Traditionally, when you look at the historical return of mutual funds, you are getting what is called a time-weighted return. For example, the 5-year return is what you would have gotten if you bought the fund five years ago and held it continuously until today, all the while reinvesting dividends.

Last year, Morningstar rolled out what it terms the Morningstar Investor Return, otherwise known as a dollar-weighted return. This measures the returns that investors actually achieved in that fund, based on dollar inflows and outflows. It’s actually pretty interesting: If investors as a whole timed their purchases correctly and bought more shares when the fund was low, then their returns would actually be higher than the time-weighted returns. If, instead, investors waited until the fund performed well before buying in, and then sold their shares when the price was lagging, then their dollar-weighted returns would be lower than the time-weighted return. Guess which one happens almost all the time?

To find these numbers, go to Morningstar and type in any symbol in the quote box. Let’s take my very first mutual fund purchase, Janus Mercury (now Janus Research), symbol JAMRX. Then click on Total Returns, and then finally on the Investor Returns tab on the top. You should find this:

Yikes. If you take the 10-year historical return, which includes both the big Tech bubble and crash, instead of the happy 10% annual return number most people see, the average investor actually lost 2% annually during this period. They tried to time it, and lost tons of money in the process. (I was one of them.)

Now, don’t think this performance chasing doesn’t apply to index funds. It does. Check out the Investor Returns for the classic Vanguard S&P 500 Index Fund, VFINX:

Not quite as bad, but the average owner still lagged the fund’s performance by over 1% a year. What do we learn from seeing these Investor Returns?

Making a decision on which mutual fund to buy based on past performance is simply not a good idea. What happens when the performance starts to lag? Since you’re making decisions based on past performance, then you’re probably going to find another fund that’s been doing well recently, and then jump on that ship instead. It’s just a never-ending cycle of losing money.

This is why when I am looking at mutual funds to purchase, I completely ignore recent performance. I couldn’t tell you the recent returns of any of my fund holdings. The things I do look at are – the asset class and what index it follows, the expense ratio, and the tax efficiency. Maybe the fund minimums too, but that’s it.

(I also ignore the Morningstar Star rating system as I think it’s pretty useless as well, but that’s another post.)

2. Volatility matters. Buy-and-hold works… if you hold! You keep hearing that people shouldn’t own too much in stocks if they can’t tolerate the risk. You can see why by viewing the Investor Returns on the more volatile funds. They stink! According to this CBS MarketWatch article, the funds with the greatest relative volatilities had dollar weighted returns of just 62% of time-weighted returns.

When people see ups and downs on the Great Stock Market Ride, as a whole they are horrible at timing when to get on and when to get off. When (not if, when!) the market crashes again, people who aren’t prepared will panic and get off the ride. But when will they get back on? The result is lost money.

Here, the lesson is that even if you do plan on sticking with index funds, you must remind yourself during the rough patches that staying the course will be most profitable in the end.

I decided to open a brokerage account with Zecco.com. This is not going to be my main brokerage account just yet, but I do plan on using it. (I’m going to revive my Play Money account, for those that have been reading for a while. More on this later.) For now, since I think a lot of people are curious about this account, here are my experiences with the account itself.

Introduction: Why open a Zecco account?
Two words: Free Trades. As of 10/1, they offer 10 free market/limit trades per month, if you have $2,500 in total account equity (stocks + cash). There is no minimum balance to open, but if you have under $2,500 trades will cost $4.50. Finally, with no inactivity fees it seems like a great account even for someone who doesn’t trade frequently. Some other brokers offer free trades, but none with such a low balance requirement. There is a $30 annual fee for IRAs.

Why wouldn’t you open a Zecco account?
This is also simple – free trades aren’t everything. Zecco has been around almost a year now, and I don’t see Chuck Schwab declaring bankruptcy. Trust and customer service are big. Can Zecco execute the trades in a timely manner, and can the online interface and customer support match the other brokerages? (Or at least come close enough.) Hopefully, this review will help answer some of these questions.

