What are Index Funds?

According to Bill Schultheis, author of The Coffee House Investor, active managers constantly and consistently underperform the stock market average for two main reasons:

First, the stock market average is already very efficient. In a broad sense, the market does reliably well. The better it performs, finding ways to “beat” it proves more challenging to near impossible.

Second, your “managed” investment will suffer from substantial annual expenses, which, of course, reduce your total return.

Since the stock market average has historically provided an already-exceptional investment return, odds are that when you try to beat it, you will fall below it. And what a shame that is to the investor who could have easily spent far less, both financially and mentally, to return the relatively superior stock market average.

What’s the solution? A passive investment approach that aims for the stock market average by using unmanaged index funds.

It’s simple.

stock index fund is an unmanaged mutual fund that owns equity in all participating companies in a stock market index. Instead of stock-picking, you invest in every stock. By doing so, investors are able to most reliably secure the approximate stock market average in their returns. There’s no need for management (besides passive quarterly inspection/infrequent rebalancing according to preferred asset allocation), because a piece of every stock is purchased. This eliminates the burden of active stock-picking or hiring a “professional” to do so—and consequently enhances your quality of life significantly.

Moral of the story? History shows that investing in the creativity of all human beings equally is actually more profitable, on average, then investing with a mutual fund manager who promises to beat the stock market by selecting the “best” companies to invest in. It also happens to be simpler, less time-consuming and stress-inducing, and much cheaper to do so by means of low-cost, unmanaged stock index funds.

As a final note, consider Pascal’s Wager and its wisdom here; would you rather invest in the entire market to secure a comfortable return that beats most mutual fund managers, foregoing great returns accompanied by great risk, or invest selectively with “professionals”, aiming for great returns, yet most likely falling short of the average? The choice is yours.

 

Key Takeaways

  • Active managers constantly underperform the stock market average return because the stock market is already very efficient and their fees and expenses reduce your total return.
  • Low-cost, passive index funds are the easiest and most cost-effective vehicles for returning the stock market average
  • stock index fund is an unmanaged mutual fund that owns equity in all participating companies in a stock market index, thereby approximating the stock market average in its return
  • These index funds are “passively managed” because, besides infrequent monitoring and annual rebalancing according to preferred asset allocation, investors never have to manage these funds.

 

Munir Gomaa is a 3rd year dental student with a passion for personal finance, self-improvement, and human psychology. He can also be found blogging at munirgomaa.com

 

Click here for related post, “Understanding the Market.”

Understanding the Market: Part 1

[editors note: We are starting a new series entitled “Personal Finance 101″ to act a primer for various personal finance topics so as to build a foundation for you that you can then use to navigate “Muslim-friendly” approaches. Enjoy!]

Discover the key to stress-free, reliable, and successful investing

What if I told you that the “best” stock investment advice—meaning the safestsimplestmostreliable, and most successful advice, according to over an entire century of data—that you can find is completely free? What if this advice could be easily applied to your entire portfolio without the help of an active manager?

Wall-Street wants you to believe that this is complete and utter nonsense. That’s because Wall-Street’s actively managed mutual fund industry’s profitability—and in turn, its clients’ financial decline, depends on you ignoring this advice.

You see, the active mutual fund manager’s profitability does not necessarily correlate with your own, despite their employment obligation to convince you otherwise. Let’s make everyone’s objectives clear:

Your goal: to receive a significant, reliable, net positive return on your investments in the stock market to supplement your portfolio, “beat” inflation, and secure a comfortable retirement.

Their goal: to maximize assets under management (AUM), because the more of your assets being regularly “managed”, the more fees and transactional expenses they receive directly from your pocket. This, on average, lowers your return by 2% (2010 Bernstein, The Investor’s Manifesto), meaning that if your portfolio returned 10%, you’ve only acquired 8%.

Sure, these active fund managers will spend their busy work schedules trying to analyze interest rates and predict future company earnings to pick the “best” specific stocks, industries and mutual funds. They use past performance, of course, to make these predictions. But history has shown us time and again that past performance in mutual funds has little to do with its future performance, and that stock-picking to beat the “stock market average” is a nearly hopeless mission. In fact, at the time The Coffee House Investor, by Bill Schultheis, was written, 86% of active mutual fund managers failed to beat the stock market average return in the three, ten and fifteen years prior (1998 Schultheis, The Coffee House Investor).

