Reader Question: Expense Ratios

A reader wrote to me a few days ago with the following question:

"Hi Shadox,

I've recently come across your blog and I'd like to say that I enjoy it very much. I do not work in the finance / accounting field so I am not very knowledgeable when it comes to personal finance. I am trying to correct this by trying to read as much as I can about it and usually I rely on the "... for Dummies" kind of books.

Anyway I'd like to ask you about a topic which still seems very confusing to me.

It's about expense ratios.

I read one of John Bogle's [founder of Vanguard - shadox] books on investing and I am totally sold on investing in low expense ratio index funds. So low expense ratios are good - that I know. But what exactly is an expense ratio? Is a 12b-1 fee included in an expense ratio?

You give an example in one of your posts: "let's say that your equity fund generates an average return of 8% a year. If your fund charges an expense ratio of 2%, you are essentially paying a commission of 25% on your profit!

The question I have is, what happens if your fund's yearly average return is negative: does money still come out of your fund to pay the expense ratio? If yes, how much? Thank you very much for your help."

I have responded to Florin's question in a private e-mail, but I think that this is an excellent question that is probably of interest to other readers, so here is a more detailed version of the answer I sent him:

First of all, most of us aren't investment advisers and don't work in the financial sector. Since personal finance is not typically taught in school most of us are left to fend for our selves and come up with our own ways of getting the information we need. Your strategy of educating yourself by reading books is certainly an excellent way to go. I do the same.

So, what are expense ratios anyway? The SEC defines expense ratios as follows:

"Expense Ratio — the fund's total annual operating expenses (including management fees, distribution (12b-1) fees, and other expenses) expressed as a percentage of average net assets."

OK... so what are 12b-1 fees? From the same source:

"12b-1 Fees — fees paid by the fund out of fund assets to cover the costs of marketing and selling fund shares and sometimes to cover the costs of providing shareholder services. "Distribution fees" include fees to compensate brokers and others who sell fund shares and to pay for advertising, the printing and mailing of prospectuses to new investors, and the printing and mailing of sales literature. "Shareholder Service Fees" are fees paid to persons to respond to investor inquiries and provide investors with information about their investments."

So to put all this in plain English, a fund's expense ratio includes all expenses paid by an investor to the mutual fund including any associated marketing expenses (but you may still be paying other fees to your broker or financial firm - for example, for buying and selling your fund shares).

To Florin's specific question, the expense ratio is paid as a percentage of assets, and you pay it regardless of whether your fund makes money or loses money in any given period. As an example, if you have $1000 invested in a fund with a 1% expense ration and the fund returns 10% in that year, your holdings are now worth $1100 and the fee you will pay that year will be $11. If the fund lost 10% that year, your fees would be 1% of the remaining $900, or $9. Make money or lose money, you still need to pay your fund's expense ratio. 

Unfortunately, the only entity who is guaranteed a return on your investment is your mutual fund company... :-)

Still, that's not a reason not to invest. It is a reason to minimize your costs.

I love answering reader questions, so if you have any, please send them to me via e-mail (you can find my address on the left column of this page) or simply leave a comment with your question on one of my posts.

Personal Finance Questions: One Line Answers

The other day I was going through my Google Analytics page to see what kind of key words bring folks to Money and Such. Actually, there are some pretty interesting ones, so I thought I would put a whole bunch of them in one post and give a one line answer to each (OK, sometimes I may go a little longer than a line, but take it in the right spirit). Here goes:

"Is renting a waste of money?" - Absolutely not. Renting is often a more lucrative form of investment than owning a house.

"Does a hybrid [car] make sense?" - that depends. How much do you drive? You can use this calculator to figure it out for yourself.

"Wife makes more money" - good for you! Now you have more money to save, invest and spend. Enjoy!

"I make more money than my husband" - Are you the wife of the guy from the previous question?

"$10,000 and a year to invest, what to do?" - with a 12 month investment horizon, I would just go with a high yield money market account or CD.

"Am I going to make money in Fidelity mutual funds this year?" - let me gaze into the future for a sec... the spirits... they are saying... "MAYBE!"

