There isn’t a single reason why you shouldn’t like index funds. They’re cheap, they offer market rates of return without fail, and they are simple to buy. They beat actively managed mutual funds a majority of the time and they are often advocated as the best investment the average Joe can put their money in. So why not put all your money into an S&P 500 Index fund like the Fidelity Spartan 500 Index or the Vanguard 500 Index, call it a day and enjoy more time with the family? Because that would be a huge mistake.

The reality is that you can’t just open an account a online discount broker, buy only index funds or index ETFs, and then call it a day. The advice of personal finance experts isn’t that you should invest only in a single index fund, it’s to invest in a basket of index funds that diversifies your risk and offers you a fair return for the risk you are taking. An index fund represents only a small part of your diversified portfolio, it shouldn’t represent the entire portfolio because it exposes you to risk without paying you adequately for it.

Risk #1. Domestic Risk

If you have everything in an S&P 500 fund, then your portfolio depends on the performance of the United States economy. As anyone who has seen their brokerage statement lately, the stock market has declined significantly since last October and the economy has been slowing down since at least six months to a year beforehand. If 100% of your investment portfolio is in domestic investments, you’re over exposed to one single country. While it’s the best country in the world, it’s still risky to put all your eggs in this basket. Some of the greatest investment gains the last few years, helped on by the decline in the value of the dollar, has come in the emerging markets funds. While I wouldn’t advise plowing all your money there (especially now that the dollar is recovering), experts recommend around 5-10% of your assets in emerging markets funds.

Risk #2. Equity Risk

An S&P 500 index fund is 100% stocks (duh), which is probably at least double digit percentage points higher than what you probably want your stock allocation to be. As I mentioned earlier, the stock market had a 20% haircut from its highs last fall and if you held just an equity index fund like the S&P 500, you took on the full brunt of that fall. Experts advocate the 120 minus age rule when it comes to stock allocation: your stock allocation should be [120 - your age] percent of your portfolio, with the rest being in bonds. While the equation is subject to tweaking based on your situation and risk tolerance, the idea behind it is that you shouldn’t be too exposed to equities because they’re riskier than bonds.

Solutions

Are you convinced yet that 100% into an index fund is a mistake? I couldn’t just leave you with an explanation of what not to do without giving you a solution! There are two solutions for those who like to “set it and forget it:”

Solution #1. Target Retirement or Lifecycle Funds

Target Retirement or Lifecycle funds (Vanguard calls them Target Retirement, Fidelity calls them Lifecycle) are funds that adjust their asset allocation as the years pass. The idea is that you buy a 2045 Fund if you intend to retirement in 2045 and the broker adjusts the asset allocation such that the risk gets lower and lower as that date nears. Target retirement and lifecycle funds are composed of other mutual funds, many of which are passively managed. These funds are truly for the “set it and forget it” types because the broker rebalances the fund for the investors based on their models (and each broker’s model is different, I once wrote about how these target retirement funds compared with the 120 stock rule).

Taking a look at Vanguard’s 2045 fund, you’ll see that the asset allocation is composed of six funds in varying allocations:

• Vanguard Total Stk Market Idx Fd Inc - 70.22%
• Vanguard European Stock Index - 10.10%
• Vanguard Total Bond Market Index - 10.00%
• Vanguard Pacific Stk Idx Fd Inc - 4.38%
• Vanguard Emerg Markets Stk Idx Fd - 3.81%
• Vanguard Total Stock Market ETF - 1.46%

Solution #2. Lazy Portfolios

Lazy Portfolios are cleverly named portfolios that are designed specifically for the lazy “set it and forget it” crowd, which includes yours truly. They are simply asset allocation recommendations that rely on a basket of low cost mutual funds, which include index funds, to build a portfolio that is easy to manage. The most well known of these portfolios is the Couch Potato Portfolio, created by Dallas Morning News columnist Scott Burns, and it’s a 50-50 split of the Vanguard 500 Index Fund and the Vanguard Total Bond Fund Index Fund. Other cleverly named titles includes the Margaritaville Portfolio, the Coffeehouse Portfolio, and others.

