Past Performance Does Not Guarantee Future Results

My thoughts on investing in mutual funds.

Part I

I just finished reading a lengthy newspaper article about a certain money manager, a fellow who founded an investing company and offered mutual funds and similar investments to wealthy people looking for profitable places to put their money.  I won’t mention his name because his name doesn’t matter.  If I were writing this a few years earlier it would have been some other money manager.  A couple years from now, and it will be yet another money manager.

The story is always the same.

In this particular case, it started about a decade ago.  This particular man got lots of people to invest their money with him, based on whatever his particular investing ideas and strategies were and what the economy was doing at the time, … and … it paid off, in a big way.  The investors got huge returns and our money manager earned a lot of money for himself.  Everyone was happy.  Our money manager was featured on the cover of the personal finance magazines.  He was the golden boy.  Everyone (or, so it seemed) thought that he was THE one.  He had it all figured out. He knew what to do.  He couldn’t lose.  What would he do next?

Then, times changed.  Contraction became recovery.  Recovery led to expansion.  The crisis in this industry or that sector ended.  Some other industry becomes the next big thing.  Or the opposite happens.  Then something else happens.  Or doesn’t happen.  The economy evolves.  Or doesn’t evolve.  Things continue to happen.  In other words, the world goes along much as it has for the past several thousand years.  Our money manager now finds that the huge returns have become losses. Shares in his special mutual fund that used to increase in value by 20, or 30, or 50% every year are decreasing in value each month.  His much touted new offerings lose value immediately.  Then comes the article in the newspaper.  This man used to be so great.  Now everyone’s wondering if he can turn it around.   Can he change losses to gains?  Can he be great again?

Past Performance Does Not Guarantee Future Results.

If you read about investing long enough, you see the same story over and over. Only the name changes.  The star money managers of last year are replaced by this year’s new stars, who, in turn, will be replaced by next year’s stars.  They come and go as quickly and regularly as the pop stars who are revered by teenagers.  You don’t even need to read to observe the spectacle.  Just look at the covers of the personal finance magazines and note the names of this year’s stars.  Wait and see if you ever hear of them again.  If you do, is it because they’re still succeeding, still beating the market?   Or is it because they’re the subject of an article like the one I mentioned above?

Many money managers can, and do, beat the market (that is, obtain investment returns that are better than the average of the entire stock market as a whole) for a year, maybe a couple years, perhaps even a few years.

investing_for_profitWhat tends to happen to almost all of them, though, is this: They have a few good years, a few bad years, a few average years, and then more of the same.  Over time, it’s generally the case that most money managers do about as well as the market as a whole. It’s basic mathematics: the average of a set of numbers is (usually) the average because many of the numbers in the set are equal to or are close to it.  In other words, the average is the average because it’s typical.

Mutual fund companies are sometimes pretty sneaky too; if a particular fund has done particularly poorly, it often ceases to exist.  It gets liquidated, merged with another fund, and is soon forgotten, much like the way some Soviet leaders got  airbrushed out of memory once they had fallen from favor.  Getting rid of under-performing funds raises the average of a company’s remaining funds, making it appear that all of a company’s offering are “above average” like all of Lake Wobegon’s children.

There are a very few money managers who can consistently beat the market year after year for decades. If you want names, here are a few: T. Rowe Price, Jr.; John Neff; Peter Lynch; and of course, Warren Buffett.  Let’s say that these, and a few more like them, are the real geniuses among money managers.

But let’s remember, these real geniuses can only be identified in retrospect.  At the start of their careers, how many investors correctly predicted how successful Lynch, Neff, Price, and Buffett would eventually become?  Were any of the investors of the 1940s, 50s, or 60s so confident that they invested ALL of their money with one of these geniuses?  I doubt it.  Most likely, the people who invested with T. Rowe Price or Warren Buffett when they were just getting started also had other investments.  In other words, they diversified their investments.  That’s financial for “don’t put all of your eggs in one basket”.  Because they diversified, some of their investments yielded huge returns, others didn’t do as well.  Maybe there were some losses that were offset by the large gains.  For many of them, maybe most of them, the bottom line probably showed returns that were pretty close to the market as a whole.

Because we can’t accurately predict the future, I think we have to accept as a given that there’s no way to say today which of today’s money managers will be the geniuses of decades to come.  Much like the investors of previous decades, all we can do is diversify.  This means investing in several different mutual funds.  Do this, and  you will probably have a few investments that do better than average, a few that do worse, and it will all even out … you will do as well as the market as a whole.  This is especially likely over the span of decades.

