Whether you're a DIY investor or work with an advisor, here's my list of six investments that can derail your wealth.
Why am I putting out this list?
I want to help you avoid mistakes while investing your money. You work hard for it.
Presumably, you're investing it to accomplish a goal (you are, right?).
I want to share what I believe are investments that can throw you off track and, over an extended period, cost you a bundle.
I'm sure I'll ruffle some feathers with my list. So be it.
I've helped a lot of people get out of some of these investments over the years and seen the damage they can cause.
I haven't ranked or listed these in any specific order.
I've listed in the order they came to my mind. There's nothing scientific about that!
I will say this, though. All of these products have one thing in common.
Sorry. You're going to have to read to find out what that is.
So, here we go.
1. High-cost mutual funds
Virtually every investor, whether you're a DIY investor or work with an advisor owns mutual funds or ETFs (Exchange Traded Funds).
No-load funds offered by Vanguard and other companies have put pressure on the active funds to lower their fees. Everyone benefits from lower costs.
The average fee for passive, index funds is around 0.20%. Many ETFs have fees under 0.10%.
Keep in mind that international funds are more expensive to run and will have higher expenses than their U.S. fund counterparts.
The chart below from Nerd Wallet shows the impact of fees on returns.
In a 30-year period, you would lose $210,700 if your mutual fund expense ratio was 1%. Don't let your advisor or anyone else talk you into high-cost funds.
Now, do you see why reducing fees is so important?
2. Variable annuities
It's one of the highest commission products brokers and advisors sell. The YTB (yield-to-broker) is often higher than the YTC (yield-to-client). Sales commission on these products run from 4% to 7%.
If you want to get money out early, you have the privilege of paying a surrender charge. Typically, these surrender charges are on a declining scale over several years.
That's the way the insurance company recoups the money they've paid to the advisor and their firm.
Here's how it might work.
If there's a five-year surrender period, the highest charge might be 5% in the 1st year. That fee would decline by 1% a year until it's gone.
A seven-year surrender period would start at 7% and would decline in the same manner.
Fees pay for benefits argument
Variable annuities have fees that traditional mutual fund investments do not.
Because there is a death benefit included, they charge a mortality and expense fee that can range from 0.40% to 1.75%.
Most people who purchase variable annuities do so to get the income guarantees. Fees for this guarantee can add another 0.40% to 0.75%.
Since most variable annuities invest in mutual fund type subaccounts, there is yet another layer of fees that can range from 0.40% to 1.75% and even higher. Add it all up, and your costs can approach 3.50% to 4% or even higher!
That's a huge drain on returns.
In most cases, these same mutual funds can be purchased outside the annuity from the fund or an advisor for a much lower cost. Insurance companies often tack on an additional fee to these funds (called sub-accounts inside an annuity).
After the 2008 financial crisis, some insurance companies stopped offering guaranteed income. Others either raised the costs for the income guarantees or made offers to buy out the existing warranties for contracts where they were losing (or going to lose) money.
To my knowledge, the companies honored these promises. However, many substantially raised the fees charged for them.
Here's an August 9, 2012 article from Forbes that talks about this mess – Variable Annuities Look to Bail on Guarantees.
In most cases, the death benefit offered in these annuities isn't worth the cost. Most would be better buying term life insurance. That's especially true for younger investors. Costs for insurance rises as we get older.
Term insurance for those who are older may not make sense or be affordable.
If you want guaranteed income, my advice is to buy an immediate annuity when the time comes.
I don't see the benefit of these for most people.
3. Permanent life insurance
Like variable annuities, brokers receive commissions based on the initial deposit. Permanent life insurance is the mother lode of all commissionable products.
Brokers receive up to 50% or more of your first-year premiums. The result is a much higher surrender cost over a much longer time (usually ten years).
I'll give you an example of one of my clients.
When he asked me to review his insurance, his agent proposed a whole life policy with annual premiums of $20,000 a year.
(An aside – another agent suggested a $50,000 yearly premium with the same concept!)
The client already had $3 million in term insurance between his law firm and individual policies. The same agent sold him the individual policies.
The reason for the additional coverage? A private pension concept.
The concept is you put in these large premiums with the idea that over an extended period of premium payments, the cash value in the policy would grow to large amounts.
When you needed the money for retirement, college expenses, or anything else, you would take out policy loans to fund it.
Loans from cash value insurance policies are tax-free. Sounds great, right?
Costs for permanent life insurance
If you break down the costs of permanent life insurance, it's made up of the cost for the death benefit (the insurance), the administrative costs, and any riders.
Riders are additional benefits available to add to the policy.
As the cash value of the policy increases over time, the amount of insurance cost decreases.
The amount at risk for the insurance company reduces. Many people get confused over this.
The death benefit does not include the cash value plus the death benefit. The death benefit is part of the cash value.
So, as the cash value increases, they are at risk for less money.
Let's say you buy a $500,000 death benefit policy. In the first year, the company is at risk for the full $500,000.
If in ten years, the cash value is $100,000, the company is only at risk for $400,000.
The longer you keep paying premiums, the better it is for the company.
If you borrow against these policies and die before paying back the loan, the amount of the unpaid loan reduces the death benefit accordingly.
To be fair, there are some conditions where this type of insurance makes sense (estate planning, buy-sell arrangements, partner insurance, etc.).
The risks are often not understood or explained well. There is a minimum premium required to keep the policy going.
Many times these contract got sold with the idea of a limited payment period for premiums. Agents (brokers) projected returns that were too high.
The higher returns meant that premium payments could stop at an earlier date.
In the bull market years, these returns seemed realistic.
I'm not saying agents and brokers exaggerated returns to make the sale. I'm sure some did.
In many cases, those selling these products didn't have a good understanding of how the policies worked.