What exactly is the “stock market average”? It’s the averaged collective return of all publicly traded companies included in any particular index (i.e S&P 500). The return realized from the good companies and the not-so-good companies altogether. And guess what? This collective “average” historically outperforms most actively managed mutual funds.

In general, the stock market average reliably outperforms 75-85% of all actively managed mutual funds. 

The logical implication here, of course, is that the wise investor should aim to return the stock-market average–nothing less, nothing more. As it turns out, doing so is also the simplest and least stressful way to invest, and it is done via low cost, unmanaged index funds.

 

Key Takeaways

  • Your financial and retirement goals are not in alignment with Wall-Street’s goals
  • Your goal is to maximize investment returns and secure a comfortable retirement
  • The goal of an active mutual fund manager is to manage as many of their clients’ assets as possible to maximize fees and transactional expenses, lowering their clients’ returns significantly
  • Past performance of mutual funds or individual stocks has little to do with future performance, and trying to beat the stock market is comparable to gambling
  • The stock market average, the averaged collective return of all publicly traded companies included in any particular index, historically outperforms actively managed mutual funds
  • Wise investors should aim to receive the stock market average in their returns

 

Click here for Part 2.

 

Munir Gomaa is a 3rd year dental student with a passion for personal finance, self-improvement, and human psychology. He can also be found blogging at munirgomaa.com

On First Principles

To start investing there are a few prerequisites that though deceptively simple, are absolutely essential. Unfortunately, the majority of people have trouble with these basics. But you are here because your are not the majority of people, and if you are able to put these in to practice and stick to them, you financial health will be off to a great start.

1) Spend Less Than You Earn aka Act Your Own Wage.

There is a famous line from the book David Copperfield written in 1850 by Charles Dickens that has come to be known as the Micawber Principle. It is named so after the character in the book Wilkins Micawber who gives the advice, but is himself unable to live it. Micawber advises:

“Annual income twenty pounds, annual expenditure nineteen pounds nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds nought and six, result misery.”

Understandings and applying this principle is the first key to any degree of financial stability. It is the foundation of personal financial success. If you cannot follow it, you may as well stop reading here as nothing else matters. Yes, it may not always be easy-as the character Wilkins Micawber proves (initially) by being unable to follow his own sage advice-but it is absolutely critical. Spending less than you earn consistently, over time is the only entry point to any true semblance of financial freedom. Again, it is hard, and that is because it requires self-discipline, which is never easy, even more so in our current culture in which self-discipline is little to be found while spending and rampant consumerism is advocated at every turn. Always remember, saving too much simply can’t be as harmful as saving too little.

“Spending is More Important than Income – The difference between financial happiness and misery isn’t how much you make (annual income is twenty pounds in both scenarios) but in spending less than you make.  I think we can all agree that more income is better than less, but if we use our income as an excuse for not living the Micawber Principle we will likely find we cannot live it no matter how much we make.  The key is to discipline ourselves to live within our means now and then widen the gap between income and spending as we make more.” –The Micawber Principle Blog

2) Develop a workable plan.

Do it thoughtfully. Write it down. Your primary job as an investor is deciding on your asset allocation. Figure this out with your age and risk tolerance. Start by gaining some basic financial literacy by reading to allow you to do this thoughtfully. Will it take some time investment? Yes. Much time investment? No.

 

3) Start early.

The earlier you start, the better your potential future returns will be, exponentially. Even if the amount you start with seems small, because it is invested early that small amount will have more value than larger amounts invested later.

Returns compounded at 8% per annum. Taken from boglehead.com

4) Keeps costs low

Just as starting early can exponentially improve your returns, fees can reduce your gains exponentially. When you hear the words stockbrokers, brokerage firms, advisors, think one thing: “fees.” Fees are one of the few variables you can truly control, thus one must pay careful attention to the fees they are being charged and make an active and intentional effort to minimize them whenever possible.

