfect credit go out of his way to learn about Lending Club when they probably have a Chase right around the corner?

This is where a personal banker is best suited to answer that question. The answer is the interest rates.

If you were to walk into my bank with your perfect credit score and apply for a loan, you will probably be offered a rate somewhere in the 9-10% range.

But look on the websites for the P2P companies. While they are known for exorbitantly high interest rates, those are only for their riskiest borrowers.

Borrowers with good enough credit to qualify for the highest rated loans (A-rated loans) earn the lowest interest rates, around 6.5%.

So imagine someone with perfect credit and a very high income is being offered two loans, one from Lending Club and the other from Chase.

They are both unsecured fixed rate loans with a 3 year term. The person can even apply online for each without leaving their home.

The two otherwise identical loans, however, come with different rates.

Lending Club’s is 6.5% while Chase’s is 9.5%.

Which do you think our hypothetical borrower will choose?

Exactly!

When you loan money to people, you aren’t just giving your money to deadbeats who survive off payday loans and minimum wage.

These aren’t the bottom of the barrel borrowers who were laughed out of the banks. These are prime borrowers who shunned the banks because they wanted a better deal.

Many of the borrowers are the sort of borrowers that the banks look for, that the banks make money off of.

But these borrowers have gone to P2P companies instead, where you make the money.

As a side note, we’d never laugh you out of the bank. We usually wait until you’re gone.

Final Thoughts:

……….Take care of yourself and each other?

I’m not expressly making the case for P2P lending here. Even though I am a lender, I am not arguing that it is awesome and everybody should do it.

There are pros and cons for all asset classes, P2P lending included. But these are arguments against P2P lending that I’ve heard here and there that I had to address because I honestly feel they don’t hold any water.

1. We know the loans don’t have any collateral; they are the same unsecured loans that a bank offers.
2. It’s not gambling; we can back test these loans to see how they’ve performed historically and only invest in the types that give us the most likely returns.
3. It’s been stress tested; these are basic consumer loans that have been around for ages.
4. And these aren’t deadbeats who can’t pay their debts coming for more money; many of them are prime borrowers who rejected the high interest rates of the major banks.

I’d like to thank MMD for giving me a chance to voice my opinions on P2P lending. I will now repay him by attempting to steal his readership using this picture of an adorable puppy.

Featured image courtesy of Pixabay.com.  See captions for all other image sources.

The post Countering The Arguments Against P2P Lending appeared first on My Money Design.

All the “ifs” in the beginning can be overwhelming!

Which ones do I pick?

Where will I find the right stock metrics and information to tell me?

Why do they keep bouncing around in price?  How long until I have a heart-attack?

Would you prefer a way to “stick your toe in the water” and not have to deal with such wild fluctuations? If so, then let me introduce you to the world of mutual funds. “What are mutual funds” you ask?

Well, for starters, they are where I started when I first invested – long before I ever bought my first shares of individual stock. But even today, after everything else I’ve learned, mutual funds still play a very important role in my investment strategy.

Here is your introduction into the world of mutual funds …

What are Mutual Funds?

Rather than give you the boring text-book answer, I’m going to illustrate how mutual funds work! To begin, let’s pretend we’re going to buy some stocks and we want to look closely at our risk.

Consider what happens if you buy one stock.

You could get lucky and it might go up. Or you could be really unlucky and watch it go all the way down to $0!! Ouch! I wouldn’t put my whole retirement account here! Too much risk!!!

So let’s instead buy five stocks.

This a little better. Maybe one or two of them will do good, and we’ll make a little money. On the down-side, perhaps one of two of them will do really poorly. But that’s okay because the good and bad have better chances of averaging out. But we still have the possibility that all five could go to $0! So we’re not exactly bullet-proof yet. Keep going ….

Now let’s buy five-hundred different stocks!

All right!! Even though the whole market may cycle up and down, our chances of going broke have been dramatically reduced!

But wait! I can’t afford five-hundred different stocks! At $7.95 per share, that’s $7.95 x 500 = $3,975 in stock commissions!! I don’t want to pay that!

Okay, so what if we get a few friends to help out? Let’s get you, me, and a few thousand other people to pool our money together in such a way that the commission costs are basically negligible.

In a nut-shell, this pooling of money to create a basket of investments is what mutual funds are!