Also, can they make enough money off of ads and margin interest to stay in business? If not, you’ll be faced with a $50 transfer-out fee and possible commissions elsewhere if you need to sell.

Opening Process Overview

1. Sign up for your MyZecco account. It is important to note that there are two parts to the Zecco website. First is the myZecco layer, which a more informal area that allows you to post on blogs and forums without an actual trading account. They will actually e-mail you this username and password, which I think is fine because no financial information is included in this layer. You don’t even need to enter your name or address.

2. Apply for a trading account. This seemed like a pretty standard brokerage application. One thing to note is that you may want to apply for a margin account, even if you don’t plan on trading on margin (borrowed money). Here’s why:

In a cash account the proceeds of a sell order will not affect your buying power until settlement, which is T+3 (trade date plus three business days). To avoid this situation you may want to consider establishing margin on your account. With a margin account the proceeds of a sell order will update your buying power immediately. To establish a margin account you can request it at the time you open your account or if your account is already established you can complete the Combined Customer Agreement Form…

3. Wait for application approval. You’ll get an e-mail saying that your application is approved, mine arrived the next morning. You will get information on how to set your Trading Key. This separate password gives you access to the second part of the Zecco website, the Trading area. This layer is a secure encrypted area and does contain sensitive information. I wouldn’t make your Trading Key the same as your myZecco password!

4. Send in your new account paperwork and copy of government ID. You should mail this in as soon as possible, as without it they will assume that you are subject to backup withholding. (Update: Now, it appears they have implemented system that allows most people to get their paperwork processed electronically.)

Still, you need to make sure it is processed before you can start trading. To check, log into your trading account at myInfo tab > Customer Info > Outstanding Paperwork. You want it to say “No” as shown below:

5. Fund your account. If you want to fund online (which is what I did), you need to first link up your bank account first if that’s how you will be making your deposit. The popular 2-small-deposit verification system is used, and takes a couple of days to show up. Other ways to fund include via check or bank wire.

6. Request money market sweep. By default, free cash in your account only earns 1% APR. But you have the option of setting up a money market sweep account by sending in this form. There are three options by Scudder Investments, and I think the symbol for the taxable money market is CSAXX, currently with a 4.38% yield. Why they don’t make this higher yield the default in the first place is beyond me. 😕 The Treasury Money Market option might be a good bet for those with state income tax rates.

7. Next Steps. After you fund and your paperwork is processed, you should be ready to trade. I’m currently waiting on my opening deposit to arrive, and will report back once I’ve done more with the website and maybe made a few trades. Here are some things I’ve noticed so far:

– The administrative back end of Zecco is clearly provided by Penson Financial Services, as it looks identical to the back end of MB Trading, another broker that I have used which is popular amongst active traders. This actually provides me with some familiarity, although the contrast between the “Web 2.0-style” Zecco website and the bare-bones Penson interface is very stark and makes the site overall feel a bit unpolished.

– Zecco does not receive payment for order flow. All orders are routed and executed by Penson Financial Services. Hopefully this will lead to good fills.

– Zecco is insured by the SIPC, like most other brokers.

– You can set up dividend reinvestment if you wish, although you can’t buy partial shares:

Dividend reinvestment is a feature that is available to our clients and can be setup during the account opening process. If you would like to add this feature after the account opening process is complete, you must submit the request in writing to our customer service department.

For the rest of my experiences, see the second part of my Zecco Review.

Navigation
Zecco Review, Part 1
Zecco Review, Part 2

With Vanguard recently launching their new bond ETFs, I can almost reconstruct my entire portfolio of Vanguard mutual funds using their equivalent ETFs instead. While they won’t work well for everyone, I am glad that Vanguard is offering this option to the public. Here are some index mutual funds and their ETF counterparts:

The ETFs certainly have an advantage in expense ratio if you don’t have the $50,000 needed to buy the Admiral shares of each fund. On average, the savings is 10 basis points, or 0.10%. That’s $10 a year on a $10,000 account, or $100 a year on a $100,000 account. In addition, the ETFs allow you to get around the minimum initial investments, as well as avoid the $10 per-fund low-balance fees, $10 per-fund IRA fees, and the purchase/redemption fees of many of their mutual funds.