Doing as well as the market as a whole — it’s not like that’s a bad thing.  Doing as well as the market as whole is pretty good.  Save and invest consistently throughout your working life, earn 5, or 6, or 7% year, on average, over a long time, and you have an excellent chance of being able to retire happily.

Part II

But wait! There’s one thing I haven’t mentioned yet.

It’s this: Money managers are expensive.

They, and their staff of assistant money managers and other related financial experts, don’t work for free.  They need to be paid.  Their salaries and other earnings are charged to the investors or come right out of the money people invest.  Mutual funds come with various fees and “loads” (purchase fees, redemption fees, exchange fees, management fees, service fees, etc.).  Added together, they take quite a bite.  The ongoing management fees are often more than 1% of the fund’s assets, paid every year.  That might not sound like much, but over time it reduces investor earnings significantly.  A mutual fund that earns average (that is, equal to the market as a whole) returns “on paper” actually gives its investors less-than-average returns once the various fees are deducted.

The only way all those fees can be justified is if the money manager consistently delivers significantly higher-than-average returns.  As explained above, most money managers can’t deliver … and, looking ahead, it’s just as impossible to select the mutual fund with the money manager that will outperform the market consistently for decades as it is to predict the future.

So, what if I told you there was a way to get average returns and pay the lowest fees possible?  Are there mutual funds that (almost) don’t charge any fees?  The answer is yes: Passively-managed index funds.

To understand what passively-managed and index mean, let’s compare them with the actively-managed funds that we’ve looked at above.  Actively-managed simply means having a staff of money managers who are actively making decisions as to what stocks a fund should buy and which to sell.  The traditional job of a mutual fund’s manager.  Money managers employ a basic investment philosophy for the mutual funds under their management (“growth”, “income”, or “value” for example), but they are able to freely buy and sell stocks as they see fit.

Now, compare the traditional actively manged fund with the the passively-managed fund.  Instead of having a money manager making day-to-day decisions, the passively-managed fund follows an explicit formula.  Generally, this means investing only in companies that are part of a certain stock market index.  The S & P 500 is one example of a stock index.  You might think of it as basically the 500 largest American corporations.  (Actually, it’s a little more complex than that; companies are selected for inclusion on the index such that the index is representative of industries in the United States and other additional factors are also considered.)

(Stock market indexes, and there are many, are separate from mutual funds.  They were originally created as a way of gauging the overall health or direction of the stock market.  Indexes have been around longer than mutual funds.  No one thought of creating a passively-managed mutual funds, based on stock market indexes, until some decades after actively-managed mutual funds became a common way to invest in the stock market.   John Bogle, who deserves the title of real genius as much as anyone, is known as the man who first popularized index funds for average investors.)

The important part: Passively-managed mutual funds are much less expensive to operate than actively-managed funds.  Why this is so is simple: No need to pay for expensive money managers.

Because a passively-manged fund tracks a given index, it earns average returns more-or-less by definition.  If you want the average returns of the S & P 500, then you buy shares in an S & P 500 index mutual fund.  If you want the average return of the entire U.S. stock market, there’s a fund for that.  There are others as well.

The fees charged by a passively-managed fund are significantly lower than those charged by actively-managed funds.  This means more of your money is working for you, instead of paying a money manager and his staff.  The difference over decades of investing are significant.

Don’t just take it from me.  Do some research.  Learn more about index funds.

If you want a hint, here’s one word:  Vanguard.

Homeowners: Pay Property Taxes and Insurance Yourself

Generally, home mortgage payments consist of 4 parts:

  • principal (a partial payment toward the amount that was initially borrowed)
  • interest (the cost of “renting” the remaining loan balance)
  • property taxes
  • insurance

mortgageWhen someone borrows money to buy a house, the lender has a good reason to want to make sure that the property is insured and the taxes are paid.  (If the house were destroyed in a fire or other accident, the lender would have no way to collect the debt if the borrower walked away.  If the taxes aren’t paid, the local government could seize the house and sell it to pay the unpaid taxes.)  Because lenders prefer to make sure that insurance and tax bills are paid, and paid on time, they include those costs in the monthly payments and pass the money along to the insurance company and local government as needed.  The money is kept in a separate “escrow” account in the mean time.  Federal Housing Administration (FHA) loans always come with an escrow account and include insurance and taxes in the payments.

Many homeowners like escrow accounts just fine.  It’s convenient.  Not making insurance and tax payments means two fewer things to worry about.  Someone lacking in financial discipline might not be able to put enough money aside for the tax and insurance payments, and that could lead to trouble.  Simply forgetting to make the payments can lead to late fees, or worse.