When returns didn't match the projections, insureds had to either pay more premiums, reduce the death benefit, or let the policies lapse.
These are complicated products that are difficult to understand by the best of us. Costs and risks can be quite high, as can the consequences.
For the average consumer, I don't see they make sense.
4. Alternative investments
Another commission juggernaut for advisors who sell them is alternative investments.
When I started as a stockbroker in the late eighties, these products, in the form of limited partnerships, were the hottest thing going.
Commissions on them averaged 8%, in a few cases more. Selling stocks and bonds paid you from 0.5% -0 1.0% commission.
Brokers did whatever they could to get these products into the portfolio of their clients.
‘At that time, these investments consisted of oil and gas programs, real estate partnerships (commercial and residential), and things like land development.
There were tax advantages to many.
Nowadays, these investments have a broader range of investments like macro funds, long-short funds, arbitrage funds, managed futures, and many more.
Most of these direct investments are still limited partnership.
These investments are incredibly complicated. The prospectuses are like books. They have layers and layers of interests, and significant fees to pay for them all.
The most common fee structure is what's called a two and twenty. Investors pay 2% of the amount they invest as an ongoing fee and give up 20% of the profits (if any) of the investment.
So, for the privilege of investing in these, you lose 20% of the gain. A 10% gain is now 8% (in simple terms).
Many use high leverage (loans) to increase returns. Risk also increases with leverage.
Though the industry boasts of high returns, the facts don't bear that out.
They have longer holding periods (6 – 10 years) with limited access to your money. Many offer windows to get out cash, usually with limits to a small percentage of your original investment.
If you're an accredited investor (see What an Accredited Investor is?) and can invest directly into a project of your choosing, you could probably do better.
Here's a success story from my blogger friend over at xrayvsn.com. Xray is a doctor and an accredited investor. Notice, though, that his success comes from a direct investment in properties via a private placement.
For most people don't waste your time.
If you aren't familiar with the term, an IPO is an initial public offering. IPOs happen when companies sell their stock to the public for the first time.
When people view IPOs, they think about the great success stories like Facebook, Google, Apple, and others. Here's a list of the 10 of the Biggest IPOs in History.
Here's the problem. These are the exceptions, not the rule.
You see media coverage of these stories and lots of follow up coverage as well.
What investors often miss is the news of people losing their shirts in these investments.
The strategy for most who invest in these companies is not to own the company. Instead, it's to make a quick buck and move on.
Like many of these offerings, institutions hold all the cards. They and their best clients get first access to these.
By the time it gets to the retail investor, there are limited shares available and the price may have gone up because of increased demand.
Hopefully, if you invest in these stocks, you're only putting in money you're willing to lose.
Looking for a quick hit in an IPO is, to me, a form of gambling. Gambling can be addictive.
If you believe in the company and want to own it for the long term, by all means, invest in it. Chances are you will have the opportunity to buy it at a lower price than the IPO price after the initial excitement is gone.
It may be a stretch to say this can derail your wealth. I included it because I've seen people lose a lot of money trying to hit the big winner.
My advice? Stay away from them.
6. Liquid alternative investment funds
Liquid alternatives are mutual funds that invest in similar investments to hedge funds.
The selling point they give is that every day, non-accredited investors gain access to the same investments the big boys have.
Investments might include long-short funds, arbitrage funds, managed futures. etc., similar to the more traditional alternative.
They are in a mutual fund format, which allows investors to withdraw money at its current market value.
These products proliferated after the Great Recession of 2007 -2008.
The chart below shows the growth.
Almost any stock or fund from any industry, sector, country or region, dropped in value. The bond funds investors held lost value as well.
Conventional wisdom at the time was that these liquid alternatives would protect against a significant drop in stocks. They would zig when stocks zagged.
But at what cost?
According to this article from Pensions & Investments, the average internal costs for multimanager liquid alt funds averaged 2.6%. Compare that to the 0.20% for passive funds and even to the 1% fees for active funds.
That's a tremendous difference and a drag on performance. See that in the chart below:
You can get diversification for a lot less money.
Steps to investment success
I'd suggest adopting these three rules looking at investment options.
- If you don't understand an investment, don't put money into it. Too many times advisors convince people to invest in complicated investments with the promise of higher returns or greater downside protection or some other supposedly compelling reason. They'll bring out charts, graphs, and reports showing how the investment “would have performed” if it existed during various time periods. Like most statistics, the data integrity matters. And backtesting is not the most reliable resource. Why do you think every investment product on the planet comes with the disclaimer “past performance is not guaranteed future results will be the same or similar” or something to that effect?
- If it sounds too good to be true, it likely is! There are no guarantees when investing in stocks, bonds, mutual funds or ETFs. If someone promised returns that are significantly higher than market returns, walk away. Too many people get lured into crazy investments with the promise of pie in the sky return claims.
- Keep it simple. Many (not all) advisors are salespeople. In many cases, their firms gave them more hours of sales training than investment and financial planning. And they're often very good at it. Buying high commission or high fee products is rarely suitable for the investor. Remember the YTB vs. YTC. If you're working with an advisor, make sure they're operating in your best interest.
In case you haven't figured it out yet, the one common theme (except for IPOs) for these six investments is high investment costs. That's one of the things over which we have complete control.
Keeping costs low increases returns.
If you're a regular reader of this blog, you know I believe in market-based, passive funds (index or otherwise). They are among the lowest cost and offer returns that mirror the markets (minus fees) they represent.
Active mutual funds and investors who chase returns, underperform. Don't be among those.
Get what the market has to offer. You'll do better than most investors out there with a lot less stress.
Now it's your turn. Has someone tried to sell you permanent life insurance? Variable annuities? Alternatives investments? If so, please tell us your story in the comments below. We can all learn from each other's experience. Thanks so much for reading.