I think my talk at TAM9 went well. I want to thank everyone that provided the kind words of encouragement on my talk. I was very glad it went well and hope that it helps someone with investing questions.
My blog stats show a spike in my blog traffic in the last couple of days so, I wanted to thank welcome anyone that has come here after seeing my talk at TAM9. I have pasted a copy of the paper that goes with the talk below.
Guaranteed Mutual Funds
Psychics use cold reading and tell you what you want to hear. Did you know that some of the same tricks that promote woo may be employed by your investment advisor? There is a strong temptation to tell you what you want to hear and find a product that matches. They may not even know that what they just sold you can hurt your long-term financial success. Most investors know that the stock market tends to return about 10% per year (over long periods of time) but can’t sleep at night when the market goes up and down. In this case a sales person can use that knowledge and try to make you feel safe and secure. They want to take away the fear you have about investment risk and, most of all, they want you to invest with them. The sales person tells you about a product that may pay a little less but it is guaranteed.
Just to let you know I am not one of those people. I’m not here to sell you anything and I don’t have a hot stock tip. The material contained here is for educational purposes only and does not constitute investment advice or a solicitation. While I’m at it, there are a few other things that the fine people at the Illinois SEC strongly suggest I make clear. I am an Investment Advisor Representative (IAR) with 15 years of experience and I am the president of Polaris Financial Planning LLC (Polaris). Polaris is a “fee-only” Registered Investment Advisor (RIA) in the state of Illinois. Registration with the state of Illinois does not reflect an endorsement by the state or Illinois. Please consult with your financial advisor before taking any action.
In an effort to avoid risk, some financial advisors and their customers find products like “Guaranteed Mutual Funds” very attractive. This product class may also be called “equity-indexed annuities”, “fixed-indexed insurance products” and “indexed annuities”. These products make a lot of promises and by the time the sales person is done telling you about one, it may be hard to say no. The description below is based on a real product that you can buy from an advisor or broker. Let’s go over some of the good things that your friendly sales person may tell you:
– This is a new product that combines the best of bonds and stocks.
– Your principle investment is guaranteed; you can’t lose.
– Part of the money is invested in an index fund .
– The balance of the money is invested in Zero-coupon bonds (Zeros).
– Zeros are issued by the US Government and they are AAA rated.
– You will make at least 40% in the next 10 years.
– The 40% return is guaranteed.
– You make about 4% each and every year.
– You could make more if the stock market goes up.
We will now cover some of the details that the sales person “forgot” to tell you. The odd thing with the investment world is that they don’t need to tell you these things verbally, because all of the details are in the prospectus. Often the prospectus is 72 pages of 6 point font written in the best legalese. You sign the last page of the prospectus that you never read, and now they can do almost anything with your money.
Now we need to get specific and do some math. I know – MATH! This is your life savings we are talking about so… be strong. Let’s start with a $100 investment which you cannot lose; it’s guaranteed. You will earn 40% in 10 years which is also guaranteed. After ten years you should have $140. We can be sure you will stay in for ten years because there is a 10% penalty for early withdrawal and the idea of losing 10% of your money scares you. That is why you bought this type of investment in the first place. Another small technicality is that you don’t make 4% per year. 4% per year compounded over 10 years would make your investment worth around $148. Based on some simple math, your result is closer to 3.4% per year compounded; but hey, it’s only your long term retirement plan, right?
Here is how we will do the math; we will start with the $140 you expect to have at the end of 10 years (per the sales pitch above) and take out a few small expenses. Did the salesperson tell you about the 8% load? A load is a sales fee that is collected from you and paid to the company and/or sales person. Eight percent is on the high side for mutual funds, but this is a really good investment, so it is a small fee to pay. You invested $100 and the $8 fee comes off the top, so you actually start with an investment of $92. Subtract $8 from your expected total of $140.
Your 40% return adds $37 to your investment not the $40 you expected. Remember, you only invested $92 ($100 – $8). Subtract $3 from your expected total of $140. As you were told in the prospectus, your money is invested in mutual funds and all mutual funds charge an annual fee. This fee covers the cost to manage your funds – and they deserve it for getting you such a great product. This fee is 1.8% per year. It is above the industry average but, you’re worth it. Total cost over ten years is just $18. Subtract another $18 from your expected return.
Since your money and the 40% return is guaranteed, it’s like insurance. You pay for auto, life and home insurance – of course you have to pay a little something for this insurance. This cost is just 1.5% per year. Total over 10 years is about $15. Subtract $15 from your $140. Isn’t this a wonderful investment?
We need to talk about taxes. The IRS does not want to wait and tax you on all the money you are going to make with the Zero Coupon Bonds. So they created a thing called imputed interest. They collect tax on the money you are going to make. This costs about $.80 year or $8 over the 10 years. Don’t forget to subtract the $8 in taxes from your fabulous investment!
You started with $100 and expected to end up with $140! After we took out a few “small” expenses and end up with $88 ($140 – $8 – $3 – $18 – $15 – $8). Your principle and the 40% return were guaranteed but, so were the all of the fees you agreed to when you signed the last page of the prospectus.
I can’t tell you what you should do with your money but, I can give you 5 simple ideas that can help you with your future investments.
– KISS = Keep It Simple Silly.
– Only invest in what you understand.
– Use ultra low cost index funds.
– Use your critical thinking skills and learn what you are doing.
– If it sounds too good to be true; it probably is.
If you wish you can read more about this type of product at this FINRA (Financial Industry Regulatory Authority) investor alert page. More information about investing can be found at Polaris Financial Planning.