However, someone who is able to manage their money and wants to spend a little extra time doing so might want to consider a no-escrow loan.  While this does not reduce your taxes and insurance costs, it does let you keep your money in your own account until you need to make the payments.  This might allow you to earn some interest from the bank (or credit union!) where you keep your checking and savings accounts.  Additionally, you might more easily meet some minimum balance requirement that eliminates monthly service charges.

It’s usually easier to avoid escrow on a new loan and harder or impossible to remove an escrow requirement from an existing loan.  Even if you can avoid escrow, watch out: banks might charge a higher interest rate on a no-escrow loan.  As always, shop around and negotiate.

Removal Salt, Avoid Rust

In much of North America the last snow of the winter usually occurs sometime in February or March, which is also the time of the last road salting.  Once the salt is gone — and it’s good to wait until there’s been a heavy rain that gives the roads a good rinsing — you will want to get the road salt off your car.  You could go to the local car wash and spend money … or you could avoid convenience and save money by doing it yourself.  I’ve always gotten good results with a bucket of warm water mixed with a little dish-washing detergent.  Apply with a large sponge, scrub, dump the remaining detergent-water mix over the car, and rinse well.

auto_rustHowever, removing the road salt from your car’s unpainted undercarriage is even more critical than washing the car’s body.  It’s the metal parts under the car that can be damaged by salt’s corrosive powers.  The painted body can usually withstand contact with road salt pretty well.  Also, the top of the car gets rinsed by the rain.  The underside of the car isn’t exposed to rain.  Most people know this, which is why commercial car washes offer an “undercarriage wash” and why they do such a good business after the end of the snowy season.

But you don’t need to pay $$$ (not to mention, wait in a long line) to give your car’s undercarriage a good washing.  You can just use a garden hose and a sprinkler.  When I wash the car for the first time after the last of the winter snow, I attach a lawn sprinkler to the garden hose, turn on the water, and use the hose to slowly push the sprinkler back and forth under the car.  It’s a good idea to avoid spraying too much water into the engine compartment.  You might need to get down on your hands and knees to make sure the water is directed at the wheels and suspension.  There are actually special tools that attach to a hose to perform the undercarriage washing.  Some clever people have made their own.  In my honest opinion, it seems that a lawn sprinkler works just as well. The whole point is to get the salt off your car, and because salt is water-soluble, all you really need to do is get water into contact with the underside of the car.

It takes a little time, but … as usual, avoiding convenience means you’re paying yourself instead of paying someone else.

(However, if you search the internet you can find lots of people saying that you need to use some kind of special salt-removing product to really do a good job.  All I can say is that the sprinkler method has worked for me, but as the saying goes, your mileage may vary.  What’s happened to me is anecdotal.  I haven’t owned enough cars to do a scientific study.  It might be that my car is less susceptible to rust or maybe I reduce my driving when roads are icy and salty.  (The second part is true.  I really do try to avoid driving when there’s ice and snow on the roads.)

Inspiration From Youtube

As I’ve mentioned elsewhere, your thoughts become you deeds.  Thus, if you control your thoughts, you end up controlling your deeds.  That’s called self-control and it’s essential if you want to reduce your spending and thus be able to increase your saving.  One way to control your thoughts is by listening, reading, and watching media on the subject of personal finance.  You can find podcasts and radio shows, books, and (of course) videos.  Here’s an example.

Maybe not everything mentioned in this video is applicable to your situation.  Okay.  So find another video.  You know how to work the internet don’t you?  Then you can find books at the library or among the used books at your local thrift shop.

Finally, I’ll mention that as you get lots of personal finance advice from a variety of sources, some of what you’ll hear or read might be not only not applicable to your situation … it might also be downright incorrect or untrue.  But that’s okay.  If something isn’t true, remember that free advice is sometimes worth what you pay for it.  And it isn’t just the actual factual content that you’re looking for.  It’s also the inspiration that comes from seeing and hearing someone else talk about doing what you want to do.  Just knowing that other people have done it should show you that you can do it too.  That’s one reason why The Richest Man in Babylon is still one of the best books about personal finance, despite the fact that it’s almost 100 years old.  So get inspired and save money!

Tightening the Newel Post

The newel post (the large vertical post at the bottom of the handrail on the stairs) at my house had gotten loose in recent years  Tightening a newel post is certainly an easy do-it-yourself job for anyone who has an electric drill and knows their way around a hardware store.  What I did was basically the same as what Tom Silva does in this video — except I used two screws, one in a tread and one in a riser.  Good tip, using a carpenter’s square to make sure the drill stays level.