In the disadvantage department are possible premium/discounts to NAV, the bid/ask spread, and commission costs. Vanguard even offers a cost-comparison calculator that takes many of these things into account.

The only ETF missing for me is their International Value fund, but I could replace that with the WisdomTree International SmallCap Dividend Fund (DLS).

Free Trades + ETFs = Cost-Saving Opportunity?
Right now, Zecco.com offers free trades with an account value of $2,500, while Wells Fargo offers free trades with an account value of $25,000. (Bank of America’s offering stinks, so I’m ignoring it.) Buying these ETFs with free trades would take away much of the traditional advantage of mutual funds.

Before I would switch to ETFs, my concerns include whether these brokers can sustain giving out free trades, and how good the customer service is. If they fail, would I keep paying slightly higher commissions on ETFs, or sell them all and go back to mutual funds? Something to ponder.

(You know what? I just figured out that Zecco stood for Zero Cost Commissions. No, I’m not the sharpest tool in the shed.)

Dividend Reinvestment Plans, or DRIPs, are programs that allow individuals to buy stock directly from the company, with dividends from the stock being automatically reinvested into more shares. Here are some popular companies that have DRIPs and also see the Wikipedia entry on DRIPS here.

DRIPs often charge no commissions, so if you set up a DRIP for General Electric (GE) and committed $50 per month, every penny of that would go towards buying $50 of GE, even if it meant buying a partial share. Dividends also get reinvested for free. The main startup costs involve buying one share through a broker and then transferring ownership to your name. This all made them a good alternative to using a broker and paying for every trade.

Do it yourself? Start with less than $100? No commissions? Sounds like something I’d go for. In fact, I don’t participate in any DRIPs. The main reason is that I’m really not interested in buying any individual company stock right now. DRIPS are meant as a very long term commitment, and I just don’t trust any one company to perform well for the next 30 years. On top of that, the accounting required to keep track of the cost-basis for all your shares sounds like a nightmare. Besides, I think there are better alternatives out there:

With just $50 a month, these days you can go through a company like T. Rowe Price or TIAA-CREF and invest in a low cost mutual fund that is diversified across hundreds of companies. It’s so easy a caveman could do it. 😉

If you have at least a few thousand dollars, there are now brokers that offer free trades like Zecco and Wells Fargo. I bet there will be even more to come in the future.

If you are waiting until the last second to fund your 2006 IRA, you’re probably not alone. Maybe you are still confused about choosing between a Roth or a Traditional IRA. Here’s an interesting fact: If you assume that your tax rates will be the same now as they are in retirement, the amount you end up with is the same whether you use a Traditional or Roth IRA. This is independent of time length and expected return

Let’s assume an annual investment rate of return of 8% for the next 30 years, and a marginal tax rate of 25% for all years. Let’s also say that you only have $1,500 of after-tax ($2,000 gross pre-tax) income to put away right now.

If you went with the Roth IRA, you pay your 25% tax on the $2,000 now ($500), but no taxes upon withdrawal:

If you went with the Traditional IRA, you don’t have to pay tax on the $2,000 right now, but you’ll be taxed upon withdrawal:

See how they are the same? The only difference is that you are able to put away “more” in a Roth IRA since the limits are $4,000 for either one. $4,000 post-tax in a Roth IRA is like putting away $5,333 in a Traditional IRA in this scenario. This ability to shield more money from taxes is why I chose to contribute to a Roth IRA. Now, if you change your assumptions about tax rates, that’s where you may start leaning more towards one or the other.

