Archive for Investment Education

Index Funds vs. Actively Managed Funds Revisited

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index funds denver fee only financial planningOne of the perils of working in financial planning is that you speak in this weird language that you think others understand, but they don’t.   This is where I rely on my friends to let me know when I am writing in financial-babble.

So, this blog goes out to my good, honest friend Dana Lynch.  Thank you, Dana, for telling me that my index fund vs actively managed fund blog was still confusing.  Since Dana is a wardrobe consultant extraordinaire (visit, I will re-frame this discussion in terms of a closet.  We’ll see if that helps.

Think of your portfolio as your closet.  In your closet, you have different categories of clothes.  You have dress clothes for work, casual clothes for general running around, and spandex/ratty clothes for the gym.  In the same way, think of your investment portfolio as your closet.  It contains different categories of investments such as US stock funds, Bond funds, and International funds.  With me so far?

OK, now to get to index vs. actively managed.  In your closet, you have clothes that come together as a matching set (like a business suit) and clothes that you buy as separates (skirts, pants, shirts, belts).  A business suit is easily put together and it will always look average-to-OK.  You don’t have to search all over the mall to get all of the pieces to create the outfit, so the time and cost of a business suit is usually lower than creating your own unique outfit.

This is similar to an index mutual fund.  Index funds are based on a pre-created list and all the mutual fund manager has to do is buy the stocks or bonds on that list.  It takes little energy or time and so the cost of creating and managing that fund is low.  The results will always be average-to-OK (the fund will return whatever the list returned, no more or less).

You might be the type who is always out looking for original pieces to create ensembles that will make you stand out from the crowd.  This would be an actively managed wardrobe.  It could look fantastic (Blake Lively), or it could be a total disaster (Helena Bonham Carter).  Either way, you’re not following a style formula, you are creating something unique.  This takes more time, energy, and money to create than a matching business suit or sweat suit for the gym.

The same is true with actively managed mutual funds.  The manager is creating his own unique blend of investments and trying to beat the established pre-created lists.  Some years, he will far out perform the standard investment list.  Other years, he will do worse.  All of this research, creativity, and trading in the portfolio costs more money than the index fund investments that just follow the list.

I hope this analogy helps clarify the difference between actively managed and index funds.  If not, let me know.  I can probably come up with a comparison to food or sports.

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Asset Allocation, or What’s in YOUR portfolio?

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Here’s a little secret that most investment salespeople will not tell you: The actual investments you choose aren’t really that important.  Buying Whole Foods or Walmart or Kroger stock is the least important financial decision you will make.

What?  How can that be, you say?  My adviser is an expert at picking money making investments.  Maybe, but that can only last so long.

What is tried and true is to build a portfolio by first determining your Asset Allocation.  Asset Allocation simply means what percentage of your money will be in different areas of the investment market (like US large company stock, International stock, Real Estate, or Bonds).    A 1991 study referred to as the Brinson Study shows that 91% of investment returns are related to the Asset Allocation of the portfolio.  Market timing and investment selection combined only account for less than 10% of your results.

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Picking investments before you have chosen your Asset Allocation is like buying all of the tile for a new house before you’ve created a floor plan.

Choosing your asset allocation has about 70% to do with your time horizon (longer time horizon = more stocks) and 30% with your loss tolerance (how low can the portfolio go before you hit the panic button).

So, after you’ve done the hard work of choosing how much you’ll have in stocks vs. bonds, picking investments to fill in those slots is pretty easy.  Look for diversified mutual funds in each area that have low costs, lower risk than their peers, and higher returns than their peers.

If this still seems like more effort than you want to put into creating your portfolio, call me and let me help you work out a plan that is right for you.

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More Financial Jargon Explained!

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Bottom-up Investing:  No, this is not a reference to Kim Kardashian breaking the internet.  Bottom-up mutual fund managers research companies individually and without regard to the current economic cycle, geography, or other big picture considerations.

Asset Allocation: I’ll spend more time on this later.  For now, know that Asset Allocation is the combination of different broad categories of investments that you have in your portfolio.  For example, if you asset allocation is 85% stock and 15% bonds, you have an aggressive growth portfolio.

Efficient Frontier:  This is used to describe the graph from Modern Portfolio Theory that shows different historical risk and returns for various combinations of stocks and bonds in portfolio.  Efficient Frontier and Modern Portfolio Theory are often cited as an argument for keeping a diversified portfolio.