Trusting Your Car to Turn Off the Headlights

c ar_parked_headlights_onAs far as I know, this opinion is unique to me, and I think there’s a good chance that some people might find it a little wacky.  But here goes:  Every time I see a driver get out of their car and walk away, leaving the headlights on, I think, “I could never do that“.

Yes, I guess it’s a little crazy.  These days most cars have some sort of electronic mechanism that automatically turns off the headlights a few minutes after the engine is turned off or the car is in park.  Sometimes I watch, and, sure enough, I see that’s what happens.

Bur suppose the lights don’t go off by themselves?  If that happens, the car’s owner might return to a car with a dead battery.  That’s a chance I don’t want to take.  Sure, the car lights go off by themselves more than 99% of the time … but there’s going to be that one time when it wasn’t a good idea to act as if you believe that no automotive component could ever fail!  Nothing in a car ever just stops working!

Besides the risk of the lights staying on and draining the battery, there are a few other things that come to mind.

Could leaving the headlights on mean that they will burn out sooner?  It stands to reason that any sort of headlight is only going to last so long, that is, some certain number of hours of “on” time.  If you burn your headlights an extra few minutes every time you start the car, they’re going to reach the end of their useful life sooner.

Also, using the headlights needlessly wastes gasoline.  The electricity in a (gasoline-powered internal-combustion-engine kind of) car’s battery doesn’t just come out of the air.  The electricity is generated by the car’s alternator, which is turned by the engine.  When it’s actually making electricity, it’s a little harder to turn, and therefore the engine uses a little more gasoline whenever the alternator needs to make electricity to charge the batter or operate the car’s electrical components.  Not only does burning the headlights for no reason waste gasoline, it also adds wear and tear on the alternator and battery, shortening their lives.

Cutting the Cheese

cut_the_cheese“You don’t mind if I cut the cheese?”, I asked my colleagues eating lunch with me at our workplace cafeteria.  As I said it, I held up the table knife I keep at my desk and the block of cheese I was eating that week (and probably the next week too).  It was a good cheddar I got at Costo.  As in most everything, it pays to avoid convenience and do the work yourself.  In this case, I was cutting the cheese to have with the crackers and salami I was having for lunch that day.  Just like the way I pay myself to carry a box of snacks to work (instead of paying the man that stocks the vending machine), just like I pay myself to bring my own iced tea to work, I can also pay myself to not only bring the cheese to work, but to also to cut it into slices.

Make Your Own Soap

The basic principle of avoiding convenience applies to soap.  You can make your own soap and save money in the process — and probably get better soap.  Exact soap-making instructions are a bit beyond the scope of this blog (you can find plenty on the internet and there are lots of instructional videos on youtube), but I’ll give an overview of the basics.

All you need are three ingredients:

  • Fat (such as lard, coconut oil, or olive oil)
  • Lye
  • Distilled water

You can also add some other ingredients for scents or added effects (such as lavender, peppermint, honey, oatmeal, and various coloring).

The preparation method for basic soap-making is

  • C-a-r-e-f-u-l-l-y add the lye to the water (rubber gloves and eye protection are mandatory)
  • Warm the fat over low heat
  • Get both the fat and lye-water to the correct temperature (which usually means warming the fat while waiting for the lye water to cool)
  • C-a-r-e-f-u-l-l-y blend them together
  • Mix until thickened
  • Add any optional ingredients
  • Pour into molds and cover
  • Allow to cool slowly
  • Remove from molds
  • Allow to cure in the air for several weeks

That’s all.

homemade_soapYou can get very creative with the scents, colors, molds, and packaging.  You might be inspired by the soap-makers in your family tree.  (“Your great-grandmother used to make her own lard soap in the backyard.”)  You might explore the soap-making traditions of your ancestors.  (“This is the kind of soap they made in the old country.”)  Once you’re a skilled soap-maker, you have an excellent and one-of-a-kind unique gift for all-purpose giving.

You’ve probably heard that lye is dangerous.  It is dangerous.  That’s why you wear gloves and safety glasses.  You should also wear long sleeves and pants.  It’s also a very good idea to work with the lye outside, as combining lye and water creates toxic fumes.  But, in my opinion, the danger level isn’t so inordinately high that soap-making must be left only to professionals working on an industrial scale.  I’d say it’s not too far from the danger level of making using hot oil on a stove to make a large batch of french-fries.  Of course, you do need to be careful and, to repeat for emphasis: wear safety glasses.

Do some research and if it interests you, procure the ingredients and make a batch.  You should find a tried-and-true recipe and follow it exactly.  Measuring quantities and temperatures precisely is absolutely essential when you’re making soap.  It’s not like making a stew or soup that you can easily vary by adding more of one ingredient or less of another.  The fat, lye, and water must be combined in the correct amounts and at the right temperature for saponification to occur.