"American express late payment, what to do?" - fight it, dude. Of course your chances of success depend on the exact circumstances of your case.

"Average cost to raise twins, calculator" - I don't have a calculator for you, but I do have twins, and all I can tell you is to get ready for some serious money drainage.

"Blowing off a headhunter" - why would you want to do that? Work with headhunters. If you don't want the job, suggest a different candidate. You never know when you would want to take advantage of their services.

"Can I leave a law firm job after one week and not cause damage to my career?" - Absolutely. In fact, if you just joined a new firm it is very much OK to leave, professionally, if you don't feel the position is working for you. In the long run, it will be good for you and will be good for your firm.

"Can I opt out of my company's 401k plan?" - yes you can. However, if you opt-out, make sure you have another plan for saving for retirement. If your employer matches 401k contributions, opting out is probably a very bad idea.

"Can you get a work out with Wii boxing?" - you better believe it!

"Cost to raise a child in the US" - I got data galore for you. Check it.

"Do we get taxed on work related expenses?" - no, we don't, thank god. In fact, if I am not mistaken you can deduct unreimbursed business expenses on your return.

"Does cashing in your 401k hurt your credit?" - nope, but it does hurt your chances of a decent retirement... don't cash in your 401k unless you absolutely have to or if you have actually retired. By the way, rolling over a 401k is not the same thing as cashing it.

"How can I put my IRA in a high yield CD?" - well, there are CD IRAs out there. They just happen to be the worst retirement vehicle ever invented, unless you are just about ready to retire - and even so, I seriously doubt this is a good strategy.

"How much do index funds overlap?" - that depends on what the underlying index is. If index funds track the same index they almost certainly overlap to a very large degree. Some index funds can be totally divergent since they track completely different indexes. Check each prospectus to be certain.

"How much should I pay my stay at home wife?" - dude, you have bigger problems than trying to figure out how much to "pay your wife". Your wife doesn't work for you.

"How to bail out financial institutions?" - boy, I hope that this question was not asked by Treasury Secretary Henry Paulson... well, actually, financial institutions fail (like other businesses) when their liquid assets are not sufficient to cover their immediate obligations. Bailing out a financial institution typically involves either giving it a nice cash infusion or taking control of some of its liabilities.

"How to find my 401k money?" - If you lost track of your old 401(k) money, a good place to start looking for it is to contact your old employer.

"How to make money as a pediatrician?" - hmmmm. Maybe you can take care of some sick kids and charge people for it?

"Labor unions - good or bad" - both, I guess. Good for protecting basic workers rights and ensuring people receive a decent wage for their work. Bad any time they do things that make life difficult for everyone else.

"Stupid advice" - I can see why you got to my blog. I am also mildly insulted.

"What not to waste money on?" - things you don't need. See the previous question.

Reader Question: Should I Get Out of Commodities?

A couple of days ago I received an e-mail question from a good friend and regular reader. Here is the full text of the question:

"Hi Shadox,

A year ago, I put about 20% of my assets into commodity related stocks as a hedge for the blazing US and APAC economy: Metal and mining ETF; Mining companies; Brazil ETF (since their economy is based on commodities); Oil company stock. Since then, most of my portfolio has shrunk while this part has exploded.

It is now about 40% of my portfolio. Now, there is talk about a commodity bubble. I have some free money and I was thinking about putting it into a commodity hedge, but I don't know what that is? Cash? Bonds? Technology? What do I do?

Also, my gut tells me Oil is peaking (my gut told me that at $80 too so I am not sure using my intestinal system is a good idea). What is an Anti-Oil hedge? You could use this for a Blog post since I am sure anyone with commodities in his portfolio is thinking the same things...."

I have been wrestling with the same question in reverse, namely, is it too late to invest in commodities? About two months ago I have come to the (apparently premature) conclusion that hell yeah, it's too late. We are not currently invested in commodities. I recently rolled over my 401K which had a 10% commodities position into an IRA which does not include such a position. However, I do understand the benefit of diversifying into commodities and have written about this in the past (too bad that I did not actually take my own advice at the time).

