Get Rich Slowly

By Jason Zweig; Benjamin Graham Tuesday, July 08, 2003
    • ILLUSTRATION FOR TIME BY DIETER BRAUN

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    Above all, you should trust your adviser enough to permit him or her to protect you from your worst enemy — yourself. "If the adviser is a line of defense between you and your worst impulsive tendencies," says financial-planning analyst Robert Veres, "then he or she should have systems in place that will help the two of you control them." Among those systems:

    --A comprehensive financial plan that outlines how you will earn, save, spend, borrow and invest your money;

    --A statement that spells out your approach to investing;

    --An asset-allocation plan that details how much money you will keep in different investment categories.

    These are the building blocks on which good financial decisions must be founded, and they should be created mutually rather than imposed unilaterally. You should not invest a dollar or make a decision until you are satisfied that these foundations are in place and in accordance with your wishes.

    How to Pick a Mutual Fund
    Large funds, soundly managed, can produce at best only slightly better than average results over the years. If they are unsoundly managed, they can produce spectacular, but largely illusory, profits for a while, followed inevitably by calamitous losses. --Benjamin Graham

    Mutual funds offer investors a convenient way to diversify their stock and bond holdings. But it matters a great deal which funds an investor selects. Most funds underperform the markets, overcharge investors, create tax headaches and suffer erratic swings in performance. What should the intelligent investor do? First, recognize that an index fund — which owns all, or almost all, the stocks in the market, all the time — will beat most funds over the long run. Its rock-bottom overhead — operating expenses of about 0.2% annually and yearly trading costs of about 0.1%--gives the index fund an insurmountable advantage. If stocks generate, say, a 7% annualized return over the next 20 years, a low-cost index fund like Vanguard Total Stock Market will return just under 6.7%. But the average stock fund with about 1.5% in operating expenses and 2% in trading costs will be lucky to gain 3.5% annually. Index funds have only one significant flaw: they are boring. You'll never be able to go to a barbecue and brag about how you own the top-performing fund in the country.

    If you decide to put part of your money into actively managed funds, here's how to recognize the possible market beaters:

    Their managers are the biggest owners. The conflict of interest between what's best for the fund's managers and what's best for its investors is mitigated when the managers are among the biggest holders of the fund's shares. At Longleaf Partners and other firms like Davis and FPA, the managers own so much of the funds that they are likely to manage your money as if it were their own — lowering the odds that they will jack up fees, let the funds swell to gargantuan size or whack you with a nasty tax bill. A fund's proxy statement and Statement of Additional Information, both available from the SEC through the EDGAR database at sec.gov , disclose whether the managers own at least 1% of the fund's shares.

    They are cheap. Decades of research have proved that funds with higher fees earn lower returns over time. Why? High returns are temporary, while high fees are permanent.

    They dare to be different. When Peter Lynch ran Fidelity Magellan, he bought whatever seemed cheap to him at any particular moment — Treasury bonds, foreign stocks, struggling Chrysler — regardless of what other fund managers owned. So before you buy a U.S. stock fund, compare its holdings against the roster of the S&P; 500 index; if they look like Tweedledee and Tweedledum, shop for another fund.

    They shut the door. The best funds often close to new investors — permitting only their existing shareholders to buy more. But the closing should occur before — not after — the fund explodes in size and becomes difficult to manage. Some firms with an exemplary record of shutting the gates are Longleaf, Numeric, Oakmark, T. Rowe Price, Vanguard and Wasatch.

    They don't advertise. The best fund managers often behave as if they don't want your money. They don't appear constantly on financial TV shows or run ads boasting of their No. 1 returns. The Torray Fund, for example, has never run a retail advertisement since its launch in 1990.

    What else should you watch for? Most fund buyers look at past performance first, then at the manager's reputation, then at the riskiness of the fund and finally (if ever) at the fund's expenses. The intelligent investor looks at the same things — but in the opposite order. Since a fund's expenses are far more predictable than its future risk or return, you should make them your first filter. There's never a good reason to pay more than these levels of annual operating expenses, by fund category:

    --Taxable and municipal bonds: 0.75%
    --Large and midsize U.S. stocks: 1.0%
    --High-yield (junk) bonds: 1.0%
    --Small U.S. stocks: 1.25%
    --Foreign stocks: 1.50%

    Next, evaluate risk. In its prospectus (or buyer's guide), every fund must show a bar graph displaying its worst loss over a calendar quarter. If you can't stand losing at least that much money in three months, go elsewhere. Finally, look at past performance, remembering that it is only a pale predictor of future returns.

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