The lazy portfolios aren’t entirely “set it and forget it” because they don’t rebalance themselves every year. Think of the portfolios as a recommended asset allocation, you still have to go in every year and rebalance them back to their recommended percentages.

(Photo: DustinMatthews)

Smart Money reviews brokers every single year and they recently just gave a preview to their results. Rather than give the straight ranking, they discussed some headline categories (Commissions & Fees, Research, Trading Tools) and then listed the best and worst from each category.

For best commissions and fees, they listed Interactive Brokers, a brokerage firm I hadn’t heard of but does charge pretty rock bottom fees (half a cent per share on equity trades). They also showed the spread was anywhere from $4.95 for TradeKing to $112.50 for Fidelity on broker-executed trades.

For research, my Roth IRA brokerage, TD Ameritrade, took the top honors with Zecco and SoGoTrade splitting the worst place ribbon. One interesting point made was that J.D. Power’s research showed that good research trumps trade execution and customer service with regards to overall satisfaction. I found that pretty surprising since there is a wealth of free investing information out there but trade execution and customer service is where the rubber actually meets the road. If they can’t execute your trade or if you can’t get on the phone with someone in a few minutes, that’d be a deal breaker for me.

Last but not least, E*Trade and TD Ameritrade snatched the number one and one-a spot for trading tools with Sharebuilder playing caboose. It’s not surprising because Sharebuilder isn’t for the typical trader, it’s for people looking for an easy way to reinvest their dividends back into equities. TradeKing’s social networking area got a shout out as did Zecco and WellsTrade, but that was because they offered less than half the thirteen tools their researchers were looking for. Thirteen tools? Wow.

Anyway, check out the preview, I’m eagerly anticipating their results and whether TradeKing will need to update their current banner and call it a three-peat.

SmartMoney’s 2008 Broker Survey

Money Magazine recently released the only 7 investments you’ll ever need and, surprise surprise, my favorite firm, Vanguard, was listed first choice for five of the seven. Their founder, John Bogle, was a major proponent of index funds and it shows in their offering, as almost all of Money’s choices were low-expense ratio index funds.

Need another reason to have a mutual fund account at Vanguard? (No, Vanguard doesn’t sponsor this site!)

Blue-chip US-stock fund: Fidelity Spartan 500 Index (FSMKX) because it replicates the S&P 500 with an expense ratio of 0.10% (coincidentally, Vanguard’s version, the Vanguard 500 Index Fund Investor Shares (VFINX) is 50% more expensive with a ratio of 0.15%).

Blue-chip foreign-stock fund: Vanguard Total International Stock Index (VGTSX) because of its solid performance, beating 90% of its peers, and because it’s an index fund with an expense ratio of 0.27%. Another Vanguard fund, the Vanguard FTSE All World Ex-U.S. ETF (VEU), was listed as an alternative.

Small-company fund: T. Rowe Price New Horizons (PRNHX) is an actively managed fund, one of the few actively managed funds they selected, and is “one of the most efficient of the actively managed crowd.” Considering it is actively managed, an expense ratio of 0.8% is pretty good, about half the average.

Value fund: Oh look, another Vanguard fund - the Vanguard Value Index (VIVAX) and its 0.2% expense ratio and a record that trumps 78% of its peers. Value funds go after investments that appear overlooked or beaten down and try earn a little off those cigar butts and dividends, rather than looking for growth potential.

High-quality bond fund: Vanguard Total Bond Market Index (VBMFX) snags this category with a 0.2% expense ratio. Bonds are good to be the rock in your portfolio to give you some grounding as your other investments shoot up and crash down.

Inflation-protected bond fund: This last category was won by Vanguard’s Inflation-Protected Securities Fund (VIPSX) and it’s 0.2% expense ratio (Vanguard’s index funds are ridiculously efficient). “Among TIPS funds, Vanguard Inflation-Protected Securities has several things going for it, including lower costs and better management than you would get if you assembled your own TIPS portfolio. While the fund returned 6.6% over the past five years, you shouldn’t expect it to make a pile of dough. Its job is to protect the money you already have.”