Risk Tolerance:  As financial advisers, we need to know how much risk you are willing to take in order to recommend appropriate investments.  Unfortunately, during up stock markets (like the last 6 years) people’s appetite for risk tends to go up because they want the big returns.  Enter the next recession (NO, I don’t know when it will be, but I promise we will have one.  The markets are cyclical after all.), and suddenly people don’t like risk so much after all.  What you really need to explain to your adviser is how much you are willing to lose and at what point you will be curled in the fetal position and screaming at your adviser on the phone.   That is called Loss Tolerance and it is much more useful than Risk Tolerance.

Next time, more about Asset Allocation!

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ETFs and Index Funds

ETFs and Index Funds

Here’s a topic that many people wish they knew more about.  That, and whether the new college football playoff system will be better than the BCS.

Exchange Traded Funds (aka ETFs) were introduced in 1993 with the launch of the S&P 500 Depository Receipt (or SPDR).  This was a mutual fund-like investment that pooled investor’s money together to buy a list of stocks dictated by the S&P 500.

The big difference between the SPDR ETF and an S&P 500 index mutual fund was the flexibility in trading offered by the ETF.  Now, instead of buying or selling your mutual fund shares once per day (at the close of the stock market), you could trade an S&P 500 ETF all during the day like a stock.  You could also write options on the ETF, short the ETF (bet on the investment falling instead of rising), or generally trade to your little heart’s desire all day on small rises and falls of the ETF price.  What fun!

I jest.  I don’t really think sitting in front of a computer all day staring at stock market ups and downs is fun.  But for those who do, ETFs are a way to buy more diversified investments than just one stock at a time.

ETFs are supposed to be less expensive than comparable mutual funds.  This is not always true!  ETFs have annual expense ratios just like mutual funds.  And they are NOT always less than their mutual fund counterparts.  For example, the expense ratio of the SPDR ETF is .09%.  Very low indeed!  However, the expense ratio of the Vanguard Index 500 Admiral Shares mutual fund is only .05%.

Also, ETFs trade like a stock and they generate stock trading fees.  This can be anywhere from $7 per trade at some discount brokerages to over $100 per trade at some full-service brokerages.

ETFs started off as simple index investments that traded like a stock.  Now, there are actively managed ETFs and the categories that ETFs cover is staggering.  Want to invest in a many-years-old list of companies trying fight global warming?  There’s an ETF for that.  How about an ETF that only invests in casinos?  Sure, there’s one out there!  A holding that only invests in beef and pork?  There’s an ETF for you!

ETFs get a lot of press because they are interesting and sexy to talk about.  For the average, long-term investor, though, they may not be necessary for your portfolio.

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Index Funds vs. Actively Managed Funds – Which is Better?

Index Funds vs. Actively Managed Funds – Which is Better?

You may think of investment people as nerds (and you are mostly right), but we have areas where we are passionate, too. One of them is whether index investing or active management is better.

On the Index side, you have people who sometimes refer to themselves as Bogleheads (kind of like Parrotheads, but WAY less fun) after the founder of Vanguard, John Bogle. These people believe that no active manager can ever consistently beat its benchmark index over a long period of time. Therefore, say the Bogleheads, you should just by inexpensive index funds and get the market return.

People who are fans of active management (sorry, no catchy nickname here) believe that there is value in having people scrutinize companies before putting your money into them.  Why invest in an Enron just because it’s part of some list if you can see that they are cooking the books and headed for disaster?  Also, people hope that active managers will help cushion the blow by changing up their investments in the face of overall market downturns.


What do I believe?  As usual, I take a middle ground.  In very efficient markets, like the US Large Cap stock market, it seems to be really hard for a manager to beat the S&P 500 index over time.  This seems like a good place to use index funds.

However, in markets where the companies are less well known, say the international small cap market, I’d like someone looking into those investments and not just investing in a list of 5,000 small foreign companies and hoping for the best.

This is a short explanation of something that investment folk rage over, but I think it gets you the basic idea.  Now, at your next nerdy dinner party, you can contribute to, or at least understand when people take up arms on this touchy subject.

Next time, what’s the difference between ETFs and Index Mutual Funds?

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Index and Actively Managed Mutual Funds

Index and Actively Managed Mutual Funds

Happy New Year!  In December I veered off in all sorts of random directions with the blog.  Between year-end to-dos and general revelry, I got way off task with the decoding financial jargon goal.  So, back to work we go.

In past blogs, I’ve explained what a mutual fund is, how to do research picking funds, and how to judge the cost of mutual funds.  Now, we turn to the question:  What is the difference between index funds and actively managed funds?

Index funds are mutual funds whose investments mirror an already established index meant to represent a certain area of the investment market.  One that many are familiar with is the Standard and Poor’s 500 Index, or S&P 500.  The S&P 500 tracks the 500 largest US stocks as measured by market capitalization.

