More FAQ

If everybody invested in index funds would it still work?

Admittedly, no. But that won’t happen. There will never be a shortage of people who want to make more money more quickly than everybody else. It’s hard to imagine that there won’t someday be enough analysts to keep security prices reasonably efficient, or that active management will be able to pay for itself with higher returns. Let the others price individual securities and do the work for you. Sit back and enjoy the returns for a low price. It might be the only free lunch in finance.

Is a bull market always a good thing?

No. Young savers who are in their accumulation phase should pray for a bear market. Their accounts may appear to suffer, but they will be buying a piece of future markets at reduced prices. This may seem counter-intuitive, but it is absolutely true. A bear market is terrible, on the other hand, for someone who is entering retirement and starting to draw down their portfolio.

Should I invest abroad?

Yes. Investors should have a portfolio that is diversified in the broadest possible sense. How much of a portfolio should be invested in international stocks is the subject of debate, but most advisors would recommend that a US investor have between 20% and 50% of their portfolio abroad.

What if my employer does not offer good investment options in my 401(k)?

This is a common problem. No matter what, you should almost always try to contribute enough to your 401(k) to receive the full company match, if there is one. After that, many employees would be better off contributing to an IRA with additional savings. If you max that out, then switch back to the 401(k) to take advantage of the tax savings. If you change employers, it is usually best to roll your 401(k) into an IRA. You could also try to campaign your employer for better investment options.

Should I open a Traditional or a Roth IRA?

There can be a lot to consider here, and sometimes it’s tough to know. It may be best to consult a good advisor. Do you want to pay taxes now or later? For a young person in a fairly low tax bracket, a Roth is almost certainly better. For an older person it can be a tossup, and in the end may not matter at all. It is worth noting that a Roth is more flexible since it doesn’t have required minimum distributions once you turn 70. And without getting into the details, maxing out your Roth contributions is more advantageous than maxing out your traditional IRA, all else being equal.

Is active management better in smaller, more inefficient markets?

While it seems that diligent research in understudied markets should yield more opportunities to beat the crowd, research has shown the opposite to be true. Smaller markets often require larger fees, and typically a larger percentage of active funds fails to beat the respective index even over shorter time periods.

Are ETF’s better than mutual funds?

Both ETF’s (exchange traded funds) and mutual funds can track indexes. While ETF’s have grown popular, they include more costs than mutual funds. Investors must worry about paying commissions, bid-ask spreads, and whether they are buying or selling close to the net asset value (NAV). You don’t get as much bang for your buck. However, for a small investor who wants to create a well-diversified portfolio and can’t meet the minimum requirements for mutual funds, ETF’s can be a good solution. If you invest in ETF’s from a strong company the bid-ask spreads can be small, and they often track close enough to the NAV. If you have an account with Vanguard or Schwab, for instance, you can also trade their ETF’s commission-free. However, once you have enough capital to meet fund minimums, you are often better off switching to index-based mutual funds.

Should I worry about inflation?

Yes and no. Over the long term, inflation will compound and degrade your purchasing power in a serious way. However, inflation rates are difficult to predict. Making assumptions based on a certain set of investment returns and then discounting for inflation is needlessly complicated. You can often get away with ignoring inflation, and focusing on what you assume your “real” returns will be. If the stock market returned 8% and inflation was 2%, your real return was about 6%. The “nominal” return was 8%. Thinking in “real,” or inflation-adjusted dollars is more intuitive, and it keeps your purchasing power intact going forward. If your advisor lures you with talk of high “nominal” returns and fails to warn you about inflation, it is misleading and unethical.

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