Depending on what fat you use and how you obtain it, I think there’s a good chance that you’ll find the money savings and the high quality of the product are worth the effort.  You might come to see, as we have in my household, that making your own soap isn’t much different than making your own breakfast, lunch, and dinner.

Finally Got a Smartphone

galaxy_lunaIn an earlier post I wrote that I didn’t have a smartphone and was getting along fine using my dumbphone that did nothing but make calls and play MP3 files.  It finally stopped working.  So I bought a smartphone, mainly because the cheapest ones cost about the same as the dumbphone I bought a few years ago.  It’s cool being able to use wi-fi to look at websites and read Wikipedia (on an app that uses the text stored in the phone’s memory).  I still mostly use it as an MP3 player.  I still use a prepaid plan and my cost will still be around $10 per month over the life of the phone.

Replacing Fluorescent Tubes With LEDs

It’s well known that LED lights are much more efficient than incandescent or fluorescent lights.  They use less electricity and last much longer, making them well worth the initial cost.  For me, the long life is the real advantage because it means I’ll spend far less time buying and changing bulbs.  Swapping screw-in incandescents led_tubefor screw-in LEDs couldn’t be easier and everyone should do it.  I did that years ago.

Recently, the fluorescent tubes in my basement laundry area (which date from the time before household LED lights became available) stopped working.  Because they both stopped at the same time, I suspected the ballast might need to be replaced.  While researching ballast replacements, I became aware that LED tubes for replacing fluorescent tubes are now available.  The advantages of LEDs make swapping them for fluorescents the obvious thing to do — but doing it isn’t as easy as unscrewing one bulb and screwing in another.

It’s the ballast (which is “used in fluorescent lamps to limit the current through the tube, which would otherwise rise to a destructive level due to the negative differential resistance artifact in the tube’s voltage-current characteristic” according to Wikipedia) that’s the issue.  “What to do with the ballast?” is the question

Keeping the Ballast.  The easiest way to convert fluorescent fixtures to LED is to replace the old fluorescent tubes with LED tubes that are specially made to work in fixtures with ballast.  Just take out the fluorescent tubes and put in the new LED tubes.  However, that’s probably not the best way.  In general, LED lights don’t require ballast, so you’re buying an LED light that is made to work with ballast.  In fact, because it’s made to work with ballast, you shouldn’t use it in a fixture that doesn’t have ballast.  There are two problems with keeping the ballast: (1) it will eventually fail (which will leave you in the dark) and need to be replaced, (2) it uses electricity, so keeping the ballast partially offsets the savings you get from using LED lights.  To avoid spending money for ballast replacements in the future (the life of the LED might be 4 or 5 times the life of the ballast), and to avoid spending money for electricity consumed by a ballast that isn’t even necessary, I decided to remove the ballast from my basement fixture.

Removing the Ballast.  It’s fairly easy to remove or at least bypass the electrical ballast in a fluorescent fixture, thus converting it to use LED.  You just need to open the light fixture, cut a few wires, and make a few connections with wire nuts.  There are lots of directions online.  However, there are two ways of doing the re-wiring.  (See, I told you this wasn’t as easy as replacing screw-in incandescents …).  You have the choice of either (1) running the live wire to one end of the fixture and the neutral wire to the other end, which is the standard way fluorescent fixtures are wired, … or … (2) running both the live and neutral wires to the same end of the fixture.  Method (1) requires LED tubes that are called “double ended” or “dual end powered”  Method (2) requires LED tubes that are “single end powered”.  It’s probably best to buy the LED tubes and do the re-wiring accordingly, because “single end” tubes require a different kind of lamp holder (a.k.a. “tombstone”).  However, note well: The wiring job has to match the tube type or your light won’t work.

To review, the choices are:

  1. Use an LED tube designed to work with a ballast (easy, but you have the cost of ballast replacement and electricity consumption).
  2.  Use an LED tube designed for use without a ballast (requires re-wiring the fixture, but eliminates cost of ballast), either
    • doubled-end LED tube, or
    • single-end LED tube

Also, LED tubes are available with either clear or frosted plastic covers.  The clear tubes are a bit brighter, but are harsh if you happen to look directly at them because you can see the actual LEDs.  I wouldn’t use them in any location where the tube itself is visible.  They might be good for recessed lighting or maybe in a fixture that has its own light diffuser.  The frosted tubes are more like traditional fluorescent tubes, bright but not harsh on the eyes.