Mutual Funds Can Be Virtually Any Combination of Investments:

Don’t take my overly simple example too literally. Mutual funds don’t necessarily have to be just stocks. A mutual fund can be virtually any number and any combination of investments:

• Stocks (value, growth, large, small, domestic, foreign, etc)

• Bonds (government, corporate, junk, municipal, etc)

• Cash (CD’s, money market, etc)

• Real estate

• Even other mutual funds!

• And a lot more ….

The exact number of things in our “basket” is different and often changing all the time. Most people who own mutual funds have little knowledge of the details of what is specifically inside them. More often, you the investor is more focused on the goals of the mutual funds.

The Goal of Mutual Funds:

Why are there so many combinations of mutual funds out there? Because each one has a specific goal for a specific type of investor:

• To make a lot of money (but take on more risk). For example, you could buy mutual funds that invest heavy in foreign stocks or real estate. Will it make you a lot of money? Maybe. Could you also lose a lot of money. Probably!

• To be ultra-safe (but possibly not return as much money). For example, you could buy mutual funds that invest in the safety of government bonds. Will you get rich? Probably not very quickly. But will you lose all your money? Not very likely!

• And everything in between ….

One of the biggest criticisms of mutual funds are that they move too slow. Most lack the sexy allure of making ten times your money in one year like some hot, unknown tech stock!

But at the same time, you rarely hear people complaining about how much money they’ve lost in a mutual fund. It’s pretty rare to lose 90% of your investment like you could at any given minute with some ill-chosen stock pick.

So even though they may not rock the boat the way individual stocks might, mutual funds still have to be selected with great care.

What to Look For in Mutual Funds:

There are always two main things to look for in mutual funds:

1. Performance: We all want to make more money, right? Isn’t this the reason we invest? So to do so, you need to find a fund that has a great record of performance (i.e. hasn’t lost a lot of money over the years). Please read my post How to Pick Good Mutual Funds for Your 401k or Retirement Plan and replace the word 401k with IRA, 403b, or even just your brokerage account. The principles will still be the same. Please note – past performance will never tell you how much you’re going to make in the future, but it can help you avoid losers!

2. Expenses: Going back to my example above with trying to buy 500 stocks, mutual funds have to cost something because there will always be some costs associated with acquiring the stocks, bonds, etc and then selling them. Some mutual funds will even have to pay a manager to make decisions about what investments it is going to have (called active funds). Others will simply follow a known bench-mark or index (a group of stocks that people already pay attention to) like the S&P 500 or Dow, and will not be actively managed (called passive funds). Overall, you want your fees to be as low as possible, and they can be reduced down to the following three categories …

What Do Mutual Funds Cost and Where Do I Find Them?

To keep things very simple, here is a brief summary of the different types of expenses that come with owning mutual funds and your strategy for keeping them as low as possible:

1. Taxes. We all know that we have to pay taxes on most things. Taxes on mutual funds are only avoidable if you are using a retirement account to buy them. For example, if you buy mutual funds through a 401k, 403b, traditional IRA or something similar, then you won’t pay any taxes until you retire. My advice – Even though you’ll pay taxes on them now, I suggest buying your mutual funds through a Roth IRA because of the advantages later on in life. Usually when you go to buy them, the broker will give you the option of buying them for an IRA or just as a regular-old taxed investment account.

2. Loads. The word “Load” means “fee”. If you ever hear the words “front load” or “back load”, run for the hills! Back when mutual funds first came out, it was pretty common to see these extra one-time fees associated with a mutual fund. But times are different and you can do better! Today, you want a “no-load fund” (meaning no fees) and there are plenty of good ones out there.

3. Expense ratio. An expense ratio is a fee you pay (expressed as a percentage) every year for the management of the fund. This one is unavoidable, but manageable. For the reason I presented above, you will always have to pay something for the convenience of owning this group of investments. But you don’t have to break the bank! My advice – seek great performing funds with the lowest ratios possible!

I hope this tutorial helps answer many of your questions about what are mutual funds and how they can be helpful in your overall investment strategy.  If you want to know anything further, please feel free to leave your questions in the comments section.

Photo Credit: Microsoft Clip Art.

The post What are Mutual Funds and How Do I Invest in Them? appeared first on My Money Design.