When I think about diversification into commodities, I am thinking about a position equal to about 10% of your portfolio. However, the reader finds himself with about 40% of his portfolio dedicated to what is potentially a very risky asset class. Let me take the reader's questions one at a time.

First things first: we need to talk about portfolio re-balancing. If you are shrewed, wise or lucky enough to make a small investment whose value explodes, you should probably think about re-balancing your portfolio such that your investments in the various asset classes come back into line with your original plan. There are many reasons to do so, but let me name the most important one: regression to the mean.
Here's the idea - each asset class has certain typical historical returns. If the return on such an asset class in the short run is dramatically higher or lower than the historical average, there is a tendency for prices to return to their historical trend through a price correction (up or down). We are living through one such example right now. In recent years real estate prices have skyrocketed and returns on real-estate assets have significantly outpaced their historical levels. No more. Returns are now regressing to the mean by way of a sharp decline in house values. Tech stocks in the beginning of this decade went through the same process, and I believe that we may be in for a similar ride on the commodities side. If your portfolio is out of whack due to massive returns, take some money off the table to reduce your exposure to that asset class and re-balance your positions.

True, this is psychologically difficult to do because essentially I am suggesting investors should sell their winners rather than their losers... but, believe it or not, that's probably a winning strategy.

Let me address the second part of the question: what is a good hedge for commodity prices? Put in other words, if commodity prices go down, which asset classes would be unaffected or even benefit from this decline? The technical term from what reader is looking for is negatively correlated assets, or at least uncorrelated assets. The following asset classes have historically been negatively correlated with natural resources: U.S. Bonds (-0.14 correlation); cash (-0.12 correlation); high-yield bonds (-0.04 correlation). If you think about it, this makes perfect sense. Commodities tend to rise at times when the economy is strong, inflation is rising and interest rates are consequently being increased. These are exactly the times when bonds tend to do worse, and vice-versa. Stocks, especially large cap stocks, are also very loosely correlated with commodity prices (0.0 for large caps; and 0.01 for the S&P 500). A correlation close to zero indicates that the asset classes tend to act independently from each other: they are just as likely to move in tandem as they are to move in opposite directions. In fact, natural resources are very loosely correlated with pretty much all traditional asset classes. This makes them a very interesting diversifier, but not at 40% of your portfolio...

To read more about asset class correlations, take a look at this excellent article, which I have previously written about.

Got Passed Up for Promotion - Now What?

A few weeks ago I received an e-mail question from one of my readers. The reader felt that she was unjustly passed up for promotion, and was wondering what her next steps should be. Here is the full, unedited text of the e-mail:

"First of all, I just want to say that I really love your blog and the topics that you talk about, your posts are always very practical and applicable.From your blog I know that you are in management and I was wondering if you might be able to give me some insights on a situation at my company.

I am an engineer in my 20s at a company with recent layoffs. After the layoffs, all but one of the senior engineers within my group were laid off. This made me the person with the longest tenure at the company within my group. At this time, our direct manager also resigned from the company.

During goal setting discussions with management, I have been consistently told that I was the best engineer on the team. There are metrics to back this up. I also received a company award for outstanding performance from management. During the performance review we had around May, I also received the highest performance rating number. So it really surprised me when two individuals from my group were recently promoted to senior engineer over me. I have longer tenure at the company than they do, perform better on all levels, and actually know more about the company's processes etc. It is not even strange for these individuals to ask me questions on how to do things during the course of the job week. One is probably in the late 30s and the other is in the 20s.

I thought that promotion was the reward for performance but I'm starting to smell a rat here...so to speak. My performance is documented and it definitely exceeds theirs, so could it be that I am being passed over based on my race, age or gender? Do you think that it would be reasonable for me to go to our group Vice President to inquire what was the criteria for these promotions and why was I not considered given my performance etc? Thanks for your time."

Interesting situation. I responded to the reader directly shortly after receiving her e-mail, but I think that my answer may be of general interest to my readers. Here is what I suggested:

"Thank you for the e-mail and for the kind words.

