8. Beware of the Closet Index Fund
Low-cost index funds are the perfect buy-and-hold investment for busy investors. What isn't such a good deal are mutual funds that charge actively managed fund expenses for portfolios nearly identical to that of an index fund. Why pay more for less return? You can identify and avoid these closet index funds by inspecting their portfolios under a microscope.
Owning closet index funds costs you big time. The least expensive index funds charge less than 0.25 percent of your assets in ongoing expenses and charge no loads. A closet index fund might charge one percent or even more for the same basic performance. The Vanguard 500 Index fund, the nation's largest mutual fund, tracks the S&P 500 index and charges 0.18 percent of assets, which is far better than the 1.4 percent for the average, actively managed, large blend fund. Translated into dollars and cents, a $10,000 investment in the Vanguard 500 Index fund costs $18 a year, whereas a similar investment in an actively managed fund costs $140 per year -- more than seven times more. Hold that fund for even five years, and you'll pay at least $610 more than the fees for the index fund.
To check for index-hugging, first find a fund's benchmark index, either in a fund report or on the Morningstar web site. Focus on the following prioritized points to spot signs of index investing:
A fund with an R-squared of 90 or higher is a strong candidate for closet index fund status. The lower the R-squared, the lower the correlation between the fund's performance and that of the benchmark index.
A fund with a beta of 1.0 has performance volatility on par with the index. The more the beta value differs from 1.0, the less likely the fund mirrors the index.
Fund-data providers classify sectors differently, but a fund with sector weightings close to the index is likely a index-hugger.
Few funds beat indexes over the long term. Closet index funds might have performance close to the three- or five-year performance of an index fund, but are likely to fall away by 10 years because of the drag of their higher expenses. Managers with a more independent mindset are less likely to closely track index performance. For funds that charge a sales load, compare the load-adjusted returns to the index returns.
Average PE ratios within a point of the index are suspicious.
Average EPS within a percentage point of the index are suspicious.
You can compare either the top ten holdings or the entire portfolio to see how many companies are the same for the fund and its corresponding index, and look for similarities in the largest holdings.
As with sector weightings, a portfolio close to the index in terms of market cap is suspicious.
Indexes followed by foreign and world stock fund managers are strict in terms of the country weightings. Funds that don't go out of bounds are candidates for closet indexhood, while those that venture outside of their limits are run likely by more independent-minded managers.
9. Forecast Future Returns
Before you purchase a stock, the challenge is to figure out what sort of return you might earn based on the price you plan to pay. After you own a stock, reevaluating its future return from time to time can help you weed the slow growers from your portfolio. With a current price and a potential price a number of years in the future, you can calculate the potential return, usually called total return. When you use fundamental analysis to evaluate stock, the earnings growth rate you expect from the company and the potential future PE ratio for the stock both play a part in forecasting the future price.
To calculate a future price, you need an estimate of future earnings and an estimate of a future PE ratio. With estimated this and estimated that, it's clear that your forecast for future price and return are only as good as the estimates that you provide. By erring on the conservative side with your earnings and PE ratio estimates, your forecast will be less exciting but probably more attainable.
Here's how you develop a forecast for a price five years in the future:
Estimate the annual earnings growth rate you expect the company to achieve for the next five years.
Calculate estimated future earnings five years from now based on your estimated earnings growth rate, as shown in the following formula:
EPS (5 years out) = EPS last 4 quarters * (1 + estimated earnings growth)5
Choose a PE ratio that you expect the company to carry five years from now. To be conservative, use the signature PE described in Tip #5.
Calculate your forecast for a future price in five years by multiplying the estimated future earnings by the PE ratio you chose, as follows:
Future Price = EPS (5 years out) * Selected Future P/E ratio
Calculate the annual return based on your forecast future price and the price at which you intend to purchase the stock using the following formula:
Annual return for next 5 years = (Future price / Purchase price)1/5 - 1
If you want to make sure that you achieve your minimum acceptable return, you can calculate a buy price based on the future price and your minimum return. To do this, calculate the present value using the following formula:
Present Value (PV) = Future value / (1 + return)5
10. Balance Risk and Return for College Costs
With college tuition soaring, parents who want to pay for their kids' education need as much help as they can get. Tax-advantaged education accounts are a huge help, but time is the best thing for college savings, by far. By starting to save for college early, you can invest in stocks and earn returns that can keep pace with the frightening rate of college tuition increases. Because stocks are risky for the short term, you must move your savings into safer investments as your child gets closer to college age.