 

5) Minimize Taxes (legally)

Just like reducing fees, doing this properly can result in huge savings. It is important to take note that there is a difference between tax avoidance, which is “the legal usage of the tax regime to one’s own advantage, to reduce the amount of tax that is payable by that are within the law,” and tax evasion, which refers to evading taxes through illegal means. Investing time to learn tax basics and being more tax-conscious can go a long way. For most people, some self-education and good tax software will usually suffice, although for the few with more complicated situations, a knowledgeable CPA is likely worthwhile. For investing purposes, for most it will come down to knowing which type of accounts are most appropriate for which type of assets.

 

6) Stay the course

You have done your reading. You have carefully scrutinized your finances, reduced your spending, and sat down and formulated a plan for yourself. You have gone through the logical reasons of why your plan makes sense for you and are convinced. The most important thing now is to stick with this plan. Most well-informed, thought out, reasonable investment plans work with minimal differences in ultimate return. Why do most people still fail at achieving their desired goals then? The problem is you. Yes you. You are your own worst enemy. Despite all the initial logic and reason that go into thinking through a plan, we are all easy prey to emotion. One has to be constantly vigilant to avoid getting side-tracked by emotion and making mistakes. You have convinced yourself that your plan works over the long term, so always be on guard to stick to it and learn to filter out all the short-term noise.

“Always remember, though many will still fall for it time and time again, there’s no such thing as a free lunch. Risk and return are inextricably related. High returns cannot be gained without losses along the way. You cannot achieve perfect safety without dooming yourself to low/negative returns. You are not trying to get lavishly rich, but rather avoiding aging poor. Remember, in the long term it is about direction, not speed. […] The promise of high returns with low risk is a reliable indicator of fraud.” -William Bernstein, The Investor’s Manifesto

Spend wisely. Educate yourself. Reign in your impulse and emotion when making financial decisions. Remember that your goal is not to became obscenely rich, but to not die poor and be able to care for your own needs as you age. Avoid scams and high fees. Invest wisely. How exactly do you going about doing this? We hope this site will help clarify that for you, even if just a little.

On a closing note, I leave you with this quote, also from Dr.Bernstein:

“Teach your children well; the most important financial bequest you make to your children will not be monetary, but rather the ability to save, invest, and spend prudently.”

The Asset Allocation Predicament: Part 2

So now that we have established what a tried and true portfolio looks like, we are left with the problem of what to do about the bond allocation of such a portfolio. While there are many similar variations of different reasonable portfolios out there, they all include bond allocations. What is the observant Muslim investor to do?

We can start by quickly reviewing why bond allocations are generally recommended to have in a portfolio. As discussed previously, you want an allocation of a stable asset  in your portfolio so that volatility is reduced. This will provide stability to your portfolio during bear markets when your stock allocation takes hit, preventing behavioral errors (selling off stocks) when large losses are hard to stomach. It also provides stability to your portfolio during your retirement/withdrawal years.

Now most people have recommended bonds as the asset to reduce volatility. However, as long as we have an asset that has some of the above mentioned characteristics, there’s actually no absolute reason we have to be limited to bonds. We want an asset that 1) reduces volatility 2) has low correlation to stocks. Additional hedges are a bonus.

Correlations of various assets. Courtesy of aaii.com

Let’s examine a few options. Perhaps real estate truly provides the best alternative, particularly with it’s steady stream of rental income.. However, except for those with very large amounts of capital, to enter the real estate investment world without financing is essentially impossible. There do exist financial products to allow the individual investor to take part in larger real estate ventures (REITs), and these have been argued to be an inflation-hedge, however, these use financing for their purchases, which again puts them in Haram Risk murky waters. Furthermore, REIT’s are strongly correlated to stocks. In terms of diversification, you want to own asset classes that not only are uncorrelated or weakly correlated.

How about ‘sukk,’ which are being presented as ‘shariah compliant bonds.’ These essentially will function just as bonds and as such obviously provide an adequate, if not near identical, substitute. However, the jury is still out on this and most would likely consider this an aggressive play in terms of Haram Risk.