Earlier this year I discussed how I was going to follow Flexo’s lead and open up a Fidelity Charitable Gift Fund. The idea behind the Fidelity Charitable Gift Fund is that you can make a charitable donation now, have the assets appreciate, and then decide where donations will go later on. Much like how a mutual fund is actually an organization, the Fidelity Charitable Gift Fund is an organization. When you donate money, you are donating to the Fidelity Charitable Gift Fund and you have two options as to where the money goes. You can either open up a Giving Account under your name (or any name you wish) or open up a Pooled Income Fund.

Giving Account

This is the type of account Flexo talked about and one that I was seriously considering. What you do is open a Giving Account, contribute funds, direct how the funds are to be invested, and then recommend grants. You will notice that all the documents say that you will “recommend” which organizations will be the beneficiary of your funds, but they aren’t legally bound to honor your wishes. I think that specific language is used for legal purposes but they honor most recommendations.

Pooled Income Fund

This is the second option and one I hadn’t considered. It’s part charitable fund and half income generation, akin to an annuity, though the final payout goes to a charitable organization (up to 10). So let’s say you contribute $10,000. You direct where the contributions will be invested and you can select up to two beneficiaries. Each quarter, the proceeds from your investments will be paid out to the beneficiaries. Upon the death of the final beneficiary, the value of the account goes towards charities. It’s different than the Giving Account and less desirable for what I’d like to accomplish.

Considerations

So, it sounds pretty easy right? Why wouldn’t everyone do this? (these concerns cover only the Giving Account)

• Initial limits and fees: The initial contribution has to be greater than $5,000 and each additional contribute has to be greater than $1,000. The fees include the expenses of the investments plus an Annual Administrative Fee. The administrative fee is the greater of 0.60% of the total fund value or $100 for the first half million, 0.3% for the second half million, 0.2% for the next million and a half, and 0.15% for the rest up to five million. Beyond that and the fees are different. If you were to contribute $5,000, you’d be talking an administrative fee of 2% plus the underlying investment fees. If you don’t have $5,000 or you don’t want to pay any of these fees, you might want to just donate directly to a charity.
• Time horizon: Since you do select investments for your contributions, there is the potential that your investments will lose value. So, if you plan on doing this, contribute funds you think you might want to use next year or the year after (or, ideally, in five years). Increasing the time horizon will smooth out the random walk of the stock market.
• Tax benefit: As much fun as it would be to have the Jim Charitable Trust, the tax benefits are better if you contribute appreciated stock. When you donate appreciated stock that you’ve held for over a year, you can deduct the entire value of the stock from your income, including the appreciation. (For more on that, read this article about reducing your capital gains by donating stock) With the Giving Account, you deduct your initial contribution and not the amount actually granted, so you never actually benefit from the appreciation (but you can donate appreciated stock).
• Grant exclusions: Almost any recommendation you give will be accepted with the exception of several groups, though there are very good reasons. For example, you cannot recommend any donation that would result in you receiving any sort of gift or preferential treatment. The list is available here.

I’ll be honest, the idea of opening a small charitable gift fund in our name does sound like fun and it would be great to be able to leverage the market to help further our philanthropic goals but with a $5,000 start price and those annual fees, I may wait a little while before opening one up. The uncertainty of the market (and a short time horizon) are also serious considerations as well… what do you all think? Good idea? Bad idea? Wait? Go now?

Need to absolutely reach your brokerage right now? Here’s a handy resources of all the brokerages I am aware of, their phone numbers, hours of operation, and a link to the brokerage’s contact page. On that page you’ll usually find a Fax number, overnight mail address, regular mail address, email addresses, and sometimes even an online chat. In many cases, there are multiple telephone numbers listed, I chose the one for existing brokerage clients (if that’s not what you need, just hit up the link and you’ll find the whole list).

Did I miss your brokerage? Let me know and I’ll add their phone number.