I understand from your e-mail that you are concerned that you may have been discriminated against. There is really no way for me to know whether this is the case, however, if your assessment of your performance and of the performance level, experience and skill sets of the engineers that were promoted is correct, it seems that you may have a reasonable basis for concern. I have a few of suggestions:

1. Understand the risks - generally speaking, if your company suspects that you may looking into possible grounds for discrimination based legal action, it will immediately re-trench and develop a story to cover itself from a legal perspective. This might go as far as creating documentation to show that you were not an appropriate candidate for promotion, or worse.

2. Understand the remedy you want - what do you expect to gain by bringing up your suspicions in discussions with the VP? Is there a possibility that you too will now be promoted to Senior Engineer? Or is the discussion purely academic? I would suggest figuring out what you are asking management to do, before you initiate any discussions. Ask yourself whether this is a realistic remedy to ask for. Is this something that the company can reasonably give you?

3. Look to the Future - getting passed up for promotion is tough. It really hurts your motivation and impacts your self image. Believe me, I know, I have been there. Having said this, it is rare that companies will reverse such promotion decisions after they have been made. In my experience, the way to address promotion issues is long before a decision is made. For example: when my boss moved to a new position two years ago, I walked into his boss' office and made it abundantly clear that I considered myself his obvious replacement. I was ready with all the relevant support for my statements, including my performance reviews but also a list of successful projects, a list of my accomplishments and so forth. It is not clear to me from your e-mail whether you were proactive about seeking the promotion, or whether you were assuming that it would happen based on the really good feedback you were getting from management. In any case, the aggressive, proactive approach often works best in these matters.

4. Alternatives - if you genuinely feel that you were discriminated against, consider whether you would like to take legal action. If this is indeed the case, I also suggest you consider whether a company that discriminates against its employees is a good employer to work for in the long term. Whatever you decide, do not look back. The worst trap you can fall into is self pity or bitterness. Either of those would essentially derail your career.

Looking forward, my advice to you is this: go to your VP. Speak with him or her and be very candid about your disappointment at the fact that you were not chosen for promotion. Do not speak ill of your fellow employees that were promoted, simply make the positive case for yourself. Solicit constructive feedback from the VP, ask why management did not select you for the promotion, and what you can do to take your performance to the next level. Managers truly appreciate employees that solicit feedback and that are genuinely interested in getting better. Maybe you will find that management had some sort of valid reason for their decision, who knows? Keep an open mind.

Next, tell the VP that while you understand and respect the decision that was made you consider yourself a worthy candidate for promotion and expect to be on the short list next time. A clear declaration of intentions - without ultimatums - would serve your purpose best. From your e-mail, I am unable to tell how big your company is, but if it is large, you may also want see if you can find another suitable position within the company."

Can you suggest other ways to deal with the situation? Would you have answered the question in a different way? What would you have done under similar circumstances?

As you can tell, I am always happy to receive e-mail questions from my readers. Please keep them coming. If you would like your anonymity maintained when I answer your questions on this blog, or if you prefer to receive a private e-mail answer, I am glad to do either or both.

How Do I Make a Million Dollars in 12 Months?

One of the things I enjoy doing is looking at the search words people use to get to this website. Often I find interesting posts to write by looking at those key words. Well, a few days ago I noticed someone got to this blog by searching for the term in the headline: "How Do I Make a Million Dollars in 12 Months".

If I knew the answer to that question I wouldn't be writing a blog about personal finance, I would be too busy raking in the dough and choosing the color for the suede furniture on my yacht. Well, maybe not suede. I think leather might work better, but I digress.

Anyway, let me take a crack at that question. I have several answers, some serious, some not so much:

1. Win the California State Lottery - according to Wikipedia, your chances of winning are about 41,000,000 to 1, but somebody has got to win, right? Of course, I believe that lotteries and virtually all other forms of gambling are a form of tax on the financially challenged.