Another option is precious metals, particularly gold. It is the ultimate hedge against currency inflation. Gold has a low correlation to stocks, in fact even less so than bonds. In fact, it has little to no correlation to any asset and this low correlation with other assets gives it a great diversification benefit.It is also a ‘crisis hedge,’ as any time there is fear, whether of inflation, paper assets losing their value, government default, or real estate collapse, people tend to turn to gold because it retains its value.  Again, gold can be regarded  as a store of value (without growth), as oppose to say stocks which are regarded as a return on value (growth from anticipated real price increase plus dividends). At the very least, gold can help one avoid the problem of keeping one’s wealth in cash, which essentially results in one’s wealth being taxed via inflation. Granted, gold will at times have sharp movements in price and can take a long time to mean revert (return to its true value), usually do to speculation and perceived ‘crisis moments’ as mentioned above. However, as long as one is willing to see it through and hold on to it as a long term play while staying disciplined and benefiting from rebalancing bonuses all the while, should ultimately only be noise.

While lagging stocks, beats short-term treasuries. Courtesy of mypersonalfinancejourney.com

It is for these reasons that gold wins out as our best alternative for constructing a sound portfolio for the observant Muslim investor. Stay tuned for further details on how to construct such a portfolio.

Related Posts:

The Asset Allocation Predicament: Part 1

The Asset Allocation Predicament: Part 1

The most important part of a portfolio is asset allocation. This refers to an investment strategy that aims to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio according one’s risk tolerance and time horizon, among other factors. The three main asset classes are equities (such as stocks), fixed income (such as bonds), and cash. Each of these has different levels of risk and return and are expected to behave differently over time. How one determines to allocate his or her assets is always very personal as it will depend largely on your individual time horizon and your ability to tolerate risk.

One of the main reasons that asset allocation is so important is to reduce the risk inherent in volatile equity asset classes (stocks) that are expected to provide higher returns by combining these asset classes with more stable fixed-income assets (such as bonds). In a nutshell, stocks are expected to perform better given enough time (often decades), but will have big ups and downs (volatility), while bonds are expected to have lower returns over the long run, but these returns are stable.

You may be thinking that if ultimately stocks will have a higher expected return, why not just invest in 100% stocks. There are a number of reasons for this, however the two main ones are avoiding behavioral errors and ensuring a stable income stream in withdrawal years.  Having fixed-income assets in one’s portfolio will reduce volatility of one’s portfolio better enabling an investor to maintain a long term investment program (stay the course) without panic selling during bear markets (down markets). Everyone thinks they can weather a bear market, until they experience one and see large losses in their portfolio. Also, by having an allocation of a stable asset volatility is reduced which provides stability during your retirement/withdrawal years. You never know the length of a recovery after a down market, and if after a down market a recovery takes 10 years but you are planning on retiring in 5, you may be in trouble.

Figuring out how what the best mix of assets is something called “portfolio theory.” Now this may all sound complicated, but devising a successful portfolio turns out to be actually rather simple. In fact, if you were to compose your portfolio 2 funds, a Total World Market index fund and Total US Bond fund, you would beat 90% of professional money managers. All that would be left to do is ‘rebalance’ once a year or so.

Rebalancing involves buying and selling to return to your desired allocation percentages. This results in you taking advantage of the opportunities as the markets shift in and out of favor, inevitably buying low and selling high. For example, if your desired allocation percentage for stocks is 70%, but that portion of your portfolio has shrunk to 60% because the stock market is experiencing a downturn (low stock prices), you end up buying these stocks at low prices to bring back the allocation to 70%.

How do you figure out what percentage your allocations should be at? The old rule of thumb used to be that you should subtract your age from 100 and that’s the percentage of your portfolio that you should keep in stocks, the rest in a fixed income asset. For example, if you’re 30, you should keep 70% of your portfolio in stocks and 30% in bond. If you’re 70, you should keep 30% of your portfolio in stocks. However, with people living longer and longer, many financial planners are now recommending that the rule should be closer to 110 or 120 minus your age. That’s because if you need to make your money last longer, you’ll need the extra growth that stocks can provide.

While there may be specific tweaks and variations depending on one’s individual situation, as long as you stick to the basic principles of starting with a higher percentage of riskier/higher expected growth assets and moving towards more stable/lower volatility assets as they near retirement, you will do well.

Now that you’ve gone over this basic overview, it should be pretty clear that for the average investor, this a very straight forward and tried-and-true plan to financial stability (as long as they can stick to it). Unfortunately, for the Muslim investor, the obvious problem here is the High Haram Risk bond allocation. So what is one to do? We will begin to tackle that in the next part of this series.