Nashawn recently asked on my post about opening a Roth IRA right this minute for some advice as to how she should invest $500 with a Roth IRA. She’s looked at Vanguard’s mutual fund accounts and ran into the minimum balance requirement for each of the funds. At Vanguard, the STAR Fund has the lowest minimum balance with $1,000 - a good $500 more than what Nashawn has at the moment. If I were her, this is what I’d do…

Wait Until April 15th Next Year
You have until tax day next year to contribute to your Roth IRA this year. That is, you have until April 15th, 2008 to contribute to your Roth IRA for 2007, giving our heroine a good nine months to try to get her balance up to $1,000. This is predicated on the fact that you are sold on Vanguard’s mutual fund accounts.

Consider Another Brokerage
You don’t have to go with Vanguard and you don’t even have to go with their mutual fund account, with a regular brokerage account your account balance minimums are lower than $3,000. TradeKing, Sharebuilder and Zecco are atypical brokerages that don’t have account minimums and both are known for their cheap/free trades. That’s crucial for a balance of $500. TradeKing has no custodial fee but Zecco charges $30/yr and Sharebuilder charges $25.

When it comes to the bigger brokerages, your pickings get slimmer. Fidelity will waive their minimum of $2,500 if you can commit to a $200/month contribution (Fidelity has no annual fee). If you can commit to that, you might as well wait a few months and go with Vanguard (if you wanted).

Summary: If you’re sold on Vanguard and can wait, wait; otherwise there are plenty of other options out there whether you want a discount brokerage like TradeKing or a more traditional name like Fidelity, just keep an eye out.

If you know of any brokerages with low account minimums and low annual fees for Roth IRAs, please share!

Do you have a Roth IRA? If so, excellent job, you’ve already done one of the best things you could probably do to ensure you have a financially viable retirement. If not, why not? If your excuse isn’t, I make more than $110,000 and thus am not allowed to contribute, then your excuse is not good enough.

Don’t have enough time? It takes literally fifteen minutes. Do it while you’re watching American Idol or CSI: Saturn. Fifteen minutes. You spend more time getting dressed in the morning. Go to Vanguard, or Fidelity, or TD Ameritrade, or Etrade or your favorite brokerage firm. (I even linked to the Open Account page to save you a few seconds)

Don’t have enough money? Did you know that if you contributed $4,000 (max for 2006 and 2007) right now and it appreciated at a mere 7% for the next twenty years, you would have $15,478.74? While that doesn’t sound like a lot of money, 7% is a relatively conservative number for your investments. If you were to instead use 11%, you’d have $32,249.25. If you were to stretch the time out thirty years at 11%, you’re talking $91,569.19 - all from a single $4,000 contribution right now.

Now, ignoring all those crazy appreciation numbers, remember that you don’t have to contribute all $4,000. You can contribute $1,000 or $100, but you need to contribute something. (I’d argue that you want to contribute as much as you can to avoid low balance fees but $1,000 is better than $0)

Afraid you’ll need the money? Since your Roth contributions are after-tax contributions, you can withdraw those contributions whenever you want. Dire emergency and you have no choice but to raid the Roth? You can still do it. You can still change your mind.

Opening a Roth IRA is ridiculously easy and it’s not something to be afraid of. Don’t be afraid you don’t have enough money and instead challenge yourself to find a way to save a hundred bucks a month and at the end of the year you’ll have $1,200 saved away (worth $27,470.76 in thirty years at 11%) that you didn’t think you had. You have until April 16th to file your taxes this year so you have until April 16th to open up a Roth IRA and contribute to it for 2006. Go! Do it!

Thinking about investing in some securities? Well you’re going to need a brokerage account. While it’s hard to compare the qualitative differences between each brokerage, it’s easy to compare one of the big quantitative differences - fee schedules. So, below I’ll compare the fee schedules of each of the major brokerages in easy to understand language and hopefully it’ll make your decision just that much easier. In the discussion below, I only talk about online trades - no phone or in person (broker-assisted) transactions.

TradeKing - Two time winner (2007 and 2006) if Smart Money’s best discount brokerage award, TradeKing leads the pack with its $4.95/trade commission schedule. I have yet to hear any bad things about this brokerage.

TD Ameritrade - TD Waterhouse and Ameritrade recently combined to form TD Ameritrade and they lowered many of their fees. Market and limit orders are $9.99 regardless of your trading frequency. I use TD Ameritrade for my Roth IRA because they have the lowest fees of the brokerages I looked at (at the time).

