2014-01: January 2014 What Works in Personal Finance Newsletter

VeriPlan is the Best Financial Planning Software for Individuals

What Works in Personal Finance Newsletter

January 2014 Newsletter

What does sub-optimal portfolio diversification cost?

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Investors more easily understand investment costs that are directly measurable, such as fees deducted on investment statements. However, many investors ignore or are unaware of the "opportunity costs" of their sub-optimal investment behaviors. Opportunity costs are usually much more difficult to measure directly, but can be even higher than the more visible costs that they do understand.

The opportunity cost of being poorly diversified can be quantified under certain circumstances. While sub-optimal diversification costs can be difficult or impossible to anticipate for individual portfolios, investors can look at studies of large investor populations for guidance on the size of investment opportunity costs. The study, ‘Equity Portfolio Diversification" by Alok Kumar of Cornell and William Goetzmann of Yale is particularly useful in providing investors with an indication of the scale of the opportunity costs incurred by poorly diversified individual investors.

Bond mutual fund fees

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Is it worth paying higher bond mutual fund management fees?

Simply put, if you pay higher bond mutual fund fees, then these bond management expenses tend just to be a "deadweight" loss to you. The best bond fund buying strategy is to pick only very low-cost no load bond funds.

In pursuit of higher risk-adjusted bond mutual fund returns, many investors wonder whether it is worth paying higher expenses and fees. If they do pay more, will they get better mutual fund performance? Will higher performance outweight the added expenses? Investment science provides a strong "no" as the answer. When you pay more in bond mutual fund fees, you are just wasting your money.

Inferior mutual fund performance

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Screen Out Inferior Mutual Fund Performance — BUT ONLY AFTER using other ETF and mutual fund selection criteria. Superior or even average mutual fund performance in the past simply DOES NOT predict similar fund performance in the future.

However, the investment research literature does provide some modest evidence that substantially inferior past mutual fund performance is more likely to lead to inferior mutual fund returns in the future. Excessive costs and high management expense ratios are the likely culprits, when explaining sub-par diversified investment fund returns.

The illusion of superior professional fund manager performance.

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Why only one Warren Buffett? The illusion of superior professional mutual fund manager performance.

If investment mutual fund managers were truly skilled at beating the market, then you would expect mutual fund manager performance prowess to persist over time. Unfortunately, the evidence indicates that superior past professional performance among mutual fund managers tends not to persist. Past superior mutual fund performance is simply not a predictor of future superior mutual fund performance.

Individual investors chase past superior mutual fund performance in the futile hope that past investment fund performance will predict superior future mutual fund performance. This strategy is just a mirage, but the mutual fund industry willingly reinforces it.

If a mutual fund family opens and promotes enough funds, random portfolio fluctuations will allow almost any fund family to brag selectively about only those of their funds that were past winners. Simultaneously, they quietly ignore their laggard funds. After investors repeatedly search the crowd for Waldo, after they have put their money into past winners, and after time has passed, only then do a few of these investors realize that Waldo was never there to found in the first place.

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