 

Further reading:

The Oblivious Investor: Asset Allocation and Risk Tolerance

Bogleheads Wiki: Never bear too much or too little risk

William Bernstein on Asset Allocation

Bogleheads Wiki: Lazy Porfolios

The Coffeehouse Investor

 

Related Posts:

The Asset Allocation Predicament: Part 2

Haram Risk Analysis

In this post, we will survey the Haram Risk of various modern financial instruments. Is this mostly subjective? Yes, absolutely. There is not any absolute metric we can use to determine these ‘ratings,’ rather we are measuring the various categories relative to themselves. In a way, you could say we are using a gold standard, no pun intended.

Precious metals: No Risk

Fiat currency: Minimal Risk

Stocks: Low Risk *

Shariah-compliant mutual funds: low risk as are guided by principles attempting to screen out high haram risk companies

Index funds: moderate risk as you are investing in the entirety of the market, it is bound to include high haram risk enterprises within it

REITs: moderate risk as are usually heavily leverage (aka high debt)

Savings Accounts/Bonds/CD/Treasury Notes: High Risk**

Futures: High Risk

Short-sales: High Risk

 

* In and of themselves, a low haram risk vehicle. Of course, what type of company one is investing is what alters things.

** Why high risk and not flat out haram? First, we are not in the business of declaring halal versus haram, rather simply providing a layperson opinion on the risk based on established concepts. Secondly, the reality is, as often mentioned on this site, is that modern finance is complicated and Muslim understanding of it is still catching up. For example, some believe that interest should be allowed up to the value of inflation, to compensate lenders for the time value of their money, without creating excessive profit. Also, there have been innovative attempts at shariah-complaint ‘profit-sharing savings accounts

Haram Risk Reduction

For anyone who participates in any way in the modern financial system, some form of uncertainty exists regarding the halal-compliance of nearly all transactions. Whether they be investments, banking products, contracts- or essentially all financial dealings for that matter- some ambiguity always remains. While an unpleasant thought, it is a reality. Want to create a balanced-asset retirement portfolio? Those bonds involve blatant interest. Avoiding that by only dealing with (more volatile) securities/stocks? Those companies likely deal in some non-halal friendly product (gambling, alcohol, tobacco, etc…). Going one step further and avoiding this pitfall by investing in a shariah-compliant fund that avoids such companies? You are unfortunately still dealing with significant interest indirectly, as practically every corporation either has conventional debt and also issues its own bonds and preferred stock. Well, what if you avoid all investments and just work and keep my money in cash you might ask. Again, your employer invariably deals in debt for finance-structuring (yes including hospitals for the healthcare workers out there). And the biggest kicker? Even money itself is intrinsically tied to interest and debt in the modern fiat currency system.

So unless you live on a farm, deal strictly in precious metals, provide your own utilities, and avoid any financial dealings with society at large, the situation is unavoidable. This is not necessarily to say everyone is doing something wrong, rather that we all consciously or unconsciously assume some form of haram risk. One can certainly live in denial, come up with complex legal-gymnastics, or even decide these tenants are outdated and not relevant to modern times and disregard them altogether. It is our opinion that is best one be a realist and face these difficult challenges head-on. Yes, the ongoings of today’s international financial system that are in many ways in conflict with our principles are nearly inescapable. We accept this rather than shy away from it, but at the same time understand that we, as individuals and as a community, should also be actively and creatively findings ways to avoid our haram exposure. And that, in a nutshell, is Haram Risk Reduction. This will be an on-going theme of this site as we try to help you (and enlist your help) in finding pragmatic solutions to help you and our community achieve a genuine financial peace of mind and spirit.

An Idea

Navigating the complexities of  wealth management, investments, retirement planning, and personal finance in today’s world can be a daunting task. Throw in the added layer of trying to do all this while adhering to Muslim financial principles and this task becomes exponentially more complex. This site was created not only to provide you with information and advice to help make that process easier, but it was made also to build a community around that very process, as such a task requires an organic, fluid, and collaborative approach. We hope you find the content beneficial and look forward to your input.