Investment by Default

Al Jacobs

Welcome to the world of investment. From the beginning of human civilization, dating back to 8,000 B.C. or thereabouts, as the last of the glaciers receded and the climate approached what it is today, we Homo sapiens began to fashion our lives with an eye to the future. Those persons in the Middle East, bordering the eastern Mediterranean Sea, the Caspian Sea and the Persian Gulf, were the most technologically advanced in the world. During this period – the Neolithic Age – they learned to cultivate grains by deliberately planting seeds, arranged to supply plants with water, found ways to prevent foods from spoiling, and experimented with preparation methods.

To safeguard their agricultural areas, groups banded together for mutual protection and the embryos of cities began to form. Almost at once, individuals came to depend upon on one another in various ways, with the practice of barter becoming common. The more industrious among them soon learned to arrange their affairs in the most advantageous ways, and with that the concept of investment was born.

Ten thousand years are behind us. Although our technological progress has been phenomenal, certain principals remain the same. We continue to depend upon one another for many of life’s necessities. And the more industrious among us, who learn to arrange their affairs in the most advantageous ways, become successful investors. It’s this subject I intend to address, for there’s an investment technique developed by the financial advisory industry which the vast majority of Americans now choose to employ, but which I contend is not in most investors’ best interests.

Presume you’re investment-minded with a desire to build an estate to insure your retirement years will be free of financial worry. Look closely at the opportunities presenting themselves as this second decade of the 21st Century draws to a close, and select the investments you hope will prove profitable. You needn’t look to the nation’s banks to provide the acceptable flow of interest on savings or certificates of deposit they once offered. They’ve discovered they can commandeer the public’s funds, for which they need pay next to nothing. And with interest still at historically low rates, returns on both corporate and municipal bonds can only be described as mediocre.

In the hope of becoming a landed entrepreneur, rental real estate is always an option. I’m sorry to report, however, it’s not a trouble-free occupation. Unless you’re able to devote a lot of time, attention, and money to your acquisitions, you’ll not fare well. It’s for this reason only the more aggressive among you choose to take this route. There are, of course, some of the heavily promoted offerings: annuities – if you don’t mind paying heavy fees as your assets are tied up for years; the purchase of tax liens – an exercise in uncertainty; timeshare opportunities – guaranteeing abysmal results; and a variety of cleverly promoted programs promising only disappointment.

This now brings us to the universally acceptable investment: corporate securities – foisted off on America by the investment advisory industry … which I term investment by default. It involves a device described as an open-end investment company, more commonly referred to as the mutual fund. Since formation of the first such company in the United States in 1924, acceptance by the public grew to become universal. Quite simply, a mutual fund controls a pool of money provided by its shareholders that it invests in a portfolio of securities selected by the fund's managers. Over the years they proliferated like mushrooms, with over eight thousand registered funds in existence at the start of the millennium – vastly more than the number of companies found on the New York Stock Exchange. They exist in near-infinite varieties offering almost every conceivable mix of securities. For the potential investor with both limited expertise and assets, this type of investment vehicle seems to meet two important criteria: astute selection of securities and advantageous portfolio diversification.

In more recent years the favored choice is the index fund – a concept devised in 1975 by John Bogle, founder of the Vanguard Group, wherein each fund mirrors the same securities as its index, such as the Dow Jones Industrial Average or the S&P 500. Inasmuch as no expertise is required in selecting favored stocks or bonds, minimal fees and established indices facilitate their aggressive sale to an accepting public.

Though in theory the index fund meets intended needs, theory and reality do not coincide. My primary concern is, if the securities making up the components of a portfolio are not selected by experienced analysts, their performance will be a matter of pure happenstance. The best to be hoped for is they somehow average out much the way the overall market performs. I don’t consider this to be enlightened investment.

With what I believe to be a haphazard approach to fund selection, it’s understandable why promotion of the index fund is now an exercise in pure marketing. The financial planning hierarchy, which has wrapped the fiduciary concept into its program in an attempt to eliminate all brokerage competition, is using every technique possible to convince the general public its future is in good hands.

A typical representation of a long-term retirement prognosis will be intermixed with a casual comment that the average annualized total return for the S&P 500 index over the past 90 years has been 9.8 percent … this, after jokingly referring to the mandated warning that "Past performance is no guarantee of future results." The implication of the quoted percentage is to suggest an investment in the index fund offered will produce a similar return. The fact is, however, the typical long term index fund return arranged by a financial planner produces no more than about 3½ percent annually for the investor.

The reason for the relatively poor performance of the typical index fund investment, as compared to its index, is fundamental. The index is the compilation of the chosen securities; its annual profit or loss is merely the sum total of each of them. The index pays no fees, incurs no taxes, nor does it engage in any transactions affecting its profitability. It’s a purely theoretical concept with no outside forces acting upon it.

The index fund, on the other hand, is everything the index is not – bristling with charges, as each individual fund in the portfolio assesses a periodic management fee. When a financial advisor is involved, another repetitive fee is added to the mix. You may add to that the cost of rebalancing, which is the process of realigning the weightings of a portfolio of assets. Rebalancing involves periodically buying or selling assets in a portfolio to maintain an original desired level of asset allocation. This naturally results in a taxable capital gain which is passed on to the investor for payment each year.

In the prior paragraph I stated the funds are “bristling with charges.” I’ll give you just a hint of what this means. A major distinction is made between load and no-load funds, the former being commissions charged to the buyers that run as high as 8½ percent of the purchase price. However, many no-load funds incorporate other equally objectionable fees. These include redemption fees, often known as back-end loads, to be paid when the shares are sold. A variation is a deferred charge when shares are redeemed within a certain number of years, known as a deferred load. Another goodie is the 12b-1 plan, permitting a fund to confiscate up to 1¼ percent per year of the fund's assets for marketing purposes. As you might guess, fees are limited only by the imagination of the fund management, with the details buried in boiler plate disclosures.

As a final word, I’ll leave you with this advice: The way to participate in the securities market is through specific stock choice – the method I chose some years ago when I took charge of a securities portfolio. Instead of acquiring funds, I selected individual companies in healthy industries with a history of stable or increasing earnings, with a generous portion regularly passed on as dividends. I preferred companies with reasonably low price-earnings (P-E) ratios, and reviewed the portfolio every several months so to dispose of those no longer meeting the criteria.

Though I solicited advice from a seasoned Merrill Lynch stockbroker, and paid occasional buy and sell commissions, I hired no advisor and paid no perpetual fees. The system worked well and the portfolio of stocks and bonds appreciated nicely over the 21 years I oversaw them. You could certainly do far less favorably – and sadly, most investors do.


Al Jacobs, a professional investor for nearly a half-century, issues weekly financial articles in which he shares his financial knowledge and experience.You may view it on



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