How good is the tax benefit?
Remember, either IRA saves you tax at least once. If you just kept it all in a regular taxable account, you would be subject to a tax on any dividends or realized capitals gains every year. Let’s see what happens to your $1,500 then. Taking the best case scenario of investing in stocks with only dividends being taxed and having no capital gains to deal with until you sell 30 years later, we’ll assume that the 8% annual return is broken down into 6% appreciation and 2% dividends. If the 2% in dividends are taxed at 15% each year, your after-tax return in 1.7%. If those dividends are reinvested:

At the end of 30 years, upon selling you’ll have a long-term capital gain of $13,885 – $1500 = $12,385. You pay tax of 15% on that: $1,858, leaving you with $13,885 – $1858, or $12,027.

With these simplified assumptions, using an IRA made you over 25% more money than if you didn’t use one. If you invested in any bonds, the difference would be even greater. 25% is huge! Imagine ending up with $500,000…. or $625,000. Which one would you rather have? This is why IRAs are a great opportunity to make your money go farther.

See here for some specific mutual fund ideas, part of my overall investing recommendations.

(This is not a comprehensive Roth vs. Traditional IRA post – There are just so many variables like the ability to take out principal without penalty, ability to use balances for a 1st home, required minimum distributions, and easy of inheritance to consider.)

Here’s another article by Jonathan Clements that I enjoyed – How Good People Make Bad Investments from the Wall Street Journal. It points that some traits that help us success in other parts of our lives actually hurt our investing performance.

For example, you would like to think the more energy you put into researching and trading stocks, the better your returns would be. But the research and historical data simply doesn’t support that. Here are some excerpts:

Athletes who train hard are more likely to win. Students who study conscientiously are more likely to get good grades. What about investors who diligently research their stocks? They’ll probably earn mediocre returns.

The fact is, the markets are full of savvy investors, all hunting for cheap stocks. Result: If there are any bargains to be had, they don’t stay that way for long. Indeed, much of the time, share prices are a pretty good reflection of currently available information.

“If you put in more effort, you’ll end up with worse results,” reckons Terry Burnham, co-author of “Mean Genes” and director of economics at Boston’s Acadian Asset Management. “It’s not the work. It’s the action that comes out of the work that’s the problem.”

Every time we buy a supposedly bargain-priced stock, we incur commissions and other trading costs. In addition, if we trade in our taxable account, we may trigger big tax bills, further denting our returns.

[…]

Your index funds will simply replicate the performance of the underlying markets, minus a small sum for fund expenses. Sound dull? You may be more excited when you look at your results — and you realize they’re so much better than those earned by optimistic, hard-working active investors.

In an interview on the website TheStreet.com, Jim Cramer of Mad Money fame talks about how he and other hedge fund managers can manipulate stock prices for easy profit. Check out the video, it’s very enlightening:

Although this actually aired online a few months ago, he’s now getting heat from various media sources that recently discovered it – including articles from USA Today and the New York Times, which provide a nice recap:

Cramer described how he would make bets that gave the impression knowledgeable investors were predicting a stock’s future. Cramer said everything he did was legal but added that illegal activity is common in the hedge fund industry, where regulation is lax.

Cramer said some hedge fund managers spread false rumors about a company to large trading desks and the media to drive a stock price lower. He said this practice is illegal, but easy to do “because the SEC doesn’t understand it.”

He also said Research In Motion and Apple are easy targets.

Mr. Cramer said he had used some of the tactics himself, including lying to ?bozo? reporters to get them to report misinformation on particular stocks. He singled out CNBC?s Bob Pisani. He separated legal activities from illegal ones (such as ?fomenting?), and never quite says he ever took part in the latter.

Let’s take a step back here. Cramer openly admits that he and others can manipulate the markets by spreading misinformation. And people actually watch his show for investing tips?!? Somebody’s getting rich, but it ain’t his viewers… Yet another reason not to trade stocks in the short term.