So, an index fund that tracks the S&P 500 invests in those same stocks in the same quantities as the list of stocks published by Standard and Poor’s.  There is no one thinking about if the investment is good or bad or if the companies will go up or down in value.  The fund is mostly managed by a computer program.  Since there isn’t a lot of human capital involved, an index fund will typically have a lower expense ratio (see October 23, 2014 blog) than actively managed mutual funds.

In an actively managed fund, a fund manager and his merry band of analysts do lots of research, interviews, and general crystal-ball-gazing and decide which companies to include in their fund.  They make proactive decisions on when to buy or sell different investments.  They try to beat the overall performance of their particular area of the investment market.  For example, the manager of the Metropolitan West Total Return Bond Fund is trying to beat the annual returns of the Barclay’s US Aggregate Bond Index.

Because actively managed funds use people to decide what investments to make (and people like being paid for their work), the annual expense ratios tend to be higher.

This comparison of fees between index funds and actively managed funds is a generalization and not always true!  Just because a fund has “index” in the title doesn’t make it cheaper than an actively managed fund.  For example, the JP Morgan Equity Index Fund Class C has an expense ratio of 1.42%.  The American Century Investments Equity Growth Fund Investor Class (an actively managed fund in the same investment category) has an expense ratio of .67%.

You must always look under the hood of your investments to know the pricing of what you are being sold.  Cheaper is not always better, but costs are one of the few things about your investment portfolio that are under your control.

Next time we’ll talk about the big debate: Which is better – active management or index investing?

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Happy New Year from Sullivan Financial Planning

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Happy New Year!

In my financial planning business, I work with three distinct groups:

  1. Those who are just starting out in their professional and investing lives (ages 25-30)
  2. People who are building careers, families, and savings portfolios (30s – 50s)
  3. Pre-retirees or people who have recently retired (50s and beyond)

Following are the New Year’s Resolutions that I hope each age group will make and keep.

Group 1 – 20s and 30s

  • Create a savings account for emergencies or job loss.  Fund it with 3-6 months’ of essential expenses.  Do not touch this money for vacations, shoes, or other non-emergency purchases.
  • Sign up for your 401(k) or 403(b) contributing at least the amount your company matches.  Set up an automatic account builder to raise your contributions to 10% within 3 years.
  • Work on paying down consumer debt.

Group 2 – 30s through 50s

  • Save at least 10% of all income for retirement.
  • Try saying “no” to your kids every once in a while.  For example, “No, I will not buy you an iPhone 6.  Earn your own money to pay for it,” to your teenager.  Or, “No, I will not pay for 100% for your out-of-state private school college expenses.  Start hunting for scholarships, jobs, or a less expensive school.”  Exercising your “no” muscle will give you the strength to protect your own finances and your kids the confidence that they can make their own dreams happen without the Bank of Mom and Dad.
  • Meet with a financial planner to see if your investments are properly diversified.

Group 3 – Pre-retirees

  • Actually write down what you spend on a monthly basis.  You must know this information to be successful in retirement.
  • Think of a part-time job you could do for the first 3 years of retirement.  This will ease your transition both emotionally and financially.
  • Meet with a financial planner to assess your retirement readiness BEFORE you tell your employer that you are leaving your job next month.

Enjoy your New Year’s celebrations!  I hope to hear from you in 2015!

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5 Smart Financial Things to Do Before December 31st Part Two

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Second in a 2-Part Series

In part one you have madly scrambled to increase your retirement plan savings and sign up for your Flexible Spending Account during the last milliseconds of open enrollment.  Now, let’s talk about the other 3 items on the list.

#3 Harvest Tax Losses

In your non-retirement (a.k.a. taxable) accounts, you report and pay taxes on dividends and capital gains each year.  If you sell an investment for a loss, you can write off that loss on your taxes each year.  The maximum loss is $3,000/year.

If you have a gain in one investment and a loss in another, you can offset the gain by selling both the gainer and the loser.  There is no limit to the amount of gain that can be offset by a loss.

You must sell your investments for gains/losses by December 31, 2014 in order it to count on this year’s taxes.  Wash Sale Rule:  If you sell an investment for a loss and re-buy that same investment within 30 days, you cannot take the write off for the loss on your taxes.

Example:  Joe and Jane own 2 investment in their joint account.