ETrade - ETrade recently acquired BrownCo, which had $5 real time trades, and they have a tiered fee schedule. If you have less than $50k and trade fewer than 29 times a quarter, it’s $12.99 each. If you make over 1500 trades (wow), it’s only $6.99 each.

Vanguard - Known for the performance of their mutual funds, Vanguard has pretty hefty fees. An online trade costs a whopping $25, or 0.025 per share (whichever is greater). My Roth IRA used to be at Vanguard but I felt the interface was a little too dated (slow, clunky), they may have since improved it (they’ve overhauled their website). My SEP-IRA is here because I can invest in Vanguard funds.

Fidelity - Also known for their mutual funds, second only to perhaps Vanguard, Fidelity has $19.99 trades in a tiered schedule as well.

ShareBuilder - Sharebuilder is a little different than the other brokerage houses, the idea with them is that you’re constantly investing small amounts, dollar cost averaging, in various securities. It’s $4 if you schedule your purchases (always onto a Tuesday) and it’s $15.95 if you want real time trading (all sales are real time). Limit orders are $19.95. I would not recommend ShareBuilder for anything other than for a long term investment plan in which you want to dollar cost average your positions. Also, ShareBuilder has been known for having a lot of free money promotions (follow the link for an explanation on how they work and for promotional codes).

Did I leave out your favorite brokerage firm? Let me know and I’ll add them to the list.

There has been some interest in an explanation of how the Vanguard Target Retirement Funds work since I mentioned them in an explanation about Mutual Funds in a past article (read The Beauty of Mutual Funds). In this article, I’ll give you a little explanation of how these funds work and what you might expect from them (past performance is not an indicator of future performance!).

They’re in the asset class titled “Lifecycle” by Vanguard and several other brokerage houses have very similarly structured, lifecycle mutual funds (Fidelity has the Fidelity Freedom Funds if that rings a bell). The concept is as the target date draws closer, the fund will invest in increasingly stable investments that have higher yields. Vanguard recommends the lifecycle funds for those seeking “an all-in-one retirement portfolio that automatically grows more conservative as their expected retirement date nears…”

In looking at the fund’s performance and yield, the trend behaves as you would expect. The Retirement Income (which you would purchase if you are already retired) has the highest yield of 3.75% and the lowest average annual total return of 3.96%. The Retirement 2045 (the one with the farthest horizon) has the lowest yield at 1.34% and the highest average annual total return of 9.12%. The remaining funds trickle in between the two at rates you’d expect given the risk characteristics of the funds. And performance since inception? The same trends you’d expect are reflected with the Income coming in at 6.85% and the 2045 coming in at 15.79%.

The Target Retirement funds are simply holdings, in varying percentages based on risk tolerance, of other Vanguard funds. The table below is a percentage of holdings as of 1/31/05 of several of the funds.

As you can see from the table, the Income and 2005 are more conservative than the 2045 and even the 2045. The first two don’t touch Europe and the Pacific while the 2045 has nearly 20% overseas.

So we’ve talked about their performance, but what about their expense ratios? Each one clocks in at 0.21% to 0.22%, which is low, about on par for index funds. Look at the Vanguard 500 Index Fund has an expense ratio of 0.18%, you can be pretty confident that Vanguard isn’t fleecing you on fees for these Retirement funds. Now, these funds are “Funds of Funds” which in some cases may mean the expense ratio listed is charged on top of the expense ratios of the underyling funds. This is not the case with the Target Retirement funds, the expense ratio is the weighted indirect expense ratio. There is a footnote in the prospectus that does state “Although the Fund is not expected to incur any net expenses directly, the Fund’s shareholders indirectly bear the expenses of the underlying Vanguard funds in which the Fund invests.”

Again, if you are interested in these or other Vanguard funds, request a prospectus! Read all about it before you invest and see if they’re for you. And please don’t read my views on these funds as a recommendation to buy into them, I’m just boiling down all the facts available on Vanguard’s site in one easy place. And I invite one and all to comment on my thoughts of the Target Retirement funds (too conservative even with the 2045?) and look forward to them.