2. Have a Rich Uncle Die and Leave You a Bundle - unfortunately, unless you have a wealthy relative who is in poor health and that loves you like a son, banking on that is probably not a great strategy. There is also that tiny matter of homicide laws preventing you from helping nature along.

3. Go On American Idol - in which case you can build yourself a million dollar career by either doing very well or by being the weirdest guy around. If you are seriously searching the Internet for ways to make a million dollars in 12 months, you may actually have a shot at the latter.

OK, enough with the fun and games. Yes, there are some real world scenarios in which you could make a million dollars in 12 months. To do that, you have to either be extremely lucky, extremely knowledgeable, or more likely, a combination of both. If you are a professional at the top of your game, you might also be able to earn a cool million in one year. Some investment bankers, lawyers and doctors can make that much. Of course, if you are a member of the corporate elite, say the CEO of a Fortune 500, a million dollars is chump change for you. And if you are sitting on the next Apple iPod, YouTube or eBay, you might be able to pull off the $1M in 1 year trick.

There are many ways in which some individuals can make vast amounts of cash in a short amount of time. Those make for some excellent dinner party conversations. Sadly, for the vast majority of us middle class folks, riches are not easy to come by, and patience is the quickest road leading to financial security. If you were to ask me about saving a million dollars in 30 years, well that's a question worth discussing seriously.

If you are looking for quick ways to make a million bucks on the Internet, chances are you will run into something or someone that will offer you just what you are looking for. Chances are also that in the course of chasing down this imaginary pot of gold, you will lose much of your money to the scam artist which lured you into his trap.

Come to think of it, if you need to make a million dollars in 12 months, maybe your best bet is to become a online con man. It seems like there is a new client born every minute...

To Buy or Not to Buy, That Is the Question...

Based on the request of a regular reader of Money and Such, this post will be dedicated to the age old question: Should you buy a new vehicle or lease one? If you have topics you would like me to cover in future posts, please let me know and I will do my best to oblige.

Let's start with the premise. I think that buying (or leasing) a new car is a bad use of money. Simply put, a car is a depreciating asset, it is NOT an investment. As such, I don't like spending money on my car and I have been driving my 1997 Geo Prism since 1999. Unfortunately, it is pretty much at the end of its useful life, and I too will have to buy a new chariot in the near future. So my first piece of advice is: don't buy (or lease) a new car.

Of course, other people treat their cars differently. Some consider their car a hobby. Others treat it as a status symbol. Some spend so much time commuting that driving in a decrepit old vehicle like mine is simply unacceptable. Whatever the reason, if you have your mind set on a new car, should you buy it or lease it?

The answer to that question is grounded in pure economics: consider all the costs of owning, consider all the costs of leasing, and choose the lowest cost option. This Excel template will help you to consolidate all the different factors and perform the calculation for you.

Exact calculations aside, I would expect leasing to be the more expensive alternative as a rule of thumb. First, leasing is a less transparent deal than an outright sale, and more complicated deals have more places to hide nasty little surprises and fees. Second, for the dealer leasing is probably a much more complex undertaking, and as such I would expect the dealer to demand higher margins to cover his costs. Third, and most important, when leasing you "own" the vehicle at the most expensive point in the cost curve. During the first couple of years in a vehicle's life it depreciates at the fastest pace. By leasing a new vehicle every two years you are dooming yourself to repeatedly owning the most expensive part of the depreciation curve, and let someone else enjoy the milder portion of the curve. That doesn't sound like a very good deal to me.

As a final thought, I would like to propose that instead of buying a new car, you should consider buying a certified, "pre-owned" vehicle. Alternatively, I would consider buying a used car from Hertz car-sales. Hertz sells the top cars from their fleet - vehicles that typically have under 20,000 miles and are approximately one year old. The vehicles are very well maintained, and come with both a manufacturers warranty and Hertz's own short term warranty. The cars sell for a substantially lower price than an equivalent car at the used car dealership, and best of all: it's a no haggle transaction. The price quoted is the final price.

About 3 years ago my wife and I bought a nine month old Honda Accord from Hertz, and I have nothing but great things to say both about the car and about the transaction. The car even had an (almost) "new car smell".