If you're an overachiever, you can start setting money aside for college before your bundle of joy is even a glimmer in your eye. For many parents, the birth of a child is a wake-up call (even several a night for many months). These early years are great for getting ahead of the college curve. Start investing money regularly in mutual funds that own stocks. Because of the number of years you'll have to save, and the higher returns that stocks or stock-based mutual funds provide, your monthly contribution can be more reasonable. With 12 years of investing at a 10 percent return, you need about $350 a month to reach $100,000. If you don't start saving until five years before school and use safe investments paying four percent return, you'll need $1500 a month to reach the same goal.
The adolescent years bring a host of problems, both psychologically and financially. You're on your own interfacing with your teenager. Fortunately, the financial transformation of college savings will seem easier, by comparison. Because you don't want to lose money in the stocks in your college savings when there's little time for them to recover, the transition to safer investments begins when your child is 12 years old. The conventional advice is to start depositing new savings into safer investments, such as long-term certificates of deposit or zero coupon treasury bonds (also known as zero-coupon treasuries) that mature when your child heads off to college. However, if you make automatic monthly deposits to a stock fund, you could choose to continue that, and sell a chunk of your stocks or mutual funds to meet your target percentage for CDs or bonds. However, if a recession appears imminent, switch your monthly deposits to a secure savings option.
By the time your child is 14, about half of your college nest egg should be in safer investments. Therefore, between ages 12 and 14, you must gradually reduce the percentage of funds invested in stocks from 100 percent to 50 percent. Realistically, you continue to reduce the percentage of money in stocks until all of your college savings are safe by the time your child heads off for college.
Using CDs, traditional bonds, or zero coupon bonds for your secure savings also requires some planning. You want sufficient holdings to mature each year. In addition, if you decide to add your monthly contributions to safe investments, you could end up with numerous CDs for each contribution. Small bond purchases can kill you with minimum commissions. Here's one approach to keep things simple:
When you transfer money from stocks to safe investments, buy a fixed-income investment that matures in time for freshman year.
Continue using stock transfer dollars to buy fixed-income investments that mature for freshman year up to the amount you forecast for freshman year expenses.
When freshman year is covered, start buying fixed-income investments that mature for sophomore year until sophomore expenses are covered. Continue this approach to cover junior and senior years.
When you want the monthly contribution to go into safe savings, deposit the monthly contribution in a money market account, money market fund, or savings account with a decent interest rate.
Twice a year, use the money in the money market to purchase fixed-income investments that mature for the college year that isn't yet covered.
Unfortunately, the money you invest in stocks grows faster than the money in safe investments, and the monthly contributions further unbalance your plan. Trying to figure out how much money to transfer between stocks and safe havens each year might give tax preparation a run for its money as something you'd rather not do. That's why it's a good idea to create an Excel spreadsheet to help you plan your college savings program.
The spreadsheet in Figure 3 assumes a steady monthly contribution from the time your child is born until she graduates from college. $400 a month adds up to well over $200,000 when you save for 22 years. So sending your child to a good, private school requires nothing more than saving the money you would spend on a cappuccino on your way to work and eating lunch at a restaurant each workday.
Figure 4. Calculate the money you should invest in stocks and fixed-income investments to reach your goal
When your child reaches 12, the example switches to yearly calculations. In this example, the monthly contribution goes into stocks, so the formula for calculating the future value takes into account both monthly contributions and the balance at the beginning of each year. Because the returns you supply for calculations are average annual returns, your year-to-year results almost never match your estimates. For that reason, when you get to the beginning of each year processed in your spreadsheet, replace the values for stocks and safe investments in columns C and D with the actual balances in your accounts.
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