  • Mutual fund ABC has gained $2,000 since they bought it
  • Mutual fund XYZ has lost $1,000 since they bought it.
  • Joe and Jane can sell both funds, but only report a $1,000 gain on their taxes, since the $1,000 loss in XYZ offsets $1,000 worth of the gain of ABC.
  • Or, they could sell just enough of ABC to realize $1,000 loss that could be offset by selling XYZ.
  • They can buy back both funds 31 days or more after selling to avoid the Wash Sale Rule

#4 Give to Charity

This is a great time of year to reflect on all that you are grateful for in your life and give to those who aren’t as lucky.  Most people don’t give to charity because there is a tax benefit, but it would be foolish not to take advantage of government incentives that are out there.  Some things to be aware of:

  • Contributions to qualified charity made on or before December 31, 2014 can be used to reduce your 2014 income taxes.
  • Keep receipts for contributions of $250 or over (i.e. donations to Goodwill).
  • Cash donations can be written off to a maximum of 50% of your Adjusted Gross Income.
  • Donations of securities (stocks, bonds, mutual funds) can be deducted to a maximum of 30% of Adjusted Gross Income.
  • By donating securities that have gone up in value, you avoid paying capital gains when selling those securities.
  • People who are over 70 ½ can donate up to $100,000/year to a charity directly from their IRAs and have the donation count toward their Minimum Required Distribution.
  • If you plan to donate securities to a charity, start the process AT LEAST 7 business days before December 31st.  These transfers do not happen by magic.  There is paperwork, often notarized signatures are required, and the transfers take time.  The donation must be RECEIVED by December 31st to count for that year’s taxes.

#5 Consider a Roth Conversion

A Roth Conversion means to transfer money from a tax-deferred IRA to a Roth IRA.

You owe income taxes on the amount you convert in the year you do the transfer.

The balance then grows tax-fee and costs nothing in taxes to withdraw in retirement.

If you are in a lower-than-usual tax bracket this year and expect to earn more in subsequent years, this could be a good time to pay less taxes on a Roth Conversion.

OK, enough financial lecturing.  Get out there and stimulate the economy by buying things for relatives that they don’t need or want.  All while respecting your budget, of course!

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How Bonds Work – One Last Thing!


Last week, we saw how bond prices change based on the interest rate being paid by newer bonds in comparison with older ones that have already been bought by consumers.

We also saw 2 weeks ago how you might diversify your bond holdings by having some that are super-safe (US Government issued), pretty safe (bonds from large corporations) and risky (bonds from smaller businesses).

Another way to diversify your bond holdings is by length of maturity. When a bond matures in less than 3 years, changes in interest rates don’t affect the price of the bond much (up or down).  But, the longer until the bond’s maturity, the more price swings a bond will have based on interest rate changes.

So, if you are concerned that interest rates will go up, you might own more shorter term bonds.  The interest they pay is lower, but your principal is steadier.  If, however, you have a longer term time horizon, you can buy some longer term bonds, get a higher payment of interest, and just ride the roller coaster of returns longer.

It’s important to remember that even a bad year in bond market returns has been no big deal compared to a bad year in the stock market.  For example, 2008 was a horrible year for the US stock market with loss of 37% as measured by the S&P 500.  In 2013, it was a bad year for the bond market with a loss of 2% in the Barclays Aggregate Bond Index.

On the other hand, when stocks have a good year, it’s really good (+32% in 2013 for the S&P 500).  A great year in the bond market is more like a 6% gain.

This is why it’s good to have some of both bonds and stocks in your portfolio at all times!

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How Bonds Work – Part Deux


Bonds do go up and down in price. One reason can be because of changes in interest rates. Let’s return to Kristi’s Ranger Cookie Food Truck.

You’ve bought a $5,000 bond from me that matures in 5 years.  My business is going well and I’m paying your 5% interest every year as promised.  But, let’s say that you have a cash crisis in Year 3 and you need your $5,000 back.

Well, our arrangement is that you get your $5,000 back at the end of the 5 years and I am not prepared to pay you early. What’s your option? To sell your bond to someone else, get the $5,000 from them and you no longer get the interest payment. Your bond buyer gets the next 2 years’ interest and the principal back from me.

But, let’s say in the 3 years since you’ve bought the bond, interest rates for new risky bonds (called “junk bonds” or “high yield bonds”) has gone up to 7%. Buyers of bonds aren’t going to pay full price for a 5% bond when they can get a 7% bond for the same price.  So, you will need to discount the price of your bond to make up the difference in interest a buyer will give up.  In this example, you may sell your bond for $4,500 and the buyer will then get the original $5,000 principal back from me at the end of Year 5.

On the other hand, if new risky (high yield, junk) bonds are selling for 3% interest, you might be able to sell your 5% bond for higher than the original $5,000 price. This is called selling at a premium. So, your buyer would pay you $5,500 for the bond, get the higher-than-current-market 5% for the next 2 years, then receive the original $5,000 principal back from me at the end of Year 5.

If you don’t need to sell the bond before maturity, you don’t need to worry about interest rates rising or falling during the years you own the bond.  You paid $5,000 and you will get $5,000 back from me